Debt, simply defined, is an amount of money borrowed by one party from another. Debt is used by many corporations and individuals as a method of making large purchases that they could not afford under normal circumstances. The U.S. government uses debt in the same way, though it hasn’t been as central an issue in political debate the last few years (though now that the Democrats again hold sway in Washington, Republicans are likely to rediscover their alarm bells over debt and deficit spending).
The national debt rose by almost $7.8 trillion during President Donald Trump’s four years, the third highest increase relative to the size of the economy for any administration in U.S. history (after those of George W. Bush and Abraham Lincoln)—adding up to about $23,500 in new federal debt for every person in the country. Our national debt, now nearly $28 trillion, has reached levels relative to our economy that are nearly as high as those at the end of World War II. (Of course, we are facing a global pandemic, though the 2017 tax cuts and the tariffs and trade war also contributed to the increase in what the U.S. owes.)
But do not worry; any overdue payment notice is unlikely to come to you—though you may want to warn your grandchildren when they are old enough to understand.
Here is a primer to help you explain.
How Debt Grows and Where It is Going
To balance its finances, the federal government must take the simple step we all do as individuals: make enough money to repay what is owed. If a government does not generate enough revenue (mainly through taxation) to cover its debt, it experiences a deficit—the difference between government spending and revenue. Federal debt is the accumulation of those deficits over time. To learn more about the federal debt and deficit in general, check out our Bowen Report: https://bowenasset.com/oh-we-owe-the-national-debt-the-deficit-and-you/
Large and sustained federal budget deficits are harmful to the fiscal health of the United States, yet policymakers struggle with reining in the red ink. Even in times of economic growth, the federal government has run large budget deficits, near $1 trillion per year.
Before the pandemic, budget deficits were an ominous trend. Now that policymakers are enacting necessary, emergency measures to combat the health crisis, federal budget deficits are escalating to levels not seen since 1945. The shortfall for the 2020 budget year, which ended September 30, climbed to an all-time high of $3.1 trillion. To put that into perspective, the U.S. had a deficit of $984 billion in 2019 (4.6% of gross domestic product). Now, the federal deficit is 17.9% of GDP—nearly double what it was at its previous peak during the Great Recession. Even relative to the size of the economy, the deficit was the largest in 75 years and marked the fifth consecutive year in which the deficit increased as a percentage of GDP.
The U.S. government’s deficit in the first three months of the 2020 budget year was a record-breaking $572.9 billion, 60.7% higher than during the same period in 2019; spending to deal with the pandemic surged while tax revenue declined. The spending figure did not include the $900 billion relief package Congress finally passed after months of wrangling.
The Congressional Budget Office (CBO) has forecast that the deficit for budget year 2021 will total $1.8 trillion and will remain above $1 trillion each year through 2030. The CBO forecast for 2021 was made before the December 2020 relief package was passed and does not consider any extra spending that Congress may pass during the Biden administration. Nancy Vanden Houten, senior economist at Oxford Economics, forecast that the 2021 deficit will hit at least $2.6 trillion, an estimate that assumes stimulus checks will be boosted to a total of $2,000.
At some point, the U.S. government will have to repay its debt to lasso in the deficit—which means it can either reel in its spending, increase taxation, or find a healthy balance between the two. But as the pandemic rages on and more economic relief is needed, it is unclear when there might be an opportunity to lower the deficit—or how the government might decide to do so.
All deficits need to be financed. Such financing begins through the sale of government securities, such as Treasuries. Individuals, businesses, and other governments purchase Treasuries and lend money to the government with the promise of future payment. Thus, all deficits have the effect of reducing the potential capital stock in the economy.
A jump of 0.5 points overall means the tab for interest in 2020 will be half again higher than if the same increase happened in 2019. Rates are highly volatile, and a shift back to even the levels of early 2020 will drive interest expense from the declining trajectory now projected by the Congressional Budget Office to a rapidly raising curve that will greatly deepen future budget deficits.
Most people see deficits as a negative force on the economy. While macroeconomic proposals argue that deficits are sometimes necessary to stimulate aggregate demand after a monetary policy has proven ineffective, some economists argue that deficits crowd out private borrowing and distort the marketplace, skewing interest rates, propping up non-competitive firms, holding back productivity, and expanding the influence of nonmarket actors.
Pressures on State and Local Government
The pandemic and resulting recession have likewise dramatically reshaped state economies and budgets.
But the severity of the pandemic and economic downturn varies significantly across states, creating unique economic and political pressures. The economic slowdown caused by the pandemic has blown up budgets from coast to coast, and the impact will be lasting. State revenues have declined precipitously, and costs are rising sharply, with many businesses closed or operating at reduced hours and millions of people recently unemployed. Moody’s Analytics estimates that state and local government budget shortfalls could be a combined $450 billion over the next three years even as the economy recovers.
Unlike the federal government, states cannot run operating budget deficits. Every state in the union, with the exception of Vermont, has some type of balanced budget requirement—though many states have in the past used gimmicks, such as selling assets and then leasing them back, to circumvent the law. Under state laws, most municipalities must also keep balanced books.
Due to the economy’s rapid decline and uncertainty about its future path as well as possible federal aid, official state revenue projections do not fully reflect the unprecedented fiscal impact of the pandemic. Executive and legislative fiscal offices in many states are analyzing new economic projections and producing estimates of the damage before state legislatures meet in regular or special sessions to address shortfalls. Most states have released estimates, but they may change before state legislatures meet again in January.
The outlook for state and local governments is uncertain as the pandemic rages and the vaccine rollout lags behind expectations. For governments that rely on property-tax revenues, the impact of economic distress typically takes a while to be felt as business closures and other disruptions are factored into property values.
States ended the 2020 fiscal year in better shape than was initially forecast due to hundreds of billions of dollars in federal aid and the unusual nature of the pandemic recession. Low-wage earners in the service industries, who pay less in taxes, were devastated by job losses, while the stock market boomed, and high-wage workers were relatively unscathed. But states were still projected to see huge shortfalls in the years ahead, even before the surge of COVID-19 cases in late 2020. The situation varies significantly across states depending on the structure of their economies and their pre-pandemic fiscal health. But states still face large budget shortfalls and uncertainty as COVID-19 cases continue to climb. State budgets have been hit [SL1] by unprecedented shock and seen a significant shortfall in demand, which has affected revenues. For the cities and states more oriented toward the services sector, it has been even greater.
The combination of a shortfall in revenues and an increased demand for services means state and local governments face tough decisions when looking at their budgets for next year. Because state and local governments—whose spending accounts for 13% to 14% of GDP—have legal obligations to balance their budgets annually, they will be left with two options: raise taxes or cut spending.
States and cities supply nearly 80% of the $441 billion spent nationally on transportation and water infrastructure, according to the CBO’s most recent data. State and local governments also contribute more than 90% of the money spent nationally on K–12 education, as well as provide substantial financing for the public university system.
States are drawing on their rainy-day funds and other budget reserves to address these shortfalls but, as in the last recession, those reserves will be far from adequate. And states will worsen the recession if they respond to this fiscal crisis by laying off employees, scaling back government contracts for businesses, and cutting public services and other forms of spending.
Corporate Debt
U.S. corporations now owe a record $10.5 trillion to creditors, either in the form of bonds or loans, a stunning 30-fold increase from a half-century ago. By far, the biggest chunk of debt has been taken out by American companies with high “investment-grade” credit ratings of AAA to BBB, a segment of the market where borrowing has more than doubled in the past decade to roughly $7.2 trillion.
However, half of investment-grade corporate debt, or $3.6 trillion, resides within the borderline BBB credit-ratings category, only a few notches away from speculative-grade, or “junk,” territory. A longtime worry among investors has been that an economic downturn or a sustained cycle of BBB downgrades by credit-rating firms could swamp the junk-bond market.
Companies have raised more debt in the U.S. bond market in 2020 than ever before, approximately $2.5 trillion, as cash became king during the coronavirus crisis and took bond issuance past previous full-year totals. The previous record was $1.916 trillion in 2017. The Fed’s interventions in the second and third quarters, including buying corporate bonds, sparked a swift recovery, pulling down borrowing costs and reopening the market.
This debt-raising has driven leverage—a ratio that measures debt compared with earnings—to an all-time peak for higher-rated, investment grade companies, having already surpassed historic records. Rating agencies have responded to the increase in risk by downgrading credit ratings. A record number of companies were rated CCC-minus in 2020, close to double the number of CCC-minus ratings there were in 2019.
U.S. junk bond sales reached an annual record of $350 billion for 2020, well over the prior annual sales record of $329.6 billion set in 2012. Part of the financing was to secure a lifeline during the beginning stages of the pandemic. The financing, which improved liquidity, [SL2] also increased key measures of debt to earnings. More recent financing means companies are managing their balance sheets and giving themselves breathing room by refinancing at lower costs as well as pushing out maturities.
After an initial rush by top-rated companies to secure emergency funds, the bond binge has extended to lower-quality companies, as well as any company looking at cheap funding for opportunistic deals/projects.[SL3] However, the deluge of fundraising has raised concerns that companies are racking up debt and increasing risk even as earnings remain depressed.
Analysts note that companies remain conservative; much of the cash raised remains on their balance sheets rather than shifting to more aggressive activities like stock buybacks. The combined cash balance of S&P 500 companies has risen to a record $3.4 trillion in 2020, up $1.3 trillion from 2019 and more than three times the level seen in 2008. Much of the debt was added at record low levels, which is a positive. What the companies do with all this cash/debt remains to be seen.
In This Environment is Borrowing Good?
The pandemic has brought out both the best and the worst in borrowing. Corporations, in advance of the pandemic looked upon low-cost debt as an opportunity to get cheap money to bolster their cash foundations in the expectation of an economic downturn.
For state and local governments hampered by lending restrictions, borrowing to meet their overhead expenses in the face of declining cash flow from the recently unemployed as the economy adjusts to pandemic slowdowns and shutdowns puts them in even more of a bind. These governments, struggling to meet balanced budget requirements have very limited opportunities to borrow.
The federal government on-the-whole, is really the only entity that can borrow on a large enough scale to provide essential services to the local municipalities keeping society afloat and to maintain some economic level of activity until we can find our way out of the economic woods. It is during these times that the government is needed most to first stabilize, then stimulate the economy to drive it forward to a normalized growth. The problem is that the more debt the federal government takes on, the more pressure there will be on the economy when interest rise.
As always, if you have any questions about this report or any other questions, please reach out to Bowen Asset at info@bowenasset.com or (610) 793-1001.
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