“It is to be expected that demands will occur, in the affairs of nations, in which there will be a need to borrow. That loans in times of public danger, especially foreign war, are found to be an indispensable resource, even the richest of them. . . it is essential that the credit of a nation be well established . . . Convinced as the Secretary is that adequate financing of the current debt will make it a national boon, yet he is so far from acceding to the position, at the latitude in which it is sometimes stated: ‘public debts are public benefits’, a position that invites extravagance and is subject to dangerous abuse, and which it ardently wishes to see incorporated as a fundamental maxim in the public credit system of the United States, that the creation of debt must always be accompanied by means of extinction. (Emphasis added)” — Alexander Hamilton, “The First Public Credit Report“
The United States reached its debt ceiling of $31.4 trillion on January 19, 2023, a limit approved by Congress just two years ago. The US Treasury is now taking extraordinary emergency measures to prevent the nation from defaulting.
The current battle over the debt ceiling reveals a painful reality that the nation must face. There are two important principles at play, which Alexander Hamilton refers to in the quote above. The first is that maintaining the solvency of the United States is essential to the economic health of the nation. Voluntarily defaulting on the federal debt would compromise the very foundation of the country’s economic success. The second is that the current trajectory of unsustainable fiscal deficits could lead to an inadvertent default in the coming years that would be just as catastrophic.
These uncomfortable truths have some critical implications:
1. Public debt is no longer what it used to be
In 1790, the survival of the United States was far from certain. The country had won the Revolutionary War and ratified the Constitution, but its finances were in disarray. The states and the federal government were unable to pay their war debt or even pay their veterans. This affected the performance of the nation’s economy and the government’s ability to regulate it. But Hamilton, the first Secretary of the Treasury, understood the essential role that the integrity of the nation’s credit played in ensuring economic prosperity. He coordinated the approval of several regulations that restored the solvency of the nation. These programs included the consolidation of war debt under the federal government, the institution of tariffs to finance outstanding debt payments, and the creation of a central bank.
Without these measures, the United States might not have had the financial means to support the “demands” Hamilton referred to. Adherence to Hamiltonian financial principles helped the United States persevere through the War of 1812, the Civil War, and World War I.
When these demands ended, the country complied with Hamilton’s second principle and ran surpluses from the federal budget to extinguish the debt. But that changed after World War II. Initially, the United States serviced its debt as it had before, but by the 1960s permanent peacetime deficits had become the norm. Over the next decade, this trend is expected to continue with an average deficit of 5% of GDP per year, according to the 2022 estimate from the Congressional Budget Office (CBO). Such a trajectory is impossible to sustain indefinitely, yet population aging and secular declines in productivity threaten to worsen the problem beyond 2032.
US federal budget deficit as a percentage of GDP, 1791 to 2022
Why did the United States change its philosophical approach to public credit? One reason is simply that it could. The US dollar became the world’s reserve currency after the Bretton Woods Agreement in 1945, and US Treasuries became an essential store of value for central banks and savers around the world. The massive expansion of rights programs played a role as well. This is not impeachment: these programs have real social benefits, but the corresponding costs exceed the nation’s ability to finance them. According to the Congressional Budget Office (CBO), Social Security and health care programs like Medicare and Medicaid account for a large part of the federal budget. By 2032, they will account for more than 50%, and their costs will only increase as the population ages.
2. Don’t make the cure worse than the disease.
The United States cannot accumulate debt faster than the US economy grows forever. But it can last quite a long time. Therefore, defaulting on the debt by refusing to increase the debt limit constitutes an unforced self-inflicted injury. At the height of the 2008 global financial crisis (GFC), Congress initially voted against the Troubled Asset Relief Program (TARP), immediately causing panic to escalate. On a second vote, the measure passed, and TARP helped restore faith in America’s financial system. Nobody knows what would have happened if the second attempt had failed, but it would have been disastrous.
The same goes for the debt ceiling. The United States has never defaulted on its public debt, so we cannot predict the consequences. But they will be severe. The possibility of a default in the more distant future is a risk that needs to be addressed, but a voluntary default would be the financial equivalent of driving a car off a cliff instead of running out of gas.
The Disadvantages of a Divided Nation
America’s political divisions are at a cyclical high, but they’ve been worse. After all, the nation went to war with itself in 1861. Yet the threat to America’s financial stability demands a unified effort. The longer the accumulation of unsustainable debt continues, the more serious the consequences and the more draconian the countermeasures will ultimately have to be. As reckless as a voluntary default in 2023 may be, it would be equally irresponsible to saddle future generations with debts they cannot pay or will require dramatic reductions in their living standards to pay.
Through wars, panics, depressions, pandemics, and natural disasters, America has always managed to unite a divided people to counter these threats. This unit has been reticent at times and the degree of sacrifice unfairly distributed, but it has always met the objectives desired by the group.
The decline and collapse of great powers throughout history demonstrate that there are no guarantees that the next existential crisis facing the United States will not be its last. The solutions to the debt problem will be painful and will require sacrifice. Only time will tell if the United States will rise to the challenge or succumb to decline like so many empires before it.
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All messages are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Mark J Higgins, CFA, CFP
