The United States is $31.4 trillion in debt with no roadmap with how they will pay the debt down.

Debt-to-GDP of the US is in excess of 120%, and is expected to climb to over 200% by year 2046 based on the US Treasury’s own projections.

On top of all of this, the US has $80 trillion in unfunded obligations over the next 75 years because of Medicare and Social Security funding shortfalls.

The motivation for this article came from an off the cuff Tweet that I made in early February:

The response I got to the question was completely unexpected. The Tweet received nearly 2000 comments with people offering their suggestions on how the United States should deal with its debt problem. Some suggested that the US simply can’t pay down its debt and that we will default, some suggested that we go to war, and many suggested  that the United States just prints money and pays down its debt with inflated currency. What is really going to happen with all of this debt?

This article was created with the intention to increase the readers’ understanding of the debt situation in the US. We will first identify the debt problem and what effects it has on the economy, then identify what actions the government/Fed will likely take to address the debt problem. Lastly, the report details the best way to allocate from an investment perspective, to prepare for what is to come.

The Debt Problem

As most are aware, the United States is simply in too much debt. Government debt itself is not necessarily a bad thing. When the proceeds from the debt are used to invest in some sort of productive asset or project like public infrastructure, education, innovative research, or fighting in a necessary war;  it is “good” debt. Good debt will ultimately create productivity growth in the economy that outweighs the debt that was taken on to create the growth. With good debt, the proceeds that the government receives from the debt are used to fund an investment which will pay back the loan completely, as well as generate a return which is greater than the initial loan amount.

Good debt creation will actually improve the debt situation of the US as measured by the Debt-to-GDP ratio; which is total public debt divided by the size of the economy, Gross Domestic Product (GDP). Good debt will increase the overall debt load, but will cause the denominator, GDP, to grow even more, lowering the Debt-to-GDP ratio.

“Bad” debt is debt that is used for non-productive uses like paying for some social services, paying down existing debt, or losing a war. Bad debt creation will have the opposite effect on the Debt-to-GDP ratio. It will increase the overall debt, but without a corresponding increase of the economy’s GDP. In recent years, bad debt creation is what has led to an overall increase in the Debt-to-GDP ratio.

How the United States became So Heavily Indebted

The long term debt cycle is the framework put forth by famed hedge fund manager, Ray Dalio. Understanding the long-term debt cycle is essential to put into perspective where the US economy stands today in the big picture, so we will start there.

Most readers are probably familiar with the short term debt cycle, which is the normal ebbs and flows in the economy often known as the “business cycle”. These occur every 5-10 years and end with a recession. The short term business cycle is cyclical in nature, and is controlled by the central bank (i.e. the Federal Reserve or just the “Fed” in the US) manipulating interest rates.

The short term debt cycle is a debt driven phenomenon. When a person, business, or government takes on debt, they essentially pull spending forward. The debt that is taken is used for spending today. It also means there is a corresponding period in the future where they must reduce spending to pay off that debt. This, in aggregate across the entire population, leads to the cyclical nature of the economy we know as the business cycle, or short term debt cycle. 

The timing of the cycle tops and bottoms are controlled by Fed interest rate policy. An economy that is running hot is one that is also inflationary. When inflation becomes high enough, the economy reaches the short term cycle top. In order to bring down inflation, the Fed will raise interest rates, which causes the economy to slow to the point where the economy goes into a mild recession. Recessions reduce the demand for goods and services, which is deflationary. At the point when inflation is no longer a concern, and economic growth has slowed or reversed sufficiently, the cycle bottom is reached. The Fed will then lower interest rates again to encourage more debt creation and spur economic growth.

The short term debt cycle can be broken down into four stages:

1. Expansion: The expansion phase is characterized by economic growth, rising employment, and increased business activity. During this phase, interest rates are generally low, and inflation is relatively stable. With low interest rates, people are incentivized to take on more debt. Debt that must be paid back in the future. Much of the debt is taken on for malinvestment or non-productive uses(bad debt) which will never create a return to pay back the debt. All of the increased economic activity of the expansion phase is an inflationary force on the economy. Which leads to the next stage.

2. Peak: With the rise of undesirable inflation and excessive debt levels, central banks will use their tools to tame the inflation. The tool that they use most predominantly at this stage is interest rate manipulation. They will begin to raise interest rates, which discourages borrowing because the high cost of taking on new debt makes it less appealing. The peak marks the end of the expansion phase and the beginning of the contraction. 

3. Contraction: The contraction phase is marked by a decline in economic activity, falling employment rates, and decreased business activity. During this phase, interest rates may continue to rise, inflation may remain high, but begin to roll over as the effect of the higher interest rates begin to take hold of the economy. In other words, reduced economic activity caused by high interest rates is deflationary because there is less borrowed money available to purchase real goods and services in the economy. This part of the cycle is typically marked by a recession, which is defined as two or more consecutive quarters of declining GDP.

4. Trough: The trough marks the end of the contraction phase and the beginning of a new expansion. Interest rates may start to decrease, as inflation begins to stabilize. The recovery is often aided by increased spending by the government to encourage economic growth. In this phase, economic activity starts to pick up, and employment rates begin to rise. The cycle repeats.

That is the short term debt cycle in a nutshell, but it only describes the smaller ebbs and flows of the economy. Short term debt cycles create bumps (mini booms and recessions) which occur every 5-10 years, while long term debt cycles produce major booms and busts of the economy, but only occur every 75-100 years. 

The chart below is a basic and imprecise diagram that shows the short term debt cycle overlaid on top of the long term debt cycle. The straight line represents the productivity growth of the economy(GDP). Many short term debt cycles add up to the long term debt cycle. The smaller booms and busts of the short term debt cycle are the results of central bank policy. Lowering interest rates causes the expansion and excessive debt creation until the peak, when the central bank raises interest rates and causes the reverse. 

(chart adapted from Ray Dalio)

You’ll notice in the chart that the bottom and top of each short term cycle finishes with more productive growth than the previous cycle. However what is not plotted on the chart is that each short term cycle also ends with more overall total debt relative to GDP(Debt-to-GDP ratio), as well as more debt relative to the income which is necessary to service the debt. At a certain point the limit on how much debt relative to the GDP of the economy is reached. Near the end of the long term debt cycle, the usual tool used by the Fed of lowering interest rates no longer works, as interest rates have already hit the 0% bound and can’t be lowered any more. The economy begins to deleverage, ending the long term debt cycle. 

The long term debt cycle happens for the same reason as the short term debt cycle. Debt is taken on for spending today, which means there is a time in the future when spending must be cut back to pay back the debt. The difference is that the long term debt cycle happens on a much longer time frame. The monetary policy from the Fed is the underlying force that controls the long term debt cycle. Policy from the Fed is focused on full employment and keeping inflation under control, rather than preventing debt bubbles from forming.

Below is a chart of interest rates in the US since the 1920s. Interest rates at 0% are a clear marker of the end of a long term debt cycle. The United States has hit the 0% bound with interest rates twice already: The first time starting with the economic boom of the 1920s and ending with the Great Depression in the 1930s, and the second time starting with the housing bubble in the early 2000s and ending with the financial crisis in 2008 and 2009. In both cases interest rates reached 0%.

In the chart you will notice that interest rates declined gradually for a roughly 40 year period from 1980 until the 0% bound was hit in 2008. In that 40 year period, there were several short term debt cycles that were formed as a result of the Fed’s interest rate manipulation, but each cycle in general ended with lower low’s in terms of interest rates. The Fed gradually ratcheted down interest rates until they could not go any lower. Low interest rates encourage more debt creation, as well as asset prices to rise because of the present value effect that low interest rates have. In other words, the Fed policy led to the formation of the debt bubble that we are currently in. 

(chart source: Ray Dalio)

The main reason that the long term debt cycle can go on so long is because the Fed progressively lowers interest rates, which causes asset prices to rise and as a result, people’s wealth. Low interest rates are also stimulative for economic activity. People in general are happier in the short term, during periods of declining interest rates. That is why central banks almost always choose to lower interest rates to solve today’s problems at the expense of problems that it may create for future generations.

A full long term debt cycle is so long that by the time that the next one comes around, most people that lived through the previous cycle have passed on. A full cycle may never occur, or only occur once in a person’s lifetime. For this reason, much of the collective wisdom received from the experience of the previous cycle is lost. Since the end of a long term debt cycle has never occurred in many people’s lifetimes, people often grow complacent in their views that the “good times” will go on forever. 

However, the good times won’t last forever because much of the economic growth, and what we perceive to be wealth, is really just the short term gratification received from pulling spending forward with debt. Aggregate debt in the economy comes in cycles, and any time debt is created for spending today, there is a time in the future where spending has to be reduced to pay back the debt. When debts are as high as they are at the end of the long term debt cycle, lowering interest rates is no longer effective, because they have already hit 0%.

When the limit of debt relative to GDP and income is reached, the process works in reverse. Asset prices fall, debtors have problems serving their debts, and investors get scared and cautious, which leads them to sell or not roll over their loans. This leads to liquidity problems, which means that people cut back on their spending. And since one person’s spending is another person’s income, incomes begin to go down, which makes people even less creditworthy. At the end of a long term debt cycle, there is simply too much debt in the system, and the economy has to deleverage, which concludes the long term debt cycle.

Where We are Today in the Long Term Debt Cycle

So is the US currently in a debt bubble? Ray Dalio has a set of criteria which we can examine to determine where we are roughly in terms of the long term debt cycle, summarized below:

All three of the criteria that Dalio has identified as conditions of a debt bubble are present at the time of this writing. Let’s look at all 3 criteria in more detail.

1. Debt is Growing Faster Than Incomes

Shown below is a chart of Debt-to-GDP in the United States. We can see that since 2008 Debt-to-GDP of the United States has doubled to where it sits at about 120% today. For reference, the last time the Debt-to-GDP ratio was this high was in 1945, when Debt-to-GDP reached 121% at the end of World War II. A high Debt-to-GDP ratio is a very direct indicator of a debt bubble in the US.

Debt growth that is far in excess of actual productive capacity of the economy(GDP) is a reliable indicator of a debt bubble. The reason for the rapid increase in Debt-to-GDP after the 2008 Great Financial Crisis was the spending enabled by the introduction of Quantitative Easing(QE), which has let the debt bubble grow much larger than it otherwise would have. More details on this to come later in the report.

In addition to Debt-to-GDP, we can look at the income that the Treasury receives from the taxation of its citizens. Debt growth is only sustainable if the income received from taxes is growing at the same or greater rate than new debt creation. In 2022, the Treasury received $4.9T of income from taxes relative to a total outstanding debt load of $31.4T, meaning that income from taxes was only 16% of the total outstanding debt in 2022. The income that the Treasury receives from taxes expressed as a percentage of total public debt from 1971 until now is shown in the chart below.

The ratio peaked in 1981 at 58% and has declined consistently to about 16% where it is today. This is actually much worse than what this metric indicates because only a portion of the income collected from taxes can be used to service the debt, the majority of it is used to fund government spending programs(more on that later). The further that this ratio declines, the harder it is to reverse the trend.

This ratio can’t be used alone to determine if the US is in a long term debt bubble, but it is a piece of evidence that supports the idea that we are in one.

2. Equity Markets Extend Rally

One of the biggest contributors to the formation of a long term debt bubble is the “wealth effect” created by appreciating asset values. Explained simply, the wealth effect describes a phenomenon that as asset prices rise, so does the capacity of people who own those assets to take on additional debt, because the value of the collateral they own (the assets) has gone up. When people take on more debt, they essentially create new money out of thin air that can be used to buy real goods. When a person buys these goods, they create income for the business who sold them. For the business that sold the goods, the additional income they received improves their financial position, and therefore increases the capacity for the business itself to take on more debt. The wealth effect is stimulative for the economy because of the additional spending that it creates, and as a result is also an inflationary force.

The biggest contributor to the wealth effect is the Fed itself. When the Fed lowers interest rates, it inadvertently causes asset prices to rise because of the lower discount rate that is used to value financial assets. Using the stock market (the S&P 500) as the metric, it appears that the wealth effect is still a contributor to the debt bubble given the fact that equity markets are still near all time highs. 

Referencing the chart below, it can be seen that the S&P hit roughly the same high of 1,500 in 2000 and 2008 before crashing both times. However, something different happened after the crash in 2008; zero percent interest rate policy (ZIRP), and the introduction of Quantitative Easing (QE). After the crash in 2008/2009, and subsequent introduction of ZIRP and QE, the S&P had a massive rally of more than 600% to its most recent high in early 2022. The massive rally in equity markets is the direct result of the ZIRP from the Fed combined with QE, and has been the main driver of the wealth effect. 

At the time of this writing, interest rates are 5.25%, but S&P is 13.8% below its all time high price. Given the staggering overall rally in equities since the introduction of zero percent interest rate policy and QE, leads me to believe that the wealth effect created by the equity markets is still a significant contributor to the debt bubble. Equity prices will have to decline significantly in order for the economy to begin to deleverage. 

3. Yield Curve Inversion

An inverted yield curve is a reliable indicator of the end of a debt cycle. An inverted yield curve means that the yield on short term Treasury bonds is greater than that of long term Treasury bonds. Typically, investors would expect to receive a higher yield for lending money for a longer period of time than for a shorter period of time. The graph below shows the 10 year (long term) yield minus the 2 year (short term) yield.

This spread is currently negative and has been since July 2022. The yield curve inversion is a sign of investors seeking protection from a crash in equity markets in the near term. When the yield curve inverts, it means that investors are pessimistic about the near future, so they sell their short term Treasury bonds, and move into longer dated bonds, raising the price of long term bonds, which lowers the yield of those bonds.

Since 1955, every recession has been accurately predicted by an inversion in the yield curve, with one exception in the mid 1960s, when an inverted yield curve was followed by an economic slowdown, but not a full recession. 

The inverted yield curve, combined with the previous two indicators (debts growing faster than incomes, and an extended rally in equity markets) shows a compelling case that the United States may be at the end of a long term debt cycle, right before the part where the economy deleverages. 

Government Spending and the Debt Problem

To understand the debt problem in more detail, we can look at the budget deficit of the United States. 

The deficit refers to the difference of the income and expenses of the government. When a government receives more income from taxes than it spends, it has a budget surplus. When a government spends more than it receives in taxes, it has a budget deficit. The major sources of income and major expenses that go into determining the surplus or deficit are shown below.

For 2022 in the US this was:

The budget deficit of the US was $1.4 trillion in 2022, meaning the US overspent by $1.4 trillion in that year alone. The budget deficit(red) or surplus(green) shown for each year individually since 2001 in the chart below.

The US has run a budget deficit every year consistently since 2002. At first glance, the wars in the middle east, which started in 2001, would appear to be a major contributor to the US’s budget deficit. However, when we look at the data, the wars were only a small contributor to the overspending problem. The chart below shows the percent increase in tax revenue that the Federal government receives through taxation of citizens (bold black line) compared to items that it spends money on since 2001.

Let’s take a look at what exactly the US is spending money on. In order for spending programs to be “sustainable”, the spending on those programs cannot outpace the revenue that the government receives from taxation. If spending on a program outpaces revenue from taxation, the only way the program can be funded is through borrowing, which contributes to the overall budget deficit and ultimately the national debt.

Referencing the chart above, we can see which spending items contribute the most to the budget deficit. Growth in spending on all major categories has outpaced growth in tax revenue, but notably spending on Health, Medicare, and Social Security are by far the items that are growing at the most rapid pace, contributing to the US overspending problem. The Health category represents spending items from the US Department of Health and Human Services, Medicare excluded.

Most of the US’s overspending problem is due to taking care of our elderly population. Aging demographics are a huge problem for the United States. As the US population ages, so does its requirement for social security and health services. Spending on Health, Medicare, and Social Security  is largely driven by the baby boomer generation, which currently represents about 21% of the population now at retirement age. The US currently spends about 6X more per senior citizen than per child. It is estimated that 40% of our taxes collected are spent on seniors, and at the current pace, that number will grow to account for 70% of all taxes in 25 years.

A related point of interest is the unfunded liabilities that are caused by overspending on social security and Medicare. Looking at a 75 year period, unfunded liabilities are estimated to total over $80 trillion. Unfunded liabilities is the difference between the spending that will be required by the government to pay for its spending programs and the income it projects to receive from taxation over the next 75 years. For the United States, the unfunded liability is nearly completely caused by funding shortfalls for Social Security and Medicare. While it is true that national debt is at $31.4 trillion at the time of this writing, adding in the $80 trillion in unfunded liabilities reveals the situation to be even more dire. 

Referencing the chart above, you’ll notice that spending on interest expense, which is payments the Treasury makes to service the current outstanding debt, has not quite kept pace with the increase in tax receipts. This is only true, however, because since 2001, the Fed has consistently lowered interest rates and held them at 0% for a large portion of time. This means that the government had a low cost of borrowing due to the low interest rate environment. 

With interest rates back at 5.25% at the time of this writing, interest expense is actually set to become a large contributor to the budget deficit (more on this later).

Since the spending on these programs is more than the government receives from taxes, it has to take on debt to fund them. It does this by issuing debt in the form of Treasury bonds. The US government, like any individual or business, can only take on so much debt before people become unwilling to lend them any more money. People would only be willing to lend them money at a very high interest rate, which the government can’t afford. 

However, unlike ordinary individuals or businesses, the United States has something that they don’t: access to unlimited money through the Federal Reserve. So what happens when the debt position becomes so high that people are unwilling to lend money to you at the interest rates you want? Enter Quantitative Easing.

Quantitative Easing

Quantitative easing (QE) refers to the central bank (The Fed) purchasing debt (bonds) from the US Treasury. In this process, the Treasury receives brand new money that is created by the Fed. The Fed however does not purchase the bonds directly from the Treasury, but rather through intermediary primary banks (the big 4 banks). By purchasing US debt this way, QE is a legal workaround that allows the Fed to inject money (stimulus) into the economy and guarantee that there is always a buyer of US debt. The debt that the Fed purchases through QE is mainly US Treasury bonds, but may also include mortgage backed securities (MBS) at times. To simplify, we will focus only on the Treasury Bonds. 

The diagram below depicts exactly how QE works, and how the money that is created through rounds of QE actually ends up in the real economy. 

The Government/Treasury funds its spending programs though Quantitative Easing in basically three steps: 

1. The Treasury issues new bonds (debt) which are bought by the primary banks at auction. The primary banks consist of the big four US banks (JP Morgan, Wells Fargo, Citi, and Bank of America). These banks essentially act as a pass through entity for the Treasury bonds. 
2. The Treasury bonds are then purchased from the primary banks by the Fed. The Fed purchases the bonds with money that it printed out of thin air! The Fed is where the new money originates. With each step you can see the flow of money, which starts at the Fed, then goes to the primary banks, and finally to the Treasury. 
3. The Treasury uses the new money that has been created to pay for its spending programs including Social Security, Medicare/Medicaid, spending for defense, direct payments to its citizens, and unemployment benefits, among others. It is at this step that the new money created through QE enters the real economy. 

The main takeaway here is that the Treasury would not have the money to fund these spending programs if not for QE. 

Sometimes the money from QE enters the economy in a direct way, such as the $1,200 relief checks that were issued to citizens during the COVID crisis. Money is also injected into the economy though Social Security checks that are sent to seniors each month. These checks are used to purchase real goods and services in the economy. Since the COVID relief checks, Social Security, and other government spending programs could not be funded only with the money the Treasury receives through taxation or normal borrowing, the only way the Treasury can get the money for this spending is through Quantitative Easing. QE is the tool that enables the Treasury to continue to overspend, and rack up reckless amounts of debt. 

In the end, the money created through QE ends up in the real economy. When new money enters the economy it causes inflation, because there are more dollars available, but the supply of goods and services does not change.

In an alternate world, where the dollar is still backed by something like gold, the only way the Treasury could raise the money to fund its spending programs would be through taxation of its citizens or issuing debt at an interest rate that is attractive enough to be purchased by US citizens, or foreign buyers. Since gold is a relatively scarce asset that can’t be obtained for free, the government would not be able to easily print new units of money to spend on things that it could not otherwise afford. In other words, just like a normal person planning a personal budget, the government would be forced to spend less than it makes. It would only accrue debt when it makes sense to do things like make productive investments which contribute to the growth of the economy, or win a necessary war. 

Since the US Dollar lost its convertibility to gold in 1971, there is virtually no limit on the amount of new US dollars that the Fed can create out of thin air through QE. Even though it was introduced as a temporary measure in 2008, the US has used quantitative easing as a permanent source of financing. As shown in the next section, the spending enabled by quantitative easing has caused US debt loads to compound at an astonishing rate. 

The Effects of QE on the Economy

Quantitative easing has been a massive enabler for virtually limitless government spending, which leads to budget deficits and massive debt creation. The graph below shows the Debt-to-GDP ratio of the United States with annotations for each round of Quantitative easing announced by the Fed. 

The first step in QE is creating new debt in the form of Treasury bonds. Looking at the chart, you can see that QE has had a direct effect on the debt position of the United States. Since QE was introduced in 2008, Debt/GDP of the US has doubled from where it was just 15 years ago. From a simple visual observation of the chart, the slope of Debt-to-GDP changed drastically after the introduction of QE in 2008. 

You may notice that since 2012, each round of new QE monthly purchases announced has been larger in size than the one before it. The rounds grew from $40 billion per month in 2012, to $60 billion per month in 2019, and finally a massive increase to $120 billion per month in 2020 in response to the COVID pandemic. Not surprisingly, the latest massive spike in QE caused the Debt-go-GDP of the US to increase by nearly 30% within just weeks. This amount of debt creation simply would not be possible without QE. 

Similarly, the chart below shows the value of the total assets held on the Fed balance sheet, also annotated with the announced actions by the Fed. The assets on the Fed balance sheet are mostly US Treasuries, and Mortgage Backed Securities that the Fed buys from primary banks with the freshly printed money that they themselves create. The Fed purchasing this debt through QE has caused the Fed’s balance sheet to balloon massively since 2008.

Again, observing the shape of the curve, the before and after effects of QE are clear. Prior to QE, US debt on the Fed balance sheet was increasing, but at a slow and predictable manner. After the introduction of quantitative easing, this all changed. The Fed currently holds about 17% of all US debt, up from under 4% prior to the 2008 financial crisis. The 2008 financial crisis and response from the Fed/Treasury saw the balance sheet of the Fed increase nearly 5X, from $1 trillion to nearly $5 trillion. The monetary response to the COVID crisis saw the balance sheet more than double, from $4 Trillion, to $9 trillion. Nearly all of this was enabled by quantitative easing.

The US Treasury now relies on the Fed to purchase its debt because there are not enough willing buyers of the debt, at least not at the low interest rates it is being sold for. In an environment without QE, the interest rates on US bonds would have to be increased to a point where there is a balance of supply and demand such that there would be enough organic buyers of the debt. When the Fed/Treasury performs QE, it actually encourages existing holders of the debt to sell the debt, which further exacerbates the supply/demand imbalance. In other words, when the Fed/Treasury performs QE, they weaken the demand for US bonds even further, which means there are even fewer buyers of US debt, in a self-reinforcing cycle. 

Predicting the Future: What Will Happen Next

The debt problem in the United States is only going to get worse unless the government/Fed do something to fix it. Taking a step back and observing the situation, the problem that needs to be fixed is the debt level of the economy relative to its productive output, which is the Debt-to-GDP ratio.

What options does the US have to lower its Debt-to-GDP ratio? I would argue that they are “stuck between a rock and a hard place”. Meaning that there are no good options available to lower the Debt-to-GDP ratio because all solutions come with undesirable side effects. This becomes clear when you study the situation through the lens of the Debt-to-GDP.

Thinking through the math; in order to lower the Debt-to-GDP ratio, the United States needs to reduce the numerator (Debt), or increase the denominator (GDP). The hard part for policy makers is to choose actions that will decrease debt, without causing a corresponding decrease in GDP, or increase GDP without causing a corresponding increase in debt.

We can explore the actions that the policy makers will take to address the Debt-to-GDP problem by looking at both sides of the ratio in detail. I have separated their possible actions into the actions they are unlikely to pursue and the actions they are most likely to pursue.

Actions Policy Makers Likely Won’t Take to fix Debt-to-GDP

It is informative to first take a look at what actions policy makers wont take, and what motivation and limitations they have in their decision making.

Reduce government spending (Austerity)

In order to reduce the debt, the Treasury could simply spend less. This would allow them to turn their budget deficit into a surplus, and reduce the debt over several years. The formal term for this is austerity. 

As it stands, it is nearly impossible for the United States to successfully enact any meaningful amount of austerity for two reasons. First, the majority of government spending is mandatory, meaning signed into law by congress. Second, a reduction of government spending would pull necessary stimulus out of the economy, which would be disastrous. 

Government spending is divided into two categories; mandatory and discretionary. Discretionary spending items are those that are subject to annual appropriations by congress. Meaning that spending on discretionary items must be approved by congress each year, usually after a period of intense deliberation among congress members. Mandatory spending, on the other hand, is spending that is signed into law and not subject to a “vote” by congress each year. Spending of the Federal government for major spending categories is shown in the graph below.

The problem is that most of the major spending items are mandatory items. Specifically, mandatory spending items accounted for 73% of the Federal spending in 2022. Since mandatory spending items are signed into law, it makes it very difficult to make changes to them in a short period of time.

Reducing government spending is also nearly always politically impossible, for both discretionary and non-discretionary spending alike. No rational person would vote for a candidate or political party that promises to cut spending for mandatory spending items such as Social Security or Medicare. Also, it would be politically unfavorable, and a national security risk, to cut spending for national defense. 

If policy makers were actually able to cut spending by a material amount, it could be disastrous for the economy, which would put the entire country at risk from a national security standpoint. Remember that the US does not exist in isolation. If the United States was to take the hard path of austerity, it would weaken its own economy and cause civil unrest amongst its citizens. This would put the country in a disadvantaged place geo-politically relative to competing countries that continue to prop up their economy through debt fueled spending. This is just one more reason why a reduction in spending is not likely to happen. 

A reduction in government spending is nearly impossible to pull off. If they did pursue this action, it would result in a reduction in GDP due to the economic chaos that would ensue. This would offset the reduction of debt that they were trying to fix. For these reasons, it is highly unlikely that the government will take the path of reduced spending to lower the Debt-to-GDP ratio. 

Raise Interest Rates

Policy makers could theoretically raise interest rates. As described earlier, interest rate manipulation by the Fed is the main driver of debt cycles. High interest rates would have the effect of making debt more expensive, which would reduce the incentive for people to take on more debt, and lead to a lower overall debt load in the economy. However, high interest rates come with a significant tradeoff. Higher interest rates mean higher borrowing costs, a cost that is borne by all people and businesses in the country. When people take on debt, they essentially create money out of nothing that can be used for real spending, which is stimulative for economic growth. High interest rates take that economic activity away, which would cause the economy to veer into a recession or depression, causing the GDP to decline. 

At the time of this writing, the Fed has raised rates from ~0% to 5.25% in just over a year, which has been one of the most aggressive interest rate hikes in history. I would argue that they are on an unsustainable path with interest rates, and they are very likely to lower them in the near future out of necessity, not desire. This is due to the interest expense that the Treasury must pay on its debt.

As the Fed raises interest rates, the cost of borrowing increases for everybody, including the US government. As old debt, which was taken on at lower interest rates, matures, new debt is issued at the new, higher rates. Shown in the chart below is the interest expense that the Treasury must pay on its outstanding debt obligations. 

This chart is frightening. Around 2022, the line goes up vertically in response to the interest rate hikes from near 0% to 5.25% by the Fed. The annual expenditure on interest alone is at nearly $1 trillion at the time of this writing. That number exceeds the $767 billion spent on defense in 2022 and is set to exceed the $1.2 trillion spent on social security in the same year. If the Fed does not lower interest rates, interest expense will become the single largest spending item in the 2023 budget. 

The interest expense to service the debt is a limiting factor to how high interest rates can go. I would argue that we are currently at the limit in terms of how high the Fed can go with interest rates. Using interest rates as an indicator, small rate hikes may still be possible, but it seems like a mathematical guarantee that the Fed will ultimately be forced to lower interest rates.

Lower Taxes

Lowering taxes is stimulative to the economy because it frees up additional money that becomes available to citizens for spending on goods and services, or investing in productive assets. Reduced taxes would increase GDP, however, it may cause the government to run an even larger budget deficit due to a reduction of income that the government would receive through taxation.

Since lowering taxes would contribute directly to increasing the budget deficit and overall debt, it is very unlikely that this option would be pursued even if it would benefit GDP growth. 

Actions that Policy Makers Likely Will Take to Lower Debt-to-GDP

These are the only actions that are politically feasible, align with their goals, and/or have been done historically to lower Debt-to-GDP.

Fiscal Stimulus (More Government Spending)

Fiscal stimulus here refers to spending by the government with the intention of increasing economic activity (increasing GDP). As we know, governments have no problem spending money, so stimulus is a politically feasible option. The government will often choose to spend money on programs that it knows will create jobs such as infrastructure development. Government spending is also very politically popular when the money is being spent on services that voters enjoy such as unemployment benefits, tax rebates/credits, or business subsidies. 

War is another type of fiscal stimulus for the economy because it is another form of spending. For the past century, the US has fortunately won every major war that it has been a part of. However, going to war comes with the added risk of lowering the country’s GDP if the enemy wins the war or destroying some of the U.S’s productive capacity.

Important to later discussion, fiscal stimulus is an inflationary force, because it increases the demand for an unchanged supply of goods and services in the economy. The inflation in the economy caused by fiscal stimulus is one of the major downsides to this policy choice. The Treasury, through fiscal stimulus spending, is essentially at odds with the Fed’s mandate of keeping inflation at, or near 2%. 

To summarize, fiscal stimulus (spending) is stimulative to the economy, the spending would surely be funded by taking on more debt, again offsetting the increased GDP that would be received from the spending in the first place. Fiscal stimulus also puts an additional inflationary pressure on the economy. 

Lower Interest Rates

The Fed can use its tool of interest rate manipulation to lower interest rates in order to stimulate the economy. Low interest rates are stimulative to the economy because they lower the cost of borrowing money – money which can be used for investment in a productive asset, business, or project. The stimulative effect of low interest rates would increase GDP.

Low interest rates also contribute to the wealth effect because interest rates act like gravity for asset prices. In general, when interest rates are lowered, asset prices trend higher because of the effect that interest rates have on present value calculations. When asset prices rise, so does the income that the Treasury receives through taxation of these capital gains. The government can use this new income to pay down its debt. 

However, the effect of low interest rate policy would likely be completely offset by the overall increase of debt load that occurs as a result of a low interest rate environment. Low interest rates only encourage more debt creation as people, attracted by low interest rates, take on additional non-productive debt, which further increases debt in the Debt-to-GDP ratio.

Low interest rates are also an inflationary force on the economy due to the increased economic activity, borrowing, and wealth effects that would occur in the low interest rate environment.

Increase taxes

Another option for the government is to increase taxes. The extra income that they receive through taxation can be used towards turning the budget deficit into a surplus, and paying down the debt over time. 

As history shows, increasing taxes may be politically feasible depending on the circumstances. For example, in 1944 the marginal income tax rate on the highest earners reached over 90%, and remained that high until 1963. The circumstances at the time were dire, as the US had to fund the fighting of the second world war. It’s unknown if policy makers today can rally the support to enact such a drastic change in tax law, but directionally, higher taxes make sense.

High taxes have the negative side effect of slowing economic activity. A reduction of economic activity means a reduction of the denominator in the ratio, GDP. Nevertheless, using history as a guide, it is completely possible for the government to change tax laws if they are able to get tax paying voters to rally behind an important cause.

Monetize the Debt (QE Forever)

The Treasury and Fed can continue to do what they have been doing since 2008; monetizing the debt. They will do this through increasingly large rounds of Quantitative Easing (i.e. debt monetization). This strategy is perfectly summarized in the meme below.

Debt monetization is a very politically popular option, making it the path of least resistance for policy makers. With QE, they can kick the can down the road as long as possible. In reality, performing QE is not really a choice, because without it, there would not be enough buyers of US debt, and the Treasury would not be able to fund its spending programs. These spending programs provide stimulus to the economy and inflate asset prices. Without them there would be economic catastrophe.

Reliance on QE is self reinforcing because the debt that is taken on by the government is used for non-productive purposes, like paying interest expense on current outstanding debt. It is bad debt. The more debt that is taken on to pay down debt, the more debt that must be taken on to pay down that debt. This is reflected in the chart of Debt-to-GDP shown in the previous section of this article. Since the debt is taken on for non-productive uses, debt loads continue to compound relative to GDP. This is the self-fulfilling doom loop, often referred to as the debt death spiral. 

Notably, quantitative easing is an inflationary force on the economy. It enables virtually unconstrained money printing, spending, and appreciation of asset prices that would otherwise not have occurred. The inflation that is enabled by quantitative easing will be the defining characteristic of the economy and investing landscape in the 2020s.

Wildcard: Grow Through Innovation

The Debt-to-GDP ratio of the U.S. has been climbing consistently since around 2001(the last year that the US had a budget surplus). In other words, debt growth has outpaced the growth in productive output of the economy for over two decades. 

What if the U.S. was able to reverse this trend by growing GDP at a much faster pace than the debt? This could happen by investing in or deregulating innovative or breakthrough technologies, which would contribute significantly to GDP, without an associated growth in debt. 

Some examples of breakthrough technologies are fully self-driving vehicles, a breakthrough in energy production such as nuclear fusion, quantum computing, or artificial intelligence (AI), among others. Technologies like these have the potential to increase the overall productivity of the economy, which would allow GDP to grow without a significant offsetting growth in debt. 

The key here would be for the government to allow these industries to flourish without overregulation. The government may even choose to invest in breakthrough technologies directly by funding research and development, grants, low interest loans, or subsidies.

Growing GDP through innovation is by far the best solution to the Debt-to-GDP problem. However, it is unknown which innovations can cause a leg up in GDP, or how long it would take for them to have a material effect on the GDP of the US. Since it is not yet known how some innovative technologies will affect the economy, it is not something we can plan for as a possible fix to Debt-to-GDP, but it remains a possibility. 

Putting it all Together: What will be the overall policy response to lower Debt-to-GDP?

Summarizing the points in the previous section, we can get a good handle on what the future looks like in terms of policy decisions:

Policy makers will likely pursue policy that includes some combination of fiscal stimulus, increased tax rates, low interest rate, and debt monetization. The most important takeaway is that the combination of policy responses to deal with the high Debt-to-GDP are inflationary.

Inflation may manifest itself in two ways, (1) a high consumer price index (CPI) inflation number reported by the Bureau of Labor Statistics (the BLS), and (2) monetary inflation, which is measured as an increase in the number of overall units of currency in the financial system. The most widely used measure for monetary inflation in M2, which is reported by the Fed. CPI is the most cited and universally recognized indicator of inflation in the US. The Fed, through its policies, usually targets about a 2% CPI inflation number, which it has been unable to maintain since early 2021. 

Thinking from an investing standpoint, in an environment of high inflation, it is likely that ALL assets will perform well because they are priced relative to a rapidly devaluing currency. In addition, low interest rates encourage asset prices to rise, which contributes to spending due to the wealth effect that it creates. The biggest losers in that environment are those holding rapidly devaluing US dollars. 

Using COVID as an Example

The policy response to the COVID crisis can be used as an example of the effect that inflationary policy response will have on asset prices. The policy response to COVID included:

1. Fiscal Stimulus: The policy response to COVID saw massive amounts of fiscal stimulus, with direct payments of $1,200 to citizens, expanded unemployment benefits, financial support for businesses, and investments to strengthen the healthcare system.
2. 0% Interest Rates: The Fed dropped Interest rates back to 0% from just under 2% where they were before the crisis.
3. Debt monetization (QE): In March 2020, The Fed and Treasury announced the biggest round of QE to date, with $120B per month in asset purchases. As a result, the supply of money in the system increased by 36% (as measured by M2) during the COVID crisis, shown in the chart below.

The COVID period was selected as an example because the policy response to the crisis is similar to what we can expect to see as a policy response to fix the Debt-to-GDP problem of the country. It also serves as an excellent example of how assets will respond in a period of high CPI and monetary inflation. The policy response to COVID resulted in CPI inflation of more than 9% at its peak, and it still remains at 4.9% at the time of this writing. This is well above the Fed’s targeted 2%. 

The returns of various asset classes for the 24-month period after COVID policy responses were implemented (March 2020-2022) are summarized below:

Bitcoin outperformed all other asset classes by a wide margin as people flocked to the asset, which provided the best protection for their savings in this highly inflationary period. Why is that? I would argue that it has everything to do with specific properties that make Bitcoin the most appealing asset to own in a period of high inflation. 

Fiscal stimulus, low interest rates, and significant debt monetization (QE) will be the likely policy response to tackle the debt issue. Therefore, inflation will persist, and Bitcoin will be the “fastest horse in the race”.

Betting on the Fastest Horse

While all assets are likely to benefit in an environment of high inflation and low interest rates, Bitcoin will probably be the “fastest horse” in terms of price performance. Bitcoin will outperform other assets because (1) it has properties that make it a superior asset that a person can hold in an environment of high inflation, and (2) it’s still very early in its adoption. 

The Properties of Bitcoin

Bitcoin is competing with other assets that people may choose to prevent the reduction of purchasing power of their money due to inflation. In that sense, Bitcoin is competing with gold, equites, real estate, bonds, and fiat (cash). Fully understood, the properties of Bitcoin make it the most appealing asset that a person can truly own. Comparing various properties of Bitcoin to other assets is quite revealing. 

For the sake of not making this article too long, I go into more detail on all of the properties of Bitcoin here. 

For this discussion, I will go into detail on the first property, scarcity, because it is most relevant to a discussion of investing in an environment of high inflation. 

Bitcoin’s Scarcity

Scarce assets are sought out in an inflationary environment because people want to preserve the purchasing power of their hard earned money into the future. When governments rapidly devalue the money that people hold, they have an incentive to trade their depreciating government money for scarce assets, also known as hard assets. Hard assets exhibit the exact opposite property of inflationary government currency; the supply of these assets are fixed, or at least have a supply which is difficult to increase. Hard assets may include art, collectibles, or even vehicles in extreme cases, but most people choose precious metals like gold or silver, stocks, real estate, or more recently, Bitcoin. 

With the invention of Bitcoin in 2008, came the introduction of the first perfectly scarce commodity. 

The previous sentence can’t be overstated since scarcity is the main factor that determines the value of a non-productive commodity. Among all of the assets listed in the table above, Bitcoin is the only one that is truly and reliably scarce. The advantage that Bitcoin has over other assets is that when the price of Bitcoin goes up, no additional units of Bitcoin can be created in response. In other words, the supply of Bitcoin does not increase when the demand or price of Bitcoin increases.

The advantage of Bitcoin’s scarcity becomes apparent when you compare it to its closest analogue, gold. Say, for example, that overnight the demand for gold increased, and the price doubled. The high gold price would create an incentive for gold miners to increase production. They would mine for gold deeper in the earth’s crust where it would not have been profitable to mine at the lower gold price. Put simply, as the price of gold rises, so does the incentive to mine more gold. New gold supply would then flood the market and crush the gold price back down to near where it was to begin with. Gold miners prevent gold’s price from appreciating as a response to increased demand for it. Also, it is completely unknown how much gold is stored in the earth’s crust and what can potentially be mined in space. The total gold supply is unknown and practically infinite. 

All assets (besides Bitcoin) have a supply response to increased price/demand. Going through them:

• Equities: When the price of a stock goes up, companies have an incentive to issue more shares of their stock. Increasing the supply of shares devalues the stock price. This is admittedly only true for certain unprofitable companies that must rely on issuing new shares of stock to fund operations. Another point that should be made is that as stock prices rise, private companies will go public to take advantage of the favorable market. With the same amount of money in the equity markets chasing more shares of stock, this acts as a suppression to overall equity prices. 
• Real Estate: When the price and demand of homes and land increases, home builders have an incentive to build new homes or build vertically. Home builders will flood the market with new supply of homes which ultimately suppresses prices. 
• Bonds: A virtually limitless amount of bonds can be created out of thin air by the US Treasury because the Fed will always be there to buy them at any price. 
• Fiat Money: Since money is not backed by anything tangible like gold, a virtually limitless amount of new currency units can be printed by central banks. 

Bitcoin does not experience an increase in supply when price or demand rises because the issuance of Bitcoin is on a set schedule that is unalterable by humans due to the topology of the Bitcoin network. When the price rises, there are no people or entities that have the power to dump a new supply of Bitcoin on the market, which would suppress the price. 

The monetary policy of Bitcoin is simple: A strictly limited supply of Bitcoin units that is capped at 21 million total Bitcoin. New Bitcoin are issued every 10 minutes and received by the Bitcoin miners when a new block is mined. This compensation that the miners receive is also known as the miner reward. The amount of coins received in the miner reward started at 50 coins per block in 2009 when Bitcoin was launched, and decreases in half roughly every 4 years (every 52,000 blocks). The current reward is 6.25 Bitcoin. Meaning, the miners collectively receive 6.25 Bitcoin as a reward about every 10 minutes. Importantly, this does not change when there is more demand for Bitcoin, or the price increases. The stable monetary policy of Bitcoin is graphed below.

Bitcoin is unique among other assets because the current total supply, at any point in time, can be audited by anyone with a computer who runs the Bitcoin software. In addition, since the issuance schedule is set in stone, the supply of Bitcoin can be estimated for any date in the future as shown in the chart above. 

We Are Still Very Early

Bitcoin is an asset that is still in its infancy, at only about 15 years old. It simply has not had the time yet to grow to its full valuation potential. In fact, Bitcoin only represents a tiny fraction (0.1%) of total global assets which can be estimated at $872T, shown below. 

Savers and investors constantly make a decision among the asset classes listed above about where to put their money. As discussed briefly, Bitcoin has properties that make it a superior asset when compared to these alternatives, with the most important in an inflationary environment being its reliable scarcity. 

Bitcoin only represents 0.1% of global assets at the time of this writing. This should be seen as a massive opportunity. 

Based on today’s Bitcoin price of ~$27,000, if Bitcoin was to capture just 1% of the total value stored in global assets, it would reach a price of about $415,000 per coin, or 15X the current price. Below is a table of the corresponding BTC price if it were to capture value stored in global assets at different percentages.

As a superior asset, I think that it is reasonable to assume that Bitcoin will capture at least 1% of value stored in these assets. In my opinion, anywhere between 1-30% is a good estimation, which corresponds to a Bitcoin price between $415K and $12.4 million. What portion of global assets do you think makes sense for Bitcoin to capture?

The point of this exercise is not to speculate on the future price of Bitcoin, but rather give a sense of the potential that the asset has ahead of it. With nearly any assumptions that you can make, the potential outcome for Bitcoin is huge. That is why Bitcoin is likely to be the best performing asset class (the fastest horse) in the coming decade of high inflation. 

Closing Comments

If you like what you have read, consider sharing on Twitter, also you can follow me on twitter @thepowerfulhrv. 

If you made it this far, I sincerely thank you for reading. In this article we discussed:

1. The debt problem in terms of the short term and long term debt cycles
2. Where we are today in relation to the long term debt cycle. Based on Ray Dalio’s criteria, I concluded that we are at the end of a long term debt cycle, right before the economy begins to deleverage.
3. Next, we covered what is specifically causing the debt problem in the United States. The debt problem is a result of overspending, mostly on caring for our elderly citizens through programs such as Social Security and Medicare. 
4. We then looked at the steps that policy makers may take to lower the debt problem. Looking at it through the lens of Debt-to-GDP ratio. We concluded that the policies they will likely pursue will be inflationary. 
5. Lastly, we discussed how to survive (or even thrive) in a period of high inflation, using what I believe to be the fastest horse in the race, Bitcoin. 

Feel free to DM me with any comments or even to point out things that you disagree with in my analysis. 

Any views expressed in this article are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.

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