Trump's Debt Sustainability Math

VIDEO TRANSCRIPT:

Trump’s historic victory means he will face few limits to his power in his second term

That is except for economic limits that will significantly constrain his policy options

Why does this make Elon Musk even more important?

Why does Trump 2.0 have a very different roadmap than Trump 1.0?

What are the Trump trades?

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In representative democracies, a mandate confers legitimacy and a strong mandate provides politicians and political parties leeway in policy implementation.

Donald Trump, by winning both the electoral college majority and the popular votes, the first time that a Republican presidential candidate to do so in 20 years, has been given a strong mandate by the American people this week.

While we don’t have the final results for many of the House races yet, it looks like Trump will also have the backing of both the Senate and the House.

And because Trump won’t be seeking re-election in 2028, he is free to devote all of the next 4 years to make good his promises.

It is extremely rare that a US president serving a second term gets to enjoy the full support of Congress.

What will Trump do with this once in a generation opportunity?

Whatever he does with it, there will be no excuse for failure.

That much is clear.

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I have no illusion about what Trump will and can achieve in his second term.

This is because the starting point of his second term is very different from the starting point of his first term.

As I pointed out in a previous video, while Obama left him with some low hanging fruit, Biden is leaving him with an empty fridge.

US budget deficit was 3% of GDP on the day of Trump’s first inauguration. (Chart 1)

It will be 6% on the day of his second inauguration. (Chart 1)

US inflation was 2.2 % on the day of his first inauguration. (Chart 2)

Right now it is at 3.3%. (Chart 2)

US unemployment rates was 4.7% on the day of Trump’s inauguration (Chart 3)

US unemployment rate is at 4.1% right now (Chart 3)

The fact that Trump will be inheriting from Biden an economy with a huge budget deficit, relatively high inflation, and relatively low unemployment rate means that he will be facing significant policy constraints.

The unemployment rate is already so low that big tax cuts, which will worsen the fiscal deficit, will be more inflationary than was the case under Trump’s first term

Tariffs will likely be also more inflationary, given the relatively tight labor market and the already very strong dollar.

Trump’s promise to fund tax cuts with tariffs has driven up interest rates, gold, and the dollar lately. (Chart 4)

The only question for Main Street and Wall Street alike now is whether the promise will become reality.

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To answer this question, I want to start with the so-called debt sustainability equation.

The stock of debt of any government today is just equal to the stock of its debt yesterday minus its budget balance today. A deficit increases the debt stock while a surplus reduces the debt stock.

The budget balance has two components. One is the interest cost of servicing the debt. The other is known as the primary balance that includes everything else

Combination the two equations, we get this

If we divide the equation by GDP, we get this

What this equation says is that the higher is the primary deficit and the higher is interest rates relative to economic growth, the higher will be the debt growth.

We can rewrite this equation in terms of debt growth, meaning the difference between debt stock today and debt stock yesterday:

What this equation says is that when interest rates are lower than economic growth, it is relatively easy to stabilize debt growth.

Conversely, when interest rates and growth converge or worse when interest rates exceed economic growth, debt dynamics become explosive.

The US federal debt to GDP ratio has doubled over the past 25 years (Chart 5)

From 60% of GDP to 120% of GDP. (Chart 5)

This might seem like a big increase

But it isn’t, considering the fact that average size of the US budget deficit during this period was just shy of 5% of GDP (Chart 6)

The debt to GDP ratio would have increased much more if it weren’t for the fact that interest rates were much lower than GDP growth during much of this period. (Chart 7)

As a result, interest paid on outstanding Treasury debt securities as a share of GDP remained at just 1.5% of GDP until recently. (Chart 8)

Of course, the reason why interest rates were so much lower than nominal GDP growth during most of these years was because inflation was very low. (Chart 9)

Inflation was so low that investors were willing to accept very low risk premium for holding US government bonds.

The bottom line is that low inflation over much of the past quarter century allowed the US to run persistently large budget deficit with relative impunity.

But that is changing.

This is why Trump 2.0, at least regarding economic policies, is likely to be very different from Trump 1.0, including market implications.

It won’t be the same movie at all.

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The gap between US growth and US interest rates has been narrowing for the past two year. (Chart 7)

There are many reasons for this.

An important part of the story is the growing recognition among bond investors that the era of low inflation is coming to an end.

As the results of the 2024 US elections testify, the political pendulum has decisively swung the other way.

Increased trade barriers and reduced immigration are here to stay.

And this is as true in the US as practically anywhere else.

As a result, investors are now demanding higher inflation risk premium for holding bonds.

This is why the interest cost of servicing US federal debt has skyrocketed over the past two years.

In 2023, interest cost reached 880 billion dollars and 2.4% of GDP.  (Chart 9)

In 2024, interest cost has continued to surge. It was at 1.12 trillion dollars annualized rate in Q3 (Chart 9)

Against this backdrop, tax cuts and tariffs on imports could be counter-productive

They can easily backfire by stoking inflation fears and pushing interest rates even higher (Chart 11)

And higher interest rates will worsen debt dynamics, depress the housing market and the stock market.

Already, 10y Treasury yields are higher than the 12-month forward implied earnings yields of S&P 500 (Chart 12).

Tax cuts and tariffs are a dangerous game to play when the budget deficit is at 6% of GDP and debt is at 120% of GDP.

I want to believe Scott Bessent, a front runner as Trump’s treasury secretary, when he said that Trump’s threat of tariffs is a negotiating tactic and that he is in favor of bringing down the deficit to 3% of GDP by the end of 2028.

Necessity is the mother of invention.

What will be the direction of economic policy under a policy constrained Trump 2.0?

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My predictions:

I think the next Trump administration will focus on supply side reforms.

Meaning reforms that will raise potential economic growth

Potential growth is a function of productivity growth and population growth

Trump recent said that he is in favor of granting a green card to any foreign student completing a US college degree

This would help augment labor force growth and ease skill shortage.

This will raise potential growth.

Trump has promised massive deregulation.

Less regulations should encourage investment and stimulate competition

Less draconian banking regulations might even result in some credit easing

5 million applications were filed to start a new business every year over the past three years.

Deregulations that increase the expected return on capital will help unleash further the entrepreneurial instincts of Americans.  

Deregulation will certainly help increase productivity growth and potential growth.

Remember, to achieve debt sustainability, the US needs lower interest rates relative to growth.

Deregulation that increases US oil production and keeps inflation low has a big role to play to help.

Trump 2.0 is bullish for small caps and bearish for oil price.  

And then there is technology.

How to use technology to transform the US government into a mirror of the US private sector?

This will be essential to achieve debt sustainability without fiscal tightening.

This is where Elon Musk come in.

There is a lot of vested interest backed by lobby groups that will no doubt put up a big fight.

And it could get ugly or even bloody.

But if Elon Musk cannot do it, then nobody else can.

I don’t know if this makes me bullish about Tesla, but it makes me bearish about real estate in the Washington DC areas.