With the U.S. government’s debt reaching record highs and news headlines capitalizing on the innate fear associated with debt, we wanted to help our clients and readers grasp how it affects our economy and us as taxpayers. While national debt isn’t a new issue, the current situation is different, especially since interest rates have jumped from historic lows to levels we haven’t seen in over a decade. This combination of high debt and rising rates is putting a heavy strain on the federal budget. Let's clear up how debt affects the economy and influences financial planning for everyone.
Growth of U.S. Federal Debt - Historically
During World War II, the U.S. federal debt-to-GDP ratio skyrocketed to unprecedented levels. This was a necessary response to the massive wartime spending. But today, our debt levels have climbed to similar heights due to a bunch of factors, like the 2008 financial crisis, COVID-19 economic relief efforts, and, more recently, inflation-related expenses and rising interest costs.
The Congressional Budget Office (CBO) says that federal debt held by the public will be about 99% of GDP by the end of 2024 (check out graphic). This means that our government debt is more than just a number; it’s a big change in how the U.S. economy manages public finances and how it affects economic stability.
*Debt Held by the Public (non-government) Congressional Budget Office Data
Rising Interest Costs: A Growing Share of the Federal Budget
One major consequence of today’s debt levels is the rising cost of servicing it. In 2024 alone, interest payments on U.S. debt are projected to exceed $890 billion, surpassing defense spending. With rates at 15-year highs, the government now faces a reality where interest expenses are one of the largest items in the federal budget, trailing only major social programs like Social Security and Medicare.
Source: Congressional Budget Office US Outlays
Interest expenses not only consume a more significant portion of the budget each year but also reduce the government’s ability to invest in infrastructure, education, and other growth-oriented areas. In essence, high debt service costs create a drag on the economy by diverting resources away from productive uses, limiting flexibility in addressing future economic downturns or investing in innovation.
Why Debt Has Become Costlier: The Role of Higher Interest Rates
The Federal Reserve’s monetary policy shift over the past two years has led to a rise in interest costs. In response to inflation, the Fed has been aggressively raising interest rates, making borrowing more expensive for everyone, including the government. The 10-year Treasury yield, which is like a benchmark for long-term borrowing, hit 4.36% in November 2024, the highest it’s been in 15 years.
When older bonds with lower rates mature, they’re replaced with new bonds at higher rates. This means that the government has to pay more to service its debt, especially since it has a lot of it. This process is analogous with your mortgage payments being higher each month if you have a higher interest rate.
Long-Term Implications of Sustained High Debt Levels
Persistently high federal debt can have a range of long-term effects on both the economy and individual citizens. For one, as the government borrows more to cover its debt service obligations (yes, it will borrow more money to pay interest on outstanding debt), it may crowd out private investment by driving up interest rates for households and businesses. This phenomenon, known as “crowding out,” can reduce capital available for private investment, potentially slowing economic growth.
Additionally, high debt levels can limit the government’s policy options in times of crisis. If interest expenses are consuming an increasing share of the budget, the government has fewer resources available for emergency relief during economic downturns, natural disasters, or other crises that require rapid fiscal response.
Strategies for Tackling the Federal Debt Problem
The federal debt situation is a complex puzzle that needs a mix of policies to balance fiscal responsibility with economic growth. Fiscal ideas could be:
1. Spending cuts: Cutting back on non-essential spending can help reduce the debt.
2. Tax reforms / Tariffs: Raising taxes in targeted areas can bring in more money. Issuing tariffs on foreign imports increases government revenue (albeit at the ultimate expense of the consumer)
3. Balancing spending and revenue: Gradually aligning spending with revenue can help reduce the long-term debt burden.
4. Structural reforms: Changing major entitlement programs, like Social Security and Medicare, can help reduce future liabilities while keeping these programs running smoothly.
The other variable to fight the debt problem would be creating economic growth. When the economy grows, the government’s tax base increases, which can help offset the debt without raising taxes too much. Investing in innovation, infrastructure, and the workforce can boost productivity and economic output, making it easier to pay off the debt. Luckily, with the wave of Artificial Intelligence sweeping through the economy, productivity gains should be a lock thereby boosting economic output and providing a deflationary force.
The U.S. has managed high debt levels in the past, especially after World War II, by growing the economy. But doing this in today’s more mature economy is harder because of things like an aging population, changing global trade, and new technologies. Growth can sometimes cause inflation due to wage pressures (being upward because of record low unemployment), resource constraints, and demand-pull inflation, where prices rise due to excess demand relative to supply.
Global Comparison: How the US Stacks Up
While the U.S. debt-to-GDP ratio is high, it’s not the only advanced economy facing similar challenges. Countries like Japan and many European nations have a lot of debt, which makes us wonder if high public debt has become the new normal for these countries. But unlike Japan, the U.S. dollar is the world’s primary currency for business, which means people always want to buy U.S. Treasuries. This gives the U.S. a bit of a cushion, but it might not be sustainable forever if other countries start using other currencies more. We’ve seen this happen with trade, where countries are moving away from using the U.S. dollar. This risk has been more elevated with geopolitical tensions between Russia, China, and others.
Navigating a Path Forward / Personal Financial Impacts
The rising burden of U.S. government debt is not just a fiscal issue but an economic and social one, with far-reaching implications for current and future generations. While there is no easy solution, understanding the scope of the problem and its underlying drivers is a critical first step. Policymakers, businesses, and citizens alike have a vested interest in how the country navigates this debt landscape, as the consequences will shape economic opportunities, public services, and financial stability for years to come.
Just as the government’s large debt burden becomes more costly in a higher interest rate environment, individuals who are over-leveraged may also face significant financial challenges. With rates remaining higher for longer, those with substantial personal debt could see their debt service payments increase sharply, leading to potential financial strain or even crisis.
Conversely, for individuals who are 'asset-rich'—those holding tangible or appreciating assets—this environment could accelerate wealth accumulation. Real assets like real estate or equities that perform well during inflationary periods may continue to gain value, especially as they outpace inflation, preserving or even enhancing purchasing power.
However, for many investors, this dynamic brings a different challenge. To protect against inflation and preserve purchasing power, people may feel compelled to take on more risk within their investment portfolios. This could mean shifting to higher-yielding but riskier assets, such as equities or alternative investments, as traditional fixed-income securities may struggle to keep pace with rising prices. This shift, while potentially lucrative, also increases exposure to market volatility and investment risk.
Understanding these dynamics and assessing personal debt levels, asset composition, and risk tolerance becomes more crucial than ever. The broader economic environment shaped by the federal debt isn’t just a headline—it’s a factor that can influence personal financial resilience and strategy moving forward.
Sources: https://www.cbo.gov/publication/60419#_idTextAnchor001 , https://fred.stlouisfed.org/