A million simulations, one verdict for US economy: Debt danger ahead
The Congressional Budget Office warned in its latest projections that U.S. federal government debt is on a path from 97% of GDP last year to 116% by 2034 — higher even than in World War II. The actual outlook is likely worse.
From tax revenue to defense spending and interest rates, the CBO forecasts released earlier this year are underpinned by rosy assumptions. Plug in the market’s current view on interest rates, and the debt-to-GDP ratio rises to 123% in 2034. Then assume — as most in Washington do — that ex-President Donald Trump’s tax cuts mainly stay in place, and the burden gets even higher.
With uncertainty about so many of the variables, Bloomberg Economics has run a million simulations to assess the fragility of the debt outlook. In 88% of the simulations, the results show the debt-to-GDP ratio is on an unsustainable path — defined as an increase over the next decade.
The Biden administration says its budget, featuring a slew of tax hikes on corporations and wealthy Americans, will ensure fiscal sustainability and manageable debt-servicing costs.
“I do believe we need to reduce deficits and to stay on a fiscally sustainable path,” Treasury Secretary Janet Yellen told lawmakers in February. Biden administration proposals offer “substantial deficit reduction that would continue to hold the level of interest expense at comfortable levels. But we would need to work together to try to achieve those savings,” she said.
Trouble is, delivering on such a plan will require action from a Congress that’s bitterly divided on partisan lines.Republicans, who control the House, want deep spending cuts to bring down the ballooning deficit, without specifying exactly what they’d slash. Democrats, who oversee the Senate, argue that spending is less of a contributor to any deterioration in debt sustainability, with interest rates and tax revenues the key factors. Neither party favors squeezing the benefits provided by major entitlement programs.
In the end, it may take a crisis — perhaps a disorderly rout in the Treasuries market triggered by sovereign U.S. credit-rating downgrades, or a panic over the depletion of the Medicare or Social Security trust funds — to force action. That’s playing with fire.
Last summer provided a foretaste, in miniature, of how a crisis might begin. Over two days in August, a Fitch Ratings downgrade of the U.S. credit rating and an increase of long-term Treasury debt issuance focused investor attention on the risks. Benchmark 10-year yields climbed by a percentage point, hitting 5% in October — the highest level in more than one and a half decades.
As for how things might end, Britain’s experience in fall 2022 provides a glimpse into the abyss. Then-Prime Minister Liz Truss’s plan for unfunded tax cuts sent the gilt market into a tailspin. Yields soared so quickly that the central bank had to step in to snuff out the risk of an outright financial crisis. The bond vigilantes’ actions forced the government to call off the plan and Truss out of office.
For the U.S., the dollar’s central role in international finance and status as the dominant reserve currency lowers the odds of a similar meltdown. It would take a lot to shake investor confidence in U.S. Treasury debt as the ultimate safe asset. If it did evaporate, though, the erosion of the dollar’s standing would be a watershed moment, with the U.S. losing not just access to cheap financing but also global power and prestige.
Variable variables
How does the CBO, Washington’s official budget watchdog, arrive at its debt forecast? The CBO’s assumptions for crucial variables — GDP growth around 2%, inflation returning to 2%, interest rates drifting down from the current levels — are squarely in the ballpark of plausibility. They’re also not far from numbers in the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters. Indeed, the CBO’s view on rates is a little higher than the most recent consensus.
Examine them closely, though, and key assumptions underpinning the CBO forecast appear optimistic:
- By law, the CBO is compelled to rely on existing legislation. That means it assumes the 2017 Trump tax cuts will expire as scheduled in 2025. But even President Joe Biden wants some of them extended. According to the Penn Wharton Budget Model, permanently extending the legislation’s revenue provisions would cost about 1.2% of GDP each year starting in the late 2020s.
- The CBO also must assume that discretionary spending, which is set by Congress each year, will increase with inflation, not keep pace with GDP. As a result, defense spending falls from around 3% of GDP now to about 2.5% in the mid-2030s — a tall order given the wars currently raging and the geopolitical threats that loom. Former Treasury Secretary Lawrence Summers says a more realistic forecast would add at least 1% of GDP to the CBO’s outlook.
- Market participants aren’t buying the benign rates outlook, with forward markets pointing to borrowing costs markedly higher than the CBO assumes.
Bloomberg Economics has built a forecast model using market pricing for future interest rates and data on the maturity profile of bonds. Keeping all the CBO’s other assumptions in place, that shows debt equaling 123% of GDP for 2034. Debt at that level would mean servicing costs reach close to 5.4% of GDP — more than 1.5 times as much as what the federal government spent on national defense in 2023, and comparable to the entire Social Security budget.
Heavyweights from across the political spectrum agree the long-term outlook is unsettling. Fed Chair Jerome Powell said earlier this year it was “probably time — or past time” for politicians to get going in addressing the “unsustainable” path for borrowing. Former Treasury Secretary Robert Rubin said in January the nation is in a “terrible place” with regard to deficits. From the realm of finance, Citadel founder Ken Griffin told investors in a letter to the hedge fund’s investors Monday that U.S. national debt is a “growing concern that cannot be overlooked.” Days earlier, BlackRock Inc. Chief Executive Officer Larry Fink said the U.S. public debt situation “is more urgent than I can ever remember.” Ex-IMF chief economist Kenneth Rogoff says while an exact “upper limit” for debt is unknowable, there will be challenges as the level keeps going up.
Rogoff’s broader point is well taken: forecasts are uncertain. To put some parameters around the uncertainty, Bloomberg Economics has run a million simulations on the CBO’s baseline view — an approach economists call stochastic debt sustainability analysis. Each simulation forecasts the debt-to-GDP ratio with a different combination of GDP growth, inflation, budget deficits, and interest rates, with variations based on patterns seen in the historical data.
In the worst 5% of outcomes, the debt-to-GDP ratio ends 2034 above 139%, which means that the U.S. would have a higher debt ratio in 2034 than crisis-prone Italy did last year.
Yellen has another way of thinking about debt sustainability: inflation-adjusted interest expense, which she’s indicated she’d prefer to see below 2% of GDP. On that basis, the results are more hopeful — finding that the metric averaged over the next 10 years violates the threshold in less than a third — 30% — of simulations. The Treasury chief herself acknowledged in a Feb. 8 hearing that “in an extreme case” there could be a possibility of borrowing reaching levels that buyers wouldn’t be willing to purchase everything the government sought to sell. She added that she saw no signs of that now.
Partisan politics
Getting to a sustainable path will require action from Congress. Precedent isn’t promising. Disagreements over government spending came to a head last summer, when a standoff over the debt ceiling brought the U.S. to the brink of a default. The deal to halt the havoc suspended the debt ceiling until Jan. 1, 2025, postponing yet another clash over borrowing until after the presidential election.
It’s hard to imagine a U.S. debt crisis. The dollar remains the global reserve currency. The annual and unseemly spectacle of government-shutdown brinksmanship typically leaves barely a ripple on the Treasury market.
Still, the world is changing. China and other emerging markets are eroding the dollar’s role in trade invoicing, cross-border financing and foreign exchange reserves. Foreign buyers make up a steadily shrinking share of the U.S. Treasuries market, testing domestic buyers’ appetite for ever-increasing volumes of federal debt. And while demand for those securities has lately been supported by expectations for the Fed to lower interest rates, that dynamic won’t always be in play.
Herbert Stein — head of the Council of Economic Advisers in the 1970s — observed that “if something cannot go on forever, it will stop.” If the U.S. doesn’t get its fiscal house in order, a future U.S. president will have the truth of that maxim confirmed. And if confidence in the world’s safe asset evaporates, everyone will suffer the consequences.
Methodology
As a starting point for the analysis, Bloomberg Economics uses the baseline fiscal and economic outlook — including the effective interest rate, primary budget balance as a percent of GDP, inflation as measured by the GDP deflator, and real GDP growth rate — from the latest long-term CBO projections.
For the calculation of the debt-to-GDP ratio using market forecasts for rates, we substitute in forward rates as of March 25, 2024, and project future effective rates on federal debt based on a detailed bond-by-bond analysis.
To forecast the distribution of probabilities around the CBO’s baseline debt-to-GDP view, we conduct a stochastic debt-sustainability analysis:
- We estimate a VAR model of short- and long-term interest rates, primary balance-to-GDP ratio, real GDP growth rate, and GDP deflator growth using annual data from 1990 to 2023. The covariance matrix of the estimated residuals is then used to draw one million sequences of shocks.
- We use data on the maturities of individual bonds to map short- and long-term interest-rate shocks to the effective rate of interest paid on U.S. federal debt.
- Using this model, Bloomberg Economics considers two definitions of sustainability. First, we check if the debt-to-GDP ratio increases from 2024 to 2034. Second, we examine if the average inflation-adjusted interest expense, scaled by nominal GDP, over the 10 years from 2025-2034 is less than 2%.
With assistance from Jamie Rush, Phil Kuntz and Viktoria Dendrinou.
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