Wed Jun 18

How high can US debt go before it triggers a financial crisis?

Written by Luke Hartigan, Lecturer in Economics, University of Sydney

The tax cuts bill currently being debated by the US Senate will add another US$3 trillion (A$4.6 trillion) to US debt. President Donald Trump calls it the “big, beautiful bill”; his erstwhile policy adviser Elon Musk called it a “disgusting abomination ^[1]”.

Foreign investors have already been rattled by Trump’s upending of the global trade system. The eruption of war in the Middle East would usually lead to “flight to safety” buying of the US dollar, but the dollar has barely budged ^[2]. That suggests US assets are not seen as the safe haven they used to be.

Greg Combet, chair of Australia’s own sovereign wealth fund, the Future Fund, outlined many of the new risks arising from US policies in a speech on Tuesday ^[3].

As investors turn cautious on the US, at some point the surging US debt pile will become unsustainable. That could risk a financial crisis. But at what point does that happen?

The public sector holds a range of debt

When talking about the sustainability of US government debt, we have to distinguish between total debt and public debt ^[4].

Public debt is owed to individuals, companies, foreign governments and investors. This accounts for about 80% of total US debt. The remainder is intra-governmental debt held by government agencies and the Federal Reserve.

Public debt is a more correct measure of US government debt. And it is much less than the headline total government debt amount that is frequently quoted, which is running at US$36 trillion ^[5] or 121% of GDP ^[6].

Are there limits to government debt?

Governments are not like households. They can feasibly roll over debt indefinitely and don’t technically need to repay it, unlike a personal credit card. And countries such as the US that issue debt in their own currency can’t technically default unless they choose to.

Debt also serves a useful role. It is the main way a government funds infrastructure projects. It is an important channel for monetary policy, because the US Federal Reserve sets the benchmark interest rate ^[7] that affects borrowing costs across the economy. And because the US government issues bonds, known as Treasuries ^[8], to finance the debt, this is an important asset for investors.

There is probably some limit to the amount of debt the US government can issue. But we don’t really know what this amount is, and we won’t know until we get there. Additionally, the US’s reserve currency status ^[9], due to the US dollar’s dominant role in international finance, gives the US government more leeway than other governments.

Interest costs are surging

What is important is the government’s ability to service its debt – that is, to pay the interest cost. This depends on two components: growth in economic activity, and the interest rate on government debt.

If economic growth on average is higher than the interest rate, then the government’s effective interest cost is negative and it could sustainably carry its existing debt burden.

The interest cost of US government debt has surged recently following a series of Federal Reserve interest rate hikes ^[10] in 2022 and 2023 to quell inflation.

The US government is now spending more on interest payments than on defence – about US$882 billion annually ^[11]. This will soon start crowding out spending in other areas, unless taxes are raised or further spending cuts made.

Recent policy decisions not helping

The turmoil caused by Trump’s “Liberation Day” tariffs and heightened uncertainty about future government policy are expected to weaken US economic growth and raise inflation. This, coupled with the recent credit downgrade ^[12] of US government debt by ratings agency Moody’s, is likely to put upward pressure on US interest rates, further increasing the servicing cost of US government debt.

Moody’s cited concerns about the growth of US federal debt. This comes as the US House of Representatives passed ^[13] the “One Big Beautiful Bill Act”, which seeks to extend the 2017 tax cuts indefinitely while slashing social spending. This has caused some to question the sustainability of the US government’s fiscal position.

The non-partisan Congressional Budget Office ^[14] estimates the bill will add a further ^[15] US$3 trillion to government debt over the ten years to 2034, increasing debt to 124% of GDP. And this would increase to US$4.5 trillion over ten years and take debt to 128% of GDP if some tax initiatives were made permanent ^[16].

Also troubling is Section 899 ^[17] of the bill, known as the “revenge tax”. This controversial provision raises the tax payable by foreign investors and could further deter foreign investment, potentially making US government debt even less attractive.

A compromised Federal Reserve is the next risk

The passing of the tax and spending bill is unlikely to cause a financial crisis in the US. But the US could be entering into a period of “fiscal dominance ^[18]”, which is just as concerning.

In this situation, the independence of the Federal Reserve might be compromised if it is pressured to support the US government’s fiscal position. It would do this by keeping interest rates lower than otherwise, or buying government debt to support the government instead of targeting inflation. Trump has already been putting pressure ^[19] on Federal Reserve chair Jerome Powell, demanding he cut rates immediately.

This could lead to much higher inflation in the US, as occurred in Germany in the 1920s, and more recently in Argentina and Turkey.