Why the US deficit matters

Until recently, financial markets have shown precious little concern about the soaring US debt load. Now, they’re starting to worry, states Andreas Dombret, Global Senior Advisor at Oliver Wyman and Member of the Board at Atlantik-Brücke. You can read his guest contribution also in the originally published version at Reaction here.

When Donald Trump is inaugurated as the 47^th President of the United States on Monday, he will be entering the White House as the US national debt nears record levels, and as a leader committed to an economic programme that could increase debt by another $7.5 trillion over the next 10 years.

The next President has also repeatedly committed himself “without question” to maintaining the US dollar as the reserve currency of the world.

The task of reconciling these seemingly conflicting objectives will fall to Scott Bessent, the man Trump has appointed as his new Secretary of the Treasury.

The US is not alone among advanced economies in seeing rising levels of public spending and debt. The political consensus on both the Left and Right in many countries has shifted towards bigger government and, remarkably in the US, many Republicans even outdo Democrats when it comes to fiscal laxity.

Yields have risen on fears about inflation and widening fiscal deficits

Until recently, financial markets have shown precious little concern about the escalating US debt load. However, that has been changing and market participants are beginning to worry. Ten-year bond yields in the US Treasury market moved up and volatility increased before the US election and yields have risen further since on fears about inflation and widening fiscal deficits.

In a recent survey of CFA Institute members, which includes the cream of the investment analysis community, nearly 80 per cent of its more than 4,000 respondents said that US government debt levels, and reliance on unfunded spending were not sustainable.

Nor do they hold out hope of the US changing its spots. Three-fifths of the analyst community believe that the US lacks the political will to reduce its debt-to-GDP ratio. A similar proportion expect the US to start losing its reserve currency status within the next 5 to 15 years.

The US has the privilege of serving, almost unchallenged, as the world’s reserve currency. More than half of world trade is still conducted in dollars and other countries need to hold US dollar reserves to pay for imports, weather economic shocks, and reassure creditors that they can service their foreign currency debts. When it comes to foreign exchange transactions, the US enjoys a virtual stranglehold, with the US dollar on the side of nearly 9 in 10 global forex transactions.

How long will the „exorbitant privilege of the US dollar“ persist?

Reserve currency status allows the US to borrow in its own currency without the constraints that normally apply in financial markets. It is an economic advantage that no other country in the world enjoys, conferring on the US what a former French President described as the “exorbitant privilege of the US dollar”.

In recent years, it has allowed the US government to get away with undisciplined budgetary shenanigans and deficit spending on a massive scale because of its near unlimited ability to borrow to fund its fiscal and budgetary wish list.

Even though US debt is now at levels which are unprecedented in modern peace time, and the Congressional Budget Office projects that on current trends debt would reach a staggering 172 percent of GDP by 2054, recent US leaders have remained remarkably unfazed. Debt servicing costs exceeded $1 trillion in 2023, more than the US defence budget but there has been no attempt to curb this fiscal excess. Instead, massive deficit spending remained the only game in town.

Despite increased borrowing costs, there is no immediate indication that investors doubt the US government’s ability to borrow to fund this spending and rising interest payments. This may seem counterintuitive but there is currently no real alternative for international investors. The US government bond market is the largest and most liquid in the world and Treasury securities remain the safe haven for liquidity, repayment and safe keeping of the vast cash reserves circulating in global commerce.

Reserve currency status is a distinct global advantage that comes with a global responsibility

However, the dollar’s pre-eminence may not last forever. Authoritarian states are increasing looking for alternatives to reduce their dependence on the dollar and more and more questions are being asked about whether the US has the political will and determination to address its fiscal incontinence. Reserve currency status is a distinct global advantage, but it comes with a global responsibility to use the privilege judiciously in order to preserve trust in the dollar-based global financial system.

When confidence in businesses or institutions cracks, it invariably happens slowly at first and then suddenly. We may be but a few errant policy moves or geopolitical missteps away from undermining trust and creating broad and lasting disruption across the entire financial world.

In recent decades, when the US had both a stronger fiscal position and a more disciplined approach to borrowing, the dollar-based system successfully weathered several market crises. It withstood the dot.com crash, the global financial crisis, a pandemic cash bailout and regional bank disruptions. As a result, US financial buffers have been severely depleted.

The incoming Treasury Secretary has made clear his concerns about national debt and his own commitment to preserving the dollar’s reserve currency status through a combination of growth, higher oil production and cutting government spending. He is also committed to the Trump tax cuts, deregulation and tariffs.

It remains to be seen just how successful Scott Bessent is at achieving all these goals. What is clear is that now is the time to stop stretching the fiscal rubber-band and demonstrate concrete steps toward fiscal responsibility.

As a former Republican chair of the Council of Economic Advisers, Herb Stein, once observed about unconstrained deficit spending: “If something cannot go on forever, it will stop.”