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SOME MILESTONES are auspicious. Others are not.
This week, the Treasury announced that the federal government’s debt had topped $40 trillion for the first time.
Government debt is nothing new, but the problem is now of more concern, for two reasons. First, the scale has grown. An apples-to-apples way to look at the government’s debt load is to compare it to GDP—the economy’s total annual output. On this basis, outstanding debt now exceeds 100% of GDP, a level we haven’t seen since the period immediately after World War II.
That brings us to the second concern: If the government isn’t able to balance its books while the economy is strong, as it is today, lawmakers will have less flexibility to act when the next recession occurs.
For a brief period about five years ago, a theory known as modern monetary policy entered the conversation. The idea, popularized by a book titled The Deficit Myth, was that we shouldn’t be so concerned with deficits—that the U.S. government should be able to borrow more or less as much as it wants. What we’ve seen, though, is that eventually deficits do matter.
In simple terms, the government now takes in about $6 trillion per year in revenue, but it’s spending almost $8 trillion, resulting in deficits of roughly $2 trillion. And just like a consumer who’s run up a big credit card bill, interest payments now consume an ever-larger portion of annual spending. In round numbers, the government this year will spend about one in every six tax dollars it collects on interest and will spend more on interest than on defense.
Why have the numbers gotten so much worse? The first factor was Covid. The government had to take extraordinary measures to pull the economy out of recession. But while that spending was mostly justified, the problem is that Congress grew accustomed to larger budget shortfalls and has been unwilling to rein things back in.
Congress, in fact, went in the opposite direction when it passed a set of tax cuts a few years back. Those cuts might not have been such a problem, except that one of the lasting effects of the pandemic was inflation. It hit a high near 10% in 2022, and while it’s come down from that peak, it’s still higher than it was prior to 2020.
What’s the connection between inflation and the deficit? It’s more indirect, but it may be the government’s biggest problem at this point. The Federal Reserve’s primary strategy in fighting inflation is to raise interest rates, and that’s exactly what it did beginning in 2022. That helped with inflation but became a problem for the deficit because the government is such a large borrower, and higher interest rates translated to higher borrowing costs.
Unfortunately, the issue has now started to compound on itself. Despite the Fed’s lowering rates, which it has done a handful of times over the past few years, market interest rates have remained stubbornly high, especially long-term rates. That’s because the government is being forced to pay more to borrow, just like any prospective borrower whose finances look shaky.
This has become something of a chicken-or-the-egg problem. If rates were lower, the deficit might shrink considerably. But rates may not drop until investors see that lawmakers have gotten serious about the issue.
Why hasn’t Congress addressed the problem? In short, it’s because the two most obvious solutions—raising taxes or cutting spending—are the last thing any politician wants to do. Ironically, this may be the one area where both parties are fully aligned.
Hopefully Washington begins to get serious about the problem. For better or worse, though, this is the situation we’re in. Against this backdrop, what steps might you consider for your portfolio?
Because the deficit is so closely tied to interest rates, the first area I’d focus on would be your bond holdings. With long-term interest rates at multi-decade highs, there might appear to be an opportunity to profit from long-term bonds if rates were to drop. I would be cautious, though. Just this week, we’ve seen volatility in long-term rates, and things could easily go the other way. For that reason, I recommend a conservative posture toward bonds, with the majority in short-term holdings, only a small amount in intermediate-term and none at all in long-term bonds. To be sure, this might mean forgoing some profits if rates come down, but in my view, the bond side of a portfolio should be the part that helps investors sleep at night rather than another area to worry about.
What other steps could you take? I’d give thought to your long-term tax exposure. It’s possible that politicians will eventually get serious and raise taxes, and if they do, you’d want to be in a position to manage your own tax bill. Fortunately, there is one clear route to inoculating part of your portfolio against tax increases, and that’s to look for ways to build up dollars in a Roth account: If you’re in your working years, you could contribute to a Roth IRA or a Roth 401(k). Your employer might even allow for so-called mega back-door Roth contributions. If you’re retired or happen to have a low-income year, consider a Roth conversion.
A final recommendation: If you have a net worth over $10 million or so, you might give thought to estate tax strategies. Today the federal estate tax applies only to individuals with more than $15 million in assets, but this threshold has been a political football and could easily end up much lower. As recently as 2008, it was at just $2 million.
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.
