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Paying the Piper

Adam M. Grossman

FROM THE COLOSSEUM in Rome to the palace at Versailles, look around Europe and you’ll find artifacts of once-great empires. What happened to them?

Each faced its own challenges, but there was also a common theme: They had poor financial management and became overburdened by debt. That’s why a recent analysis in The Wall Street Journal—titled “Will Debt Sink the American Empire?”—is worth our attention.

In 2024, the federal government’s budget deficit will come in at $1.9 trillion. That will be added to an existing debt load of nearly $35 trillion. To put that in perspective, the debt is now closing in on 100% of gross domestic product (GDP), up from just 70% in 2012. If the current trajectory continues, by 2028, our debt will exceed the prior all-time high of 106% of GDP, a record set in 1946 as a result of World War II.

Given these figures, why is there no political will in Washington to right the ship? As the Journal points out, deficits are—ironically—one of the only topics that unites the political parties. That’s because the two main levers to reduce deficits are to either raise taxes or to cut spending. Neither is appealing to politicians.

In part, the issue is also structural. So much of the budget is non-discretionary. This year, 47% of spending will be allocated to Social Security and Medicare benefits, 14% will be spent on defense and 13% on interest payments. In other words, even if there were more political will, there isn’t a lot of room for maneuver.

There’s a school of thought that views debt as a non-issue, arguing that the U.S. government can simply “print money.” While that’s technically true, another economic concept also applies: When governments go too far in printing money, a side-effect can be inflation. We saw that during COVID-19. When the government ramped up spending in 2020 and 2021, the result was 2022’s 40-year high for inflation.

This idea—that printing money leads to inflation—is not new. In the last years of the Roman empire, when the government began spending far beyond its means, the imperial treasury began to “print money” in what it thought was a subtle manner. It reduced the silver content in each of its coins—from 100% all the way down to just 0.5%. This led to inflation, and even hyperinflation in some years. In the year 210, inflation compelled the government to raise soldiers’ wages by 50%.

From there, things unraveled. Without any further ability to dilute the currency, Roman officials turned to burdensome tax increases in an effort to keep up with spending, but that only led to civil unrest. Ultimately, the empire fell when, as a result of financial weakness, it was no longer able to defend its borders. According to the Journal’s analysis, other empires, including those in France and in Spain, followed similar paths.

In economic terms, what happened to these ancient empires is known as “crowding out.” As interest payments consume a greater portion of a government’s budget, the result is that less and less is available to spend on everything else. What’s concerning is that the Congressional Budget Office sees this phenomenon beginning to occur in the U.S. According to a recent report, “The current law debt trajectory will reduce income growth by 12 percent over the next three decades.”

Does this mean we’re destined to go down the same path as Europe’s faded empires? Definitely not. Relative to where those empires’ finances were in their final years, our situation is still very manageable. That said, I think our debt situation warrants more attention than it currently receives. As I noted a few weeks back, a concept known as “rational ignorance” means that the media sometimes fails to focus on the stories that are most important. But this lack of attention doesn’t mean they aren’t important.

As an individual investor, what steps can you take? I believe that the greatest risk, ironically, is to the investment that’s typically viewed as the safest: U.S. Treasury bonds. With the debt load growing, Congress has found itself deadlocked over budget issues with increasing frequency, resulting in a number of government shutdowns.

So far, thankfully, it hasn’t gotten to the point where the Treasury has missed a payment to bondholders. But we’ve gotten close, to the point where it’s required the Treasury to employ “extraordinary measures” to avoid a default. The next time, we may not be as lucky. In an extended shutdown, the Treasury could run out of options and might be forced to default. For that reason, I suggest looking for ways to diversify your bond exposure. Below are three suggestions.

First, I recommend holding a significant portion of your bond portfolio in short-term Treasury holdings. Because a default wouldn’t happen overnight, short-term bonds might allow an investor to move funds out of the way before the situation deteriorated.

Second, another way to diversify would be to hold municipal bonds. Because state and local governments can’t print money the way the federal government can, municipal bonds carry more risk than Treasurys. Still, municipals might prove less risky if Congress were deadlocked over the federal debt ceiling, but municipal governments continued to pay their bills.

What’s the third way you might diversify a bond portfolio? Interest rates today are at levels we haven’t seen in more than 15 years. Most expect rates to drop—likely this year—but that’s not guaranteed. There’s a school of thought that interest rates may remain elevated, or even rise, if concern grows about the government’s debt load. To guard against rising rates, you might hold some portion of your bond portfolio as individual Treasury bonds, which you could hold to maturity.

What other steps could you take? Because Social Security benefits account for such a large portion of federal outlays—and because the fund on which the system relies is expected to be depleted in a decade or so—it’s not unreasonable to expect that Congress might trim benefits for future retirees.

The last time Congress made changes, in 1983, the cuts amounted to a 13% reduction. To address the current situation, benefits might be trimmed as much as 20% or 25%. But to make the cuts politically palatable, Congress would most likely avoid affecting those close to retirement age today, and it certainly wouldn’t reduce the benefits of those already in retirement. If you’re earlier in your career, though, and building a financial plan, it wouldn’t be unreasonable to assume a smaller benefit than your Social Security statement currently shows.

I don’t mean to be an alarmist. Indeed, in the mid-1990s, after years of rising deficits, the federal government actually ran a surplus for a period. Things can change. The current trajectory isn’t a one-way street, and debt wasn’t the only reason those ancient empires fell. But make no mistake: This is a topic that’s worth investors’ attention.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.

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