$40 Trillion Is an Enormous Number. But What Does It Actually Mean?

The United States government does not manage money the same way a household does. The federal government can issue debt in its own currency, levy taxes and refinance obligations in ways an individual family cannot.

So reaching $40 trillion in federal debt does not mean the United States is suddenly about to “go broke.”

But that does not mean the debt is irrelevant.

Borrowing has a cost, and as the amount of federal debt grows, the cost of servicing that debt can become increasingly important to the federal budget and the broader economy.

Interest Expense Matters

When interest rates rise, newly issued Treasury securities generally become more expensive for the federal government to finance. As older debt matures and is replaced with debt carrying higher interest rates, federal interest expense can increase.

That matters because every additional dollar devoted to servicing existing debt is a dollar that cannot be used elsewhere without increasing taxes, reducing other spending or borrowing even more.

The important question for investors isn't simply how large the national debt becomes. It's what eventually has to change because of it.

What Could Rising Debt Mean for Interest Rates?

The U.S. Treasury finances federal borrowing by issuing Treasury securities. As borrowing requirements increase, the market may need to absorb a larger supply of government debt.

Treasury yields are influenced by many forces, including Federal Reserve policy, inflation expectations, economic growth, global demand for U.S. government securities and investor expectations.

Federal borrowing is therefore only one part of the interest-rate equation. But over time, the amount of debt the government needs to finance can become an increasingly important part of that discussion.

Debt, Inflation and Monetary Policy

Government debt also intersects with inflation and monetary policy.

If inflation remains elevated, the Federal Reserve may need to maintain higher interest rates than investors would otherwise prefer. Higher rates can increase borrowing costs throughout the economy, for the federal government, businesses and households.

On the other hand, weaker economic growth can create pressure for lower interest rates or additional monetary support.

These competing forces are one reason the national debt cannot be reduced to a simple prediction that rates, inflation or markets must move in one particular direction.

Could Taxes Eventually Rise?

There are only so many ways to address a persistent gap between government revenue and government spending.

Policymakers can reduce spending, increase tax revenue, allow deficits to continue, pursue policies intended to increase economic growth, or use some combination of those approaches.

For investors and retirees, that makes future tax policy an important planning consideration.

The tax environment that exists when you accumulate wealth may not necessarily be the same tax environment that exists when you eventually spend it.

What About the Stock Market?

A large national debt does not automatically mean stocks must fall.

Businesses ultimately derive their value from profits, cash flows, growth and investors' expectations about the future. Markets can continue rising during periods of increasing federal debt, just as they can decline for reasons having little to do with the headline national-debt number.

But government borrowing can influence many of the variables that matter to asset prices: interest rates, inflation, economic growth, taxes and the return investors can earn on safer assets such as Treasury securities.

The national debt may not determine what markets do next, but the consequences of that debt can eventually find their way into an investment portfolio.

So, Should Investors Be Concerned?

Concerned does not have to mean alarmed.

A $40 trillion national debt is not, by itself, a reason to abandon a long-term investment strategy or make dramatic portfolio changes.

It is, however, a reason to pay attention to the underlying economic consequences.

Interest costs matter. Inflation matters. Treasury yields matter. Taxes matter. Economic growth matters.

Rather than trying to predict exactly how Washington will eventually address the debt, investors can build financial plans designed to remain resilient across a range of possible outcomes.

That means maintaining appropriate diversification, understanding how much investment risk your financial plan actually requires and making tax, income and portfolio decisions in the context of your broader goals.

This article accompanies an episode of The Thoughtful Investor, the Yach Advisors podcast hosted by Bryan Yach, CFP®.