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Is the U.S. national debt growing out of control? Predicting when or if a tipping point may be reached is difficult (or impossible), but the country faces growing fiscal challenges as its soaring interest burden is heightening concerns about long-term debt sustainability.

To be clear, there is no indication that a crisis is imminent. The U.S. federal government has operated with a deficit for much of its existence, and this has not resulted in significant challenges for either the bond market or the broader economy. That said, the increasingly perilous debt dynamics could eventually create problems without some sort of corrective measures. And it is prudent to examine the scenarios that could play out should it ever get to that point.

What is a sustainable level of yields for U.S. Treasuries? 

Over the past two decades, U.S. debt held by the public has risen from about 60% of gross domestic product (GDP) to nearly 100% today, mainly due to the fallout from heightened deficits following the global financial crisis (GFC) and COVID-19. Forecasts like those from the Congressional Budget Office (CBO) project similar deficit spending for at least the next decade.

Until recently, the U.S. interest burden has remained subdued, despite the deficit, as the ballooning debt stock has been offset by low interest rates. However, the interest burden has begun increasing as interest rates have risen closer to long-term historical levels. Some projections suggest that, by 2050, interest payments on federal debt could double as a share of GDP and take up more than a third of government revenue. While there’s hope that economic growth will outpace real interest rates, this is highly uncertain. If growth fails to stay ahead of interest rates, the debt situation could deteriorate rapidly. When the interest burden exceeds nominal growth, this means that debt would be unsustainable even if governments run balanced budgets. 

Historically, Treasury yields have rarely gone above the interest burden as a percentage of GDP. If interest rates settle modestly below the economic growth rate, that could leave 10-year U.S. Treasuries below 4.5%, absent a large upshift in growth or inflation, although a more significant shock to rates may not be out of the question. 

That said, a crisis sparked by mass flight from Treasuries seems unlikely. The U.S. government’s ability to issue debt exclusively in its own currency and see predictable demand from investors who utilize Treasuries as the predominant safe asset of the world provides a unique level of flexibility. Outside of Treasuries, the investable universe of large, liquid, relatively safe and convertible debt is small.

If the U.S. debt becomes unsustainable, how can it get back on track? 

To reverse a rise in the debt-to-GDP ratio, one of four things would need to occur:  
 

• Higher inflation
• Financial repression
• Austerity
• Higher growth

1.  Higher inflation

If the Federal Reserve allows inflation to run above its 2% target, it could help reduce the debt burden, but this path seems unlikely to solve the problem over the long term. Higher inflation is difficult to maintain politically. Once inflation expectations adjust upward, there would only be a short window to inflate away the debt before interest rates would need to rise to ensure price stability.

In this scenario, the U.S. dollar would be expected to weaken, which would further increase inflation (mainly through higher import prices) and potentially boost exports and economic growth. However, there is a potential limit to how much this may help drive down the debt, as the falling value of the dollar may eventually dent investor confidence in the U.S. and could, at some point, threaten its reserve currency status.

While the context and situations differ sharply from the U.S., Italy allowed for high inflation as a tool to manage its debt after World War II until it joined the euro. The result was currency depreciation, investor flight and stagflation, which led to poor living standards and rising unemployment. 

2. Financial repression 

Financial repression with some combination of implicit yield pegs and debt monetization could be the most likely scenario. The goal would be to keep nominal 10-year yields below nominal growth for an extended period. But this likely only works if inflation expectations remain low, such as in Japan during its quantitative easing era. If financial repression and large deficits lead to higher inflation, the situation could become untenable. 

The Federal Reserve’s ability to maintain stable inflation expectations is crucial. This could be more challenging for the U.S. than it was for Japan. Numerous factors in Japan, such as a higher household savings rate, low wages and a declining population, helped keep consumer demand and inflation low. 

Financial repression implies very negative real yields (due to some form of yield curve control), requiring central banks to swallow up most of the markets, like the Bank of Japan. Such an outcome could lead investors to worry that the Fed has lost its independence, unless the central bank could convince markets that this action was required to maintain financial stability. 

The Treasury can also help with financial repression at the margin by adjusting the maturities of the bonds it issues. The market reaction and this scenario’s ultimate success are likely to depend on whether the market believes any commensurate rise in inflation is transitory.

3. Austerity 

An implicit acceptance of higher inflation, central bank accommodation and ongoing large deficits may work for a while, but ultimately, fiscal restraint could be the necessary end game. But austerity typically only comes after a shock.

Governments do not tend to run tighter budgets unless the market forces them, and these policies usually only come after the central bank and/or the Treasury tries to step in. As stated above, a crisis in the U.S. does not seem likely, but the markets are already periodically testing governments. We’ve seen extremely large standard deviation moves in bond yields in the U.K. and France that forced governments to address debt sustainability. And yields can greatly overshoot a sustainable level before action is taken.

If it comes to this point, austerity would be particularly complicated for the U.S. to implement. Government spending is dominated by Medicare, Social Security and defence, and there appears to be little bipartisan appetite for spending cuts in these areas.

4. Higher growth 

The least painful way to escape the problem would be through accelerated growth and lower inflation. This may seem unlikely, as real rates have been on a structural uptrend and it could take some time for growth to accelerate enough to keep pace. But over the longer term, there could be cause for hope. 

Significant non-inflationary productivity benefits from AI and robotics could take shape with the U.S. potentially leading. If generative AI succeeds, even moderately, nominal GDP growth could rise above CBO projections. Over a decade, this compound growth difference could materially reduce debt-to-GDP ratios. 

If the U.S. maintains or widens its tech leadership, its debt outlook should improve relative to others. If the productivity gap between the U.S. and other countries holds or expands, relative debt burdens would be less concerning. Technological change may also be disinflationary. Historically, major technologies (e.g., electricity, semiconductors) have reduced costs and prices. AI may exert similar downward pressure on inflation. 

That said, if generative AI disappoints or has setbacks, it may also be beneficial for bonds, assuming the U.S. continues to be the global reserve currency and safe-haven asset. If yields fall, it could allow the U.S. to lower its debt burden and potentially extend out maturities again.

Where do we go from here? 

A large increase in the risk premium on U.S. Treasuries seems unlikely, but debt sustainability continues to matter. If the issue comes to a head, inflation and financial repression would likely follow, and austerity could ultimately be the only way out. This all speaks to a higher term premium on Treasuries and/or a weaker U.S. dollar until austerity becomes a real possibility.

That said, there is still reason for optimism. Long-term debt sustainability is fundamentally a function of future GDP growth, not just current deficits. Technological change — particularly from generative AI — could be a primary driver and determinant of growth and thus fiscal sustainability. If generative AI succeeds and the U.S. leads the way, it may be able to keep its head above water.