Believe it or not, U.S. debt was once a source of national strength, before it became a sword of Damocles hanging over the federal government and the bond market.
While the nation celebrates the 250th anniversary of the Declaration of Independence, the origin of U.S. financial might can be traced back to a controversial decision in 1790 to consolidate debts from the Revolutionary War.
Alexander Hamilton, who served as the first Treasury Secretary, is considered the architect of American finance as he engineered one of the most consequential economic decisions in early U.S. history.
He recognized how debt can unlock resources that could transform the young republic. But first he had to untangle the mess created by the Revolutionary War.
To fight off the British Empire, the Continental Congress borrowed heavily domestically and internationally via various instruments, while individual states racked up their own war debts.
Under Hamilton’s plan, the nascent federal government took on state debts and consolidated everything into one national debt. At the same time, he committed the U.S. to repaying the debt in full rather than claiming that the government established by the Constitution wasn’t responsible for war-era borrowing.
For a fragile new country, this was a revolutionary idea and established its creditworthiness early on, as investors had expected the U.S. to instead default on its debts or force investors to take a hair cut.
By building a reputation for reliability, demand for U.S. debt grew, and Treasury bonds were soon traded in European markets. This also allowed the U.S. to borrow more money relatively cheaply, as investors were reassured by the “full faith and credit of the United States,” with fresh debt helping finance the Louisiana Purchase.
Fast forward more than two centuries to today, and Treasury bonds underpin the global financial system and are considered one of the world’s safest assets.
They also fill reserves in central banks and corporate coffers while also reinforcing the U.S. dollar’s status as the top reserve currency, enabling the U.S. to flex its financial muscle wherever greenbacks are exchanged.
This “exorbitant privilege” has allowed to U.S. to borrow more cheaply than its fiscal profligacy would otherwise permit.
U.S. debt is now $39 trillion, with publicly held debt equaling the size of the entire economy. Interest costs alone are $1 trillion a year, topping the defense budget and adding to a pile that’s soon headed for territory not seen since the immediate aftermath of World War II.
The explosion in red ink, especially in the last 20 years, has fueled growing and increasingly dire alarms, as the trajectory is unsustainable. Meanwhile, lawmakers continue cutting taxes that weaken revenue without tackling the biggest drivers of spending, namely Social Security and Medicare.
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But for now, investors are continuing to buy new U.S. debt, though some recent Treasury auctions required a higher yield to draw the necessary demand.
The Treasury market also remains the world’s deepest and most liquid, with over $30 trillion in outstanding securities and more than $1 trillion in daily trading volume.
Although the precise debt level that would spark a crisis is unknown, the Penn Wharton Budget Model recently put the threshold at more than 210% of GDP.
Above that “outer bound,” there’s no feasible tax on labor income that can finance interest payments on U.S. debt at returns acceptable to investors,PWBM warned.
According to PWBM, the outer bound of federal debt is the solvency limit, beyond which defaulting on either Treasury debt or pay-as-you-go transfers like Social Security becomes a near certainty on an inflation-adjusted basis.
The debt-to-GDP ratio is about 100% today, and forecasts from the Congressional Budget Office see it hitting 175% by 2056—suggesting 210% is decades away on its current trajectory.
But depending on how much healthcare costs rise and boost Medicare spending, that threshold could come much sooner.
The U.S. has 25 more years in a lower-growth scenario, 22 years with medium growth, and 19 years with higher growth, PWBM estimated. But even that may downplay the risk.
“Under the historical growth rate of healthcare costs, there is a 25% chance of hitting the debt maximum in 14 years,” it added.
