Understanding the national debt: implications and strategies for your financial future

Article | November 12, 2024

Authored by Weinlander Fitzhugh

The United States is facing a significant economic challenge: a national debt exceeding $35 trillion. While the US debt-to-GDP ratio places the country somewhere in the middle compared to other advanced economies like those in the G7 group, it’s not just the current debt level that’s concerning – it’s the pace at which it’s growing and the trajectory it’s on for the future. 

The rapid increase in debt raises questions about economic stability, potential inflation, and how it may widen the wealth gap. 

In this article, we’ll explore the implications of the escalating national debt, how it affects inflation and wealth distribution, and what steps you can take to prepare for potential economic changes. 

Understanding the basics: what is the national debt?

The national debt is the total amount the US government owes to creditors, both domestic and foreign. But how does the government accumulate this debt, and who exactly is lending it money? 

When the government spends more than it collects in revenue (primarily from taxes), it runs a budget deficit. To cover this shortfall, the government borrows money by issuing Treasury securities, such as bonds, notes, and bills. These are essentially IOUs that promise to repay the borrowed funds with interest at a future date. 

Who lends money to the government?

The creditors who purchase these Treasury securities include: 

• Individuals and institutions: US citizens, banks, mutual funds, pension funds, and other financial institutions buy Treasury securities as a safe investment. 
• Foreign governments and investors: countries like China and Japan hold significant amounts of US debt. They purchase Treasury securities to invest their US dollar earnings from trade. 
• Federal Reserve: the US central bank buys and sells Treasury securities to regulate the money supply and manage economic conditions. 
• Government trust funds: programs like Social Security invest surplus revenues in Treasury securities. 

By selling these securities, the government raises the cash needed to fund its operations and obligations when revenues fall short. 

Understanding the debt ceiling and budget deficits

Congress has set a debt ceiling, which limits how much money the federal government can borrow to meet its existing legal obligations. When spending plans exceed this limit, Congress must vote to raise or suspend the ceiling. Failure to do so can lead to a government shutdown or even a default on debt, which would have severe economic consequences. 

A budget deficit happens when government expenses outpace its revenues in a fiscal year, necessitating borrowing that adds to the national debt. While occasional deficits can be manageable, consistent deficits point to a structural budget imbalance. This persistent issue is primarily caused by the expansion of government programs and costs without a proportional increase in revenue and tax cuts without corresponding spending reductions.

It’s important to note that Congress is responsible for both setting the federal budget and establishing the debt ceiling, but these are separate processes. Critics of this approach argue that since Congress has already authorized spending through the budget, limiting the ability to finance that spending is redundant and counterproductive. However, proponents of the process feel that a separate debt ceiling forces periodic evaluations of government borrowing, providing fiscal oversight and an opportunity for lawmakers to negotiate policy changes. 

Why is the debt growing?

The escalating national debt is the result of multiple factors, including substantial pandemic relief spending, high defense and social program costs, rising interest rates, and various economic and policy issues. 

Pandemic relief spending

In response to COVID-19, the government implemented massive relief packages. Programs like the CARES Act resulted in federal spending of over $2 trillion in 2020 alone. While these measures were essential for stabilizing the economy and providing a safety net, they significantly increased the national debt in a short period. 

High defense costs

Defense spending is a major component of the federal budget. In fiscal year 2024, the US allocated approximately $883.7 billion to national defense. This generally reflects the country’s extensive global military commitments and efforts to maintain national security. To put this in perspective, US defense spending exceeds that of the next several countries with the highest spending combined. 

High social program costs

Social Security, Medicare, and Medicaid programs are also significant drivers of federal spending due to rising healthcare costs and an aging population. In 2024, Social Security was allocated $14.27 billion, Medicare was $848 billion, and Medicaid was $633 billion. Compared to other G7 countries, the US spends more on healthcare per capita, yet often with less favorable health outcomes, indicating inefficiencies that contribute to higher costs. 

Rising interest rates

As the Fed raises interest rates to combat inflation, the cost of servicing the national debt increases. Higher interest rates mean that when the government issues new debt or refinances existing debt, it does so at higher costs. In 2024, interest expenses are expected to be around $892 billion. A larger share of the federal budget is thus allocated to interest payments rather than funding essential programs. 

Economic and policy issues

Various economic conditions and policy decisions have exacerbated the debt issue:

• Recessions: economic downturns and recessions reduce tax revenues and incomes, and corporate profits decline, while government spending typically increases to provide unemployment benefits and stimulate the economy. 
• Tax cuts: substantial tax cuts without corresponding spending reductions or new revenue sources also decrease government income and increase deficits. 
• Demographic shifts: an aging population means more individuals are drawing benefits from Social Security and Medicare, increasing mandatory spending obligations. 
• Program expansion: government programs often expand over time, raising expenses without proportional revenue increases. 

Potential impacts on the economy and wealth gap

High levels of national debt can significantly influence the economy and exacerbate the wealth gap. 

Higher interest rates

As the government increases borrowing to finance its debt, it competes with the private sector for available funds, driving up interest rates. Higher borrowing costs make loans more expensive for individuals and businesses, which can slow economic growth by reducing consumer spending and business investments.

Inflation

When the government borrows heavily, it can increase the money supply, which may result in higher inflation. Elevated inflation diminishes the purchasing power of money, disproportionately affecting lower and middle-income households who spend a larger share of their income on essential goods and services. This scenario can widen the wealth gap, as those with fewer financial resources struggle more to keep up with rising costs.

Less private investment

Another significant impact is the “crowding out” of private investment. When the government absorbs a large portion of available capital, less funding is available for private enterprises. This reduction in private investment can hinder innovation and expansion, limiting economic growth and job creation.

Fiscal implications

Fiscal implications of a growing national debt include a larger portion of the federal budget allocated to interest payments. This leaves less funding for critical areas such as education, infrastructure, and healthcare. This reduced fiscal flexibility limits the government’s ability to implement effective policies, especially during economic downturns or emergencies, and may necessitate cuts to essential services and programs. These cuts can negatively impact citizens’ well-being and lead to public dissatisfaction.

Impact on individuals and businesses

The national debt translates to potential future tax increases for individuals and businesses as the government seeks additional revenue to address the debt. Higher taxes can reduce disposable income, leading to decreased consumer spending, a key driver of the economy. Businesses may face higher operational costs and reduced demand for their products and services, which can slow growth and limit employment opportunities. Additionally, there is a risk of cuts to government benefits and programs, such as Social Security and Medicare, which many Americans rely on for financial security and healthcare.

Economic uncertainty

Economic uncertainty stemming from high debt levels can also cause businesses to hesitate in investing or hiring, further stalling economic growth and reducing job creation. This environment of uncertainty can undermine confidence in the economy, making it more challenging to achieve sustainable growth and equitable wealth distribution. Moreover, a heavily indebted nation may be more vulnerable to financial crises or economic downturns, with less fiscal flexibility to respond effectively. 

Future projections and potential consequences

As the national debt continues to rise, the outlook presents several concerning projections and potential consequences that could have long-term impacts on the economy and society. 

One significant risk is the erosion of investor confidence. If investors begin to doubt the US government’s ability to manage its finances responsibly, they may demand higher interest rates to compensate for increased risk or seek investments elsewhere. This shift can lead to higher borrowing costs, exacerbating the debt problem. Diminished investor trust can also destabilize financial markets and undermine the global standing of the US economy. 

The burden of the growing national debt will fall heavily on future generations. Children and grandchildren may face higher taxes as the government seeks to service and reduce the debt. Budget constraints could lead to cuts in essential services and benefits, such as Social Security and Medicare. 

How can individuals and businesses prepare?

While it’s essential for the government to address the national debt, individuals and businesses can also take steps to safeguard their financial futures. 

Consider potential inflation and higher taxes in your budgeting and retirement planning. You may also want to factor in possible cuts to government benefits. This might mean saving more for retirement in anticipation of lower Social Security benefits. 

Spread your investments across different asset classes to manage risk. Consider including assets that historically hedge against inflation, such as Treasury Inflation-Protected Securities (TIPS), real estate, commodities like gold and silver, and inflation-resistant stocks. 

Also, build a savings buffer to protect against economic downturns or unexpected expenses. An emergency fund provides financial stability during uncertain times, reducing the need to rely on high-interest debt. 

Take the next step

Empower yourself by taking proactive steps today. Contact one of our expert advisors to review your current financial situation, explore tax-efficient strategies, and develop a plan tailored to your unique needs. By taking action now, you can better navigate potential challenges and secure a prosperous future for yourself and your loved ones.