Is US Federal Debt too High or too Low?

The rapid growth in US government borrowings has created increasing concerns. Even before the COVID-19 pandemic, investors were worried about the escalating level of US federal debt. After a brief period of decline in the 1990s, Federal debt has been on a steady upward trend for most of the 21st century.

So, the pertinent question is whether the US federal debt level is too high or too low?

There continues to be a disagreement as to whether the federal debt is too high or low. It depends on two different viewpoints.

One point of view, and the more popular one, centers upon using the US federal debt as a percentage of the US GDP. The reason why many consider this to a proxy for the health of the US economy is over the long-term, the federal debt depends heavily on the size of the US economy.

The federal debt as a percentage of Gross Domestic Product reached 100% in the years following the Great Recession (2007-2009). Last year's historic pandemic relief US government spending caused the already-elevated federal debt to jump sharply by more than 25%, pushing the US government debt level as a percent of US GDP to a record high of 135.64% by mid-2020. Some consider a debt level above 100% of the annual US GDP high. While others believe this level is too high. Nonetheless, by Q3 2020, the US debt level has contracted slightly to 127.28% of US GDP.

See the attached long-term chart from the FRED (Federal Reserve Bank of St. Louis – Economic Research) for further information. A review of the government gross debt levels as a percentage of GDP for several key G7 countries also confirms rising global debt trends. For instance, Japan's gross debt as % of GDP has jumped to 236.57% (2018). Italy's gross debt as% of GDP has also risen to 134.80% (2019). See the enclosed chart for a comparison of the different G7 member debt levels.

The second and the less common view centers upon the total US public debt as a percentage of GPD multiply by 10-year Treasury Constant Maturity Rate/100. The alternative metrics show how much total US debt costs as a share of the overall US GDP. During Q4 1994, US debt peaked at a high of 5.05%. Emboldened by historically low-interest rates, it has since then fallen precipitously to a record low level of 0.83%. As all US debt is not in 10-year Treasuries, and the issue dates of different US government debts differ within the portfolio, some believe the overall US debt may be too low.

Over the near-term, the soaring federal debt may not be such a concern because the FED has dramatically lowered the cost to borrow by reducing the FED funds rate down to a range of 0%-0.25%. Historically the near-zero interest rate is favorable for the government as they pay its bondholders less in interests. Also, because the FED has guaranteed a market for Treasuries, they can reduce the yield the government needs to offer to entice outside buyers (i.e., international investors, institutional investors, and foreign central banks).

However, when the US economy begins to recover, the FED will likely look to raise rates to fight rising inflation. Over the longer-term, rising interest rates and higher interest payments will hurt the US economy. Lower government spending may result in cutting back on infrastructure investments and other capital expenditures. And when the government spends and invests less in the economy, growth tends to suffer.

In summary, it is not if the US federal debt is too high or too low. It is relative. When the US economy recovers, then US interest rates will begin to rise. When US interest starts to trend much higher, it will lead to higher US debt levels, triggering an economic contraction and the next recession.

Source: Courtesy of FRED (Federal Reserve Bank of St. Louis – Economic Research)

Source: Courtesy of FRED (Federal Reserve Bank of St. Louis – Economic Research)

Source: Courtesy of FRED (Federal Reserve Bank of St. Louis – Economic Research)

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