False Ceiling

There has already been plenty of banter in the news about the debt ceiling and with the Treasury Department’s extraordinary measures running out sometime this summer; this is an issue that isn’t going away any time soon. Most of the concern is that Congress will be unable to reach a deal to increase the debt ceiling, but we don’t share that concern. The U.S. will not default on its debts, at least not now, but partisan politics apparently requires Congress to wait until the very last moment in hopes of gaining some advantage with electorate. In our experience, there are no political winners in debt ceiling dramas, but that won’t prevent the drama from occurring anyway.

The debt ceiling is important because it each time we reach it, we are given another opportunity to focus on the mounting debt problem this country faces. The real issue is how to stop the seemingly inexorable increase in the Federal debt, which the non-partisan Congressional Budget Office (CBO) now estimates will climb from the current 98% of GDP to 118% of GDP by 2033.

What we don’t know is where the economic tipping point lies. At what level does the debt become so burdensome that it begins to harm economic growth? We may be there already. Back in 2010, the World Bank estimated that, on average, a persistent debt to GDP ratio of 77% or higher will begin to reduce the potential growth of an economy. A similar study by economists Carmen Reinhart and Kenneth Rogoff, performed around the same time, concluded that a debt to GDP level of 90% would have similar effect.

Determining precisely where that tipping point lies is not possible, but now that the U.S. is above both of those theoretical thresholds, we must consider the current debt trend more seriously. If these studies are correct, or even close to being correct, it is about to become much more difficult to extricate ourselves from our large and rapidly growing debt load. The chart below illustrates the problem quite well. (All charts are from the Congressional Budget Office.)

In a broad sense, the preferred answer to the debt problem is faster economic growth to pay for it. However, if the level of debt is now at a point where it begins to restrict growth, the opportunities to grow our way out of the problem begin to diminish. (We will present some of the potential solutions available to us next week. For now, let’s focus on the problem.)

The story here is not new. The CBO updates this report every 6 months and has been sounding the debt alarm for a long time. Since the last report back in May 2022, the CBO estimates that the cumulative debt over the next ten years is now $3.1 trillion larger. The primary differences are higher projected net interest outlays and spending on mandatory programs, such as Social Security. With interest rates rising to fight inflation, interest costs have risen rapidly and are projected to continue that trend as the debt level increases at an increasing rate. Cutting Social Security and Medicare are political non-starters, making it especially difficult to hold down those costs. It is easy to see how mandatory expenses will continue to grow very rapidly.

Shockingly, discretionary expenditures, as a percent of GDP, are projected to decline over the next ten years (see chart below). This trend is helpful, but it limits the options available to to control the debt problem. The implication is that Congress is going to face some increasingly tough decisions in coming years that will make the debt ceiling debate seem like child’s play.

The revenue side of the equation is not encouraging either. Individual income taxes, as a percent of GDP are expected to be near historical highs. Corporate taxes are expected to trend down slightly over the next ten years, but even if corporate taxes were raised substantially, it would be a relative drop in the bucket. (Note that all of the estimates reflect currently passed tax legislation).

The risk is not that we fail to raise the debt ceiling; the risk is that we fail to adequately address our rapidly growing debt level and send the U.S. toward a downward economic spiral. The U.S. dollars status as the world’s reserve currency is risk on several fronts, and this is one of them. Our debt problem will not solve itself, and it certainly won’t be solved by a deeply divided Congress. It is becoming critical that we find a path to a cooperative tone in politics, and only the voting public can force that issue.

“‎We must make our choice between economy and liberty or confusion and servitude…If we run into such debts, we must be taxed in our meat and drink, in our necessities and comforts, in our labor and in our amusements…if we can prevent the government from wasting the labor of the people, under the pretense of caring for them, they will be happy.”
― Thomas Jefferson

What We’re Reading

The Budget and Economic Outlook: 2023 to 2033

Macy’s, Best Buy Sales Decline, Reflecting Shopper Pullback

Mortgage rates jump back over 7% as inflation fears drive yields higher

Bringing inflation down will be slower and take longer than expected

House ethics panel opens investigation of Rep. George Santos

Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

General News, Investor Education

By: thinkhouse