US debt dynamics look scary. Effective policy is critical

We’re at a key juncture when it comes to US debt dynamics. Government debt is approximately equal to the value of GDP. In other words, there’s a c.100% debt/GDP ratio. This makes the mathematics relatively easy. Basically, when debt is the same size as GDP, debt dynamics are broadly determined by whether the growth in nominal GDP is above or below the average coupon print on the debt. Provided the former is higher than the latter, then the debt/GDP ratio can trend lower.

That is the case where the primary deficit is in balance, which is not the case for the US. The primary deficit is the fiscal deficit excluding interest payments. In the US, the primary deficit ran at around 4% of GDP in 2024 and is projected at around 3% of GDP in 2025. If we assume a 3% primary deficit, for the debt/GDP ratio to fall, then the value of GDP must grow by more than the average coupon print plus 3%. That’s a tough circle to square. For 2024, the value of GDP likely rose by almost 4.5% (not enough).

The weighted average fixed coupon print right now is around 2.85%. Bills then tend to account for around 20% of total debt and are rolling over at a cost of around 4.25%. That comes to an average interest rate cost of a little over 3%. The risk case is a trend towards 4% over time, as the yield on the weighted average 7yr maturity is over 4%, and the funds rate is not projected to get too far below 4% through 2025/26. Conservatively we should assume at least a 3% interest rate cost.

The final mathematics is as shown above. We have a primary deficit of some 3% of GDP and interest rate costs of some 3% on total debt. With the debt/GDP ratio at around 100%, that means the value of nominal GDP needs to rise by some 6% for the debt/GDP ratio to stabilise. A repeat of 2024’s c.4.5% value increase risks adding 1.5% to the debt/GDP ratio on an annual basis. Something similar for 2025, and over subsequent years would continue to build the debt/GDP ratio.

Moreover, as the debt/GDP ratio rises above 100%, the problem is amplified. Take an extreme – a 200% debt/GDP ratio would require the growth in the value of GDP to be double that of the annual coupon cost (plus half of the primary deficit ratio). This is a nightmare scenario we don’t want to see, but it’s one we trend towards on CBO estimates if nothing changes on the various components as described above. And so far, there is little in the works to divert us from this path.

Typically, what happens in crises seen elsewhere is the market begins to believe the negative spiral well ahead of it occurring. We saw this for example when the Greek debt dynamics began to gap in the wrong direction. Once the debt/GDP ratio hit 130%, the markets quickly saw 150% and beyond coming, and jumped to price a default scenario.