If you are living in the US, you have generally been hearing a lot lately especially post-election about the ballooning deficit in the US. A few people have asked me about why it matters to the average person, and what are the implications from a personal finance standpoint.Today, I want to attempt to simplify the answers to these questions in a way I normally attempt to do in my blog posts.
What Does a Government Deficit Mean?
Just like individuals or companies, governments have income and expenses. A government’s income comes from taxes, fees, and other sources, while its expenses cover welfare, infrastructure, public services, and more. When income exceeds expenses, there’s a surplus; when expenses exceed income, there’s a deficit. Unlike businesses, governments don’t report profits or losses—they focus on surpluses and deficits.
Countries like Qatar and Singapore have budget surpluses, while others, like the US, Germany, and Japan, run deficits. But is that necessarily bad?
Is a Deficit a Bad Thing?
Not by itself. A government deficit isn’t inherently bad. However, a consistent deficit, especially when paired with a weak economy, can be problematic. Greece’s financial troubles are a recent example. More on that shortly.
How Do Countries Pay for Deficits?
When you and I don’t have enough money, we borrow. Governments do the same. While they may borrow from international institutions like the IMF or World Bank, the most common method is issuing bonds. In the US, these are government bonds.
Is having deficits a problem in the first place? The US continues to have large deficits but nothing seems to be bad there….
As I mentioned above, having sustained deficits have created problems for countries like Greece and Argentina in the past. But they have not yet seemingly become an issue for countries like the US or Japan. Why is that?
Fundamentally, the going theory is two fold – one, if you have an economy that is growing consistently at a rate higher than your borrowing cost, then there should not be an issue. You hear people telling you can borrow money at 4% and if you can invest it and get back 8%, you are doing it right – same concept. Two – if the borrowed money is fundamentally to invest in growing the economy long term, it is generally a good thing and deficits are not a problem (vs spending on expense items like administrative costs). This is a growing area of discussion among Modern Monetary Theory economists. The situation for each country is different so for the scope of this article, I am going to stick to talking about the US.
So why does the US seem to be able to continue to borrow money? Four broad reasons:
- Strong credit worthiness of the US – You speak to anyone in the world and they will always call the US backed securities as one of the safest and risk-free assets. The reason for that is because they know and believe the US will always pay back its debts. Its a global benchmark for a risk-free return.
- Dominance of the US Dollar – The US Dollar is the world’s primary reserve currency still (though there are some events recently somewhat challenging with alternate currencies – but all that still seems a distant reality). Many countries and financial institutions hold US bonds as a way to maintain currency reserves.
- Sophisticated and liquid financial markets – the US bonds can be easily traded in the financial markets and that makes it very liquid.
- Returns – Remember, bonds normally have an inverse correlation to stocks (though as recent as 2022 that was not the case) and hence, the returns have been a good buffer through the cycles. The yield is always lower than stocks but better than putting it under your mattress.
So given all this, what is the problem? Seems like the US can continue to borrow – no issues, right? Well, not really….
Let me share 2 important numbers for you:
- At the time of writing this article in Nov 2024, US 10-year treasury yield is around 4.3%. Back in May 2020, it was around 0.7%! That has been a function of a lot of things that have happened in the last few years and are indirectly influenced by the interest rates set by the FED. But that means the government has to pay investors 4.3% interest today to borrow money.
- At the time of writing this article in Nov 2024, the actual US debt is around $34T. That’s a Trillion with a T btw. Back in 2020, the US debt was 27.7T.
So now let’s understand this – our debt has gone up and the interest rates have gone up. So that means the interest the US has to pay has gone up even more – actually by a lot more! If we use the above numbers, the interest payments alone for the US went up from around 500B in 2020 to around $1.2T estimated in 2024!! Wait a minute! – our interest expense is also in the trillions now??? <Note: the numbers are somewhat estimated for 2024 so they may not be 100% accurate but they are close enough for this discussion>
Below is a visual of how interest payments of US government have gone up for the last almost 100 years.
Now, lets look at another data point. Let’s compare US GDP growth in the last 20 years with the US government spending.
So this means our expenses have been growing at a much larger pace than our income. So it’s no wonder our deficits have been growing and therefore, our debts have been growing.
Irrespective of what happens to interest rates, unless our spending is curbed or our income is increased, this deficit is going to continue to increase. So not only are we not paying off our debts, we are actually increasing it. Only way for the deficit to actually reduce without reducing spending, is for the economy to grow significantly more than what it is currently growing at – probably more than double of the spending %. This is an unlikely scenario – its silly to expect a mature economy like the US economy to consistently grow at around 7% – 8% annually. AI and other changes are expected to bring productivity but nothing that can juice up the economy that much.
And by all indications, spending is going to only continue to increase based on the plans by both the current and incoming political administration in the US.
So what could potentially happen?
If there is no political will to address this, in my mind, it is fairly certain that there will reach a point where interest expenses will continue to rise and become an increasing burden on the US economy. It will take one recession to make things really hard on the US – because tax receipts will reduce, and the deficits will become worse. As this continues, this will slow down public investment as more of the spending continues on interest payments. This will make coming out of recessions harder. It has the potential to become a vicious cycle.
I am not into doomsday conspiracies, and I do believe there are a lot of advantages the US has (as I explained earlier). Maybe the Modern Monetary Theory economists are right, and we can continue to spend our way to growth. But my question simply is why gamble with the fate of the future generations of the US economy? While I don’t envision having zero deficits, I would love to see the US taking some solid steps to help reduce these deficits. That would be a good thing.
What does all this mean for my personal finances?
If you have read this far along, I really appreciate you bearing with me so far. Now comes the ‘What’s in it for me’ part of the article. Ultimately this is a personal finance blog, and my goal is to educate my readers on the economy so they can understand the implications to their personal finances. Here are a few possible negative outcomes to consider:
- Higher inflation – As the government works to borrow more, they have to ‘print’ more money leading to an increase in money supply which will lead to inflation. Given, we have all lived through inflation in the recent years, this is something that has been tough on all of us. Inflation is particularly bad for retirees who have a fixed portfolio. I hope to be a retiree in the next 15-20 years, and this absolutely scares me.
- Tax increases – One of the most common expected outcomes is that in order to finance the deficits, the government is going to have no choice but to increase tax rates.
- Higher interest rates – as the government borrows more, they may have to offer higher interest rates. This will in turn impact borrowing costs for different items like personal loans, mortgages and so on. For the average consumer, borrowing costs will go up.
So, what can you do? You should consider the following:
- Tax-diversify your investments – future tax rate increases make a strong case for putting more money into Roth investments. This topic can be a separate blog post and there are ways for everyone to move money into Roth accounts.
- Diversify your investments across asset classes as much as you can – invest in diversified index funds, put money into real estate if you can. Also, invest into inflation protected securities.
- Pay off all debts before you retire
- Plan on a reduced Social Security benefit – while social security is funded through payroll taxes, there is a gap currently on receipts vs outflows and the gap is being funded by the government. I am personally planning for only around 70% of the current estimated full benefits. If you are below 60 as of today, that is what I would advise most people to do.
Concluding thoughts
In one of my earlier blog posts, I have mentioned I am an armchair economist. So, I don’t have any competency to forecast the future in terms of GDP, interest rates etc. I have simply made an attempt to lay out the data as I see it currently and make some conclusions on this. Again, I don’t claim any monopoly on these conclusions. Many of these conclusions have been made by others. There are very loud voices on both sides of this argument. My goal in this blog has been primarily to educate people in a non-partisan way and ultimately help you as a reader make sound personal finance decisions.
Thank you for reading and I wish you success in your personal finance journey.
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
