Category: Essentials of Economics: Ch 15

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US national debt reaches $40 trillion: but does it matter?



The US national debt hit a milestone in August 2026. It reached a staggering $40 trillion. The national debt is the amount owed by the US federal government to holders of government bonds and bills (treasury securities). The debt grows each year by the size of the annual government deficit, which is the amount that government expenditure exceeds tax and other revenues. The bigger the deficit, the more the national debt grows. The $40 trillion debt represents 126% of GDP – in other words it is more that the total annual output of the USA. It represents around $118,000 per head or $290,000 per household

But does this high and rising debt matter? And how does it compare with other countries?

The comparative size of the national debt

In absolute terms, the US national debt is huge, reflecting, in part, the size of the US economy. In percentage terms (126% of GDP), it is higher than Germany (65%), the UK (104%), Canada (110%) and France (118%) and slightly higher than the G7 average (124%). It is lower, however, than Italy (138%) and much lower than Japan (204%).

What is more, the IMF forecasts that the US national debt will rise from 126% of GDP in 2026 to 139% by 2030. This is because of continuing budget deficits, which require funding. The federal budget deficit is forecast to be around $2 trillion in the financial year ending September 2026 – it was $1.78 trillion in the previous financial year.

Japan’s debt percentage, by contrast, is forecast to fall from 204% in 2026 to 194% by 2030. Also, only about 10% of Japan’s debt is held by foreign investors. Around 90% is financed domestically by Japanese households, local banks, insurance companies, and the Bank of Japan. This makes Japan’s debt more sustainable than the USA’s, where around 28% is held by foreign investors (foreign governments, companies, banks and individuals).

Unlike domestic institutions (such as pension funds), which often have a structural bias to hold domestic assets, foreign investors typically view a country’s bonds as one of many global alternatives and are likely to switch faster to other countries’ assets during periods of market stress. The higher the proportion of bonds held outside the country, the more vulnerable the country is likely to be to bond market speculation.

The UK’s national debt percentage is forecast to fall slightly from 104% of GDP in 2026 to 103% in 2030. However, the UK is a global financial hub and the percentage of debt held by foreign investors (around 30%) is a little higher than in the USA. UK debt held overseas has risen from around 15% in the mid-2000s. It is likely to rise further.

Does high and rising US national debt matter?

Servicing the debt.  In February 2022, the US central bank rate (the Federal Funds rate) was 0.25%. It then rose in increments to combat rising inflation and reached 5.5% by July 2023. Although it has come down slightly since, standing at 3.75% in August 2026, US interest rates are higher now than at any time from 2008 to 2022. With higher interest rates, the USA now pays roughly $1.1 trillion annually just to service the debt. This accounts for around 15% of total federal spending – up from an historical 50-year average of just under 9%.

Upward pressure on domestic borrowing rates.  To fund its deficits, the US Treasury Department must continually issue massive amounts of government bonds. This high volume of government borrowing competes for capital in global financial markets, which can push up broader interest rates. For businesses, this imposes a cost on investment and can act as a disincentive to borrow. For consumers, it adds to cost-of-living pressures by raising the cost of mortgages, car loans, credit card debt and other borrowing.

Crowding out other public spending.  The money spent on servicing the debt is not available for building roads or other infrastructure, funding education, healthcare or defence, or providing social security. Annual interest payments of around $1.1 trillion now exceed national defence spending (around £960 billion), making it the third-largest item in the federal budget after healthcare and social security. As the national deficits and debt expand, so a higher proportion of current taxes is being used to fund past expenditure.

Long-term fiscal risk

The US dollar is the world’s primary reserve currency. This creates persistent global demand for US debt. However, ratings agencies and other organisations, such as the Congressional Budget Office (CBO), warn that adding $1 trillion to national debt roughly every five months is an unsustainable trajectory that could eventually erode confidence in the US economy.

Already, many countries are seeking to expand the range of currencies used as reserves, including Chinese yuan, the euro and crypto currencies. They are also holding more gold. In 2001, the US dollar accounted for 72% of currencies held globally as reserves; by 2025 this had fallen to 57%. This process could accelerate as confidence in the USA is eroded because of the size of the debt and the capricious policies towards trade.

During periods of quantitative easing (QE), central banks, including the Fed, purchased large amounts of government bonds. But now, as central banks scale back their bond holdings in programmes of quantitative tightening (QT), foreign private investors and domestic households are being forced to absorb the majority of newly issued government debt, making pricing and yields increasingly sensitive to global investor demands. A decline in confidence can lead to a large sale of bonds, forcing down their price, thereby forcing up their yield and hence the interest that has to be paid on newly issued bonds. This is what happened in the UK in September 2022 under the short-lived administration of Liz Truss when she and her chancellor, Kwasi Kwarteng, made unfunded promises of tax cuts.

The USA is not immune to such bond market jitters. In mid-August, the yield on 30-year US Treasury bonds reached 5.3% – the highest level since 2007.

A worsening problem

The US deficit is likely to increase, making the national debt rise more rapidly. There are various reasons.

The US population, as in many countries, is ageing and the proportion of retired people is rising. This puts increasing demands on healthcare and social security, with a proportionately smaller workforce to fund them.

The deficit has also been increased by deliberate government policies. For example, Donald Trump’s 2025 ‘One Big Beautiful Bill’ Act made substantial tax cuts, largely for the wealthy.

Congress caps the debt at a certain level and in the past this has acted as a brake on size of the deficit. However, the cap was raised by $5 trillion in 2025 and this could well happen again, allowing debt levels to expand further.

But reining in the deficit could have a contractionary effect on the economy as taxes are raised and/or expenditure is cut. Governments are reluctant to do this as it could lead to recession, or at least falling growth in the short term, and this could affect their chances or re-election. With the mid-terms approaching in the USA, and the presidential election just two years later, this is an unlikely policy for the Trump administration to pursue.

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Questions

  1. Distinguish between national debt, central government debt and general government debt.
  2. Would it be possible to run a budget deficit and yet for the national debt to fall as a percentage of GDP?
  3. Japan and Italy have a higher debt to GDP ratio than the USA or the UK. Why are they less subject to bond market pressures than the USA or the UK?
  4. What policy measures would you recommend to the US government to tackle the rising national debt and why?
  5. Could the USA ‘grow its way out of the debt problem’?
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Propping up the yen?



The yen has been depreciating against the dollar and other currencies for several months. It fell from 100 yen = $0.97 in January 2021 to $0.61 by the end of July 2026 – a fall of 37%. This marked a 40-year low. But then, at the end of July it rallied and by 3 August the rate was 100 yen = $0.64 – a rise of nearly 5%. But why did this happen and what will be the implications for Japan and the wider world economy?

Why has the yen fallen so much since 2021?

There have been two main drivers.

The first is fiscal policy. For many years, Japan has been pursuing expansionary fiscal policy in an attempt to stimulate the sluggish economy. This has led to large budget deficits and public-sector debt. Since 2020, general government gross debt has been around 255% of GDP, the largest of any high-income economy.

Recently, the Japanese government has adopted aggressive supplementary budgets to fund, among other things, fuel subsidies and public-private investment initiatives. This has involved the issuance of more government bonds to fund the necessary borrowing.

Fiscal pressures have also increased becase of demography. A rapidly aging population and declining birth rates have required substantial public spending on healthcare, social security and pensions. Meanwhile, the tax-paying working-age population has declined as a proportion of total population.

On the plus side, unlike most highly indebted nations, over 90% of Japan’s debt is held domestically by Japanese residents, Japanese institutional investors, banks and the Bank of Japan (BoJ). This lowers the risk of default and hence the risk premium on Japanese bonds.

The second driver is monetary policy. Interest rates have been kept low over many years, including periods of negative rates, as the BoJ has attempted to stimulate the economy. Low interest rates have sometimes been backed up with quantitative easing to increase money supply.

Since March 2024, however, there have been four interest rate increases. The latest was in June 2026 when the BoJ raised the short-term policy rate from 0.75% to 1.0% – the highest level since 1995. Despite this, interest rates have remained below those in other countries, and this contributed to the continuing fall of the yen.

A falling yen has helped to increase Japanese exports by making them more competitive, but more expensive imports have contributed to rising Japanese inflation.

Low interest rates have also stimulated the yen-dollar carry trade. This is where investors borrow money in yen at low interest rates, convert it into US dollars and invest it in higher-yielding US assets, typically US government bonds (‘Treasury bonds’). This borrowing in yen to buy dollars further contributed to the depreciation of the yen against the dollar.

Co-ordinated intervention

In an attempt to raise the value of the yen, the Bank of Japan and the US Federal Reserve acted together – their first joint currency rescue operation since 2011. The BoJ spent tens of billions of dollars to buy yen; the US Treasury bought yen by selling euros. Prior to the intervention, global hedge funds held near-record short positions against the yen, meaning that they sold yen at a current price, agreeing to buy them back at a particular later date, hoping that the yen would fall in the meantime and that they would therefore make a profit. The sudden joint intervention forced these traders to buy back the yen to cut their losses before the rate rose further. This accelerated the yen’s appreciation.

But why did the USA join Japan in intervening? Japan is the largest foreign holder of US Treasuries ($1.1 trillion). The USA intervened to discourage Japanese investors from selling US Treasuries in order to raise cash, thereby pushing up US borrowing costs.

The rise in the yen was also encouraged by speculators who are expecting further interest rate rises from the BoJ to counter inflation and support public finances, driving domestic bond yields higher. This will lead to a narrowing of interest rates between Japan and other countries.

Effects on the Japanese economy

If the yen continues to appreciate, this will help to reduce inflation by making imports cheaper and will help to ease cost-of-living pressures on Japanese consumers. Japan is heavily reliant on imported energy and raw materials.

However, the decline in the yen over recent years has provided a large boost to Japanese exports. A sharp reversal in this could severely affect exporters’ profits and have a serious negative impact on economic growth.

If the appreciation continues, it would lead to an unwinding of the carry trade. To prevent mounting currency losses, highly leveraged institutional investors would be forced to sell assets, such as US and other countries’ shares and bonds to buy back yen and pay off their debts. This potentially massive unwinding would be likely to create global market volatility and drive up interest rates.

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Questions

  1. What have been the benefits and costs to Japan of a depreciating exchange rate?
  2. Explain the carry trade.
  3. Why might the yen-dollar carry trade unwind and what would be the consequences for Japan and the USA?
  4. Find out what has happened to the exchange rate between the yen and the euro. Has this been driven by the carry trade?
  5. For what reasons might the yen (a) now continue rising; (b) resume depreciating?
  6. Find out what has happened to the yen/dollar exchange rate since this blog was written. Explain your findings.
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Economic games in the Iran war

Economists use game theory to understand decision making where the outcome for an economic actor – individual, firm, government, etc. – depends on the actions and reactions of other actors. It models how rational actors make optimal decisions based on their expectations about such actions and reactions of competitors. Sometimes these expectations will be based on considerable knowledge; sometimes they will be based on hunch or the degree of optimism or pessimism.

Perhaps the most famous game is the prisoners’ dilemma. This is where two or more firms (or people) independently attempt to choose the best strategy, thinking about how their rivals are likely to react. But they end up in a worse position than if they had co-operated in the first place. For example, if a firm is considering cutting price, it would gain market share if the other firm does not cut price; in such a scenario it is likely to gain by cutting price. If, however, the other firm is expected to cut its price, the first firm will have to cut price itself to avoid losing market share; in this scenario it will also cut price. Assuming the other firm reasons the same, the outcome is likely to be a price war, with both firms losing profit. However, if they both colluded to maintain prices or even raise them (assuming they can evade any legal restrictions on collusion), they will both gain.

Another example is the game of chicken. This is where two or more actors engage in brinkmanship, hoping that the other actor(s) will give in first. Take the above example of a price war. Assume that two firms are engaging in price cutting. They know that this will damage their short-term profit. But each hopes that the other will give up first and may then be willing to collude or, better still, be driven out of business. If either firm thinks it can win the game, it will reason that short-term pain is justified by long-term gain.

The war in Iran

A game of chicken is currently being ‘played’ by the USA and Iran. Iran is blocking the Strait of Hormuz; the USA is blockading Iranian ports, preventing ships from arriving or leaving. Both policies inflict economic pain. Blocking the Strait of Hormuz has driven up oil and gas prices and the prices of many other products exported through the Strait – products such as fertilisers, plastics, petrochemicals, sulphur, methanol and helium.

Each side hopes that the economic pain inflicted on the other will cause it to give up first.

But the game is ‘asymmetric’: the costs of continuing the blockades are different for each side and thus the pressures on each side to concede differ. For Iran, the blockade of its ports is massively curtailing its exports and is doing huge damage to its economy, already battered by bombing. But the war has so far seemed to allow the Iranian authorities to tighten their political grip and they may be prepared to play the ‘long game’ by rallying the Iranian population against the US and Israeli assault. The authorities may calculate that the Iranian people will be prepared to endure greater hardship for some time.

The USA is facing a much lower economic cost. Much of the hardship from the effective closure of the Strait of Hormuz is being borne by other countries. Energy and fertiliser shortages and the resulting rise in price of these critical inputs threaten a humanitarian disaster in some of the poorest countries. Harvests will be down, as will GDP; food prices will soar. There will be widespread economic hardship across Africa and much of Asia, particularly in those countries struggling with existing high debt burdens.

But for Donald Trump and his administration, those costs are likely to be seen as important only in so far as they affect the USA. However, oil prices are determined in international markets and, despite the US economy gaining from higher oil prices as the USA is a net exporter, the price of fuel to the US consumer has risen substantially. Petrol prices in the USA have risen some 45% since the start of the war and jet fuel prices have doubled, driving up air fares. With the prices of other key products, such as medicines, clothing and electronics increasing too, US inflation is now rising – aggravated by the effects of the tariffs on many products. These costs matter to the US consumer and, with mid-term elections approaching and with Donald Trump’s approval rate plummeting, the USA is likely to be more sensitive to short-term economic costs than Iran.

But the USA poses a much greater military threat to Iran than vice versa and this is seen in the USA as a major advantage in this high-stakes game of chicken. But the Iranian authorities’ willingness to endure further military strikes for what they see as long-term gain, may make them unlikely to concede first.

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Questions

  1. Explain the prisoners’ dilemma game and explain what is meant by the Nash equilibrium in the game.
  2. What is the Nash equilibrium of a game of chicken?
  3. Explain the asymmetries in the ‘game’ being ‘played’ by the USA, Israel and Iran?
  4. What other actors are there in the ‘game’ and do they play any significant role?
  5. How important is information and understanding held by the USA, Israeli and Iran about the likely consequences of their actions?
  6. What can mediators, such as Pakistan, do to de-escalate the situation?
  7. What are the likely long-term costs to the global economy if the blocking of the Strait of Hormuz persists for a number of months?
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The Russian economy after four years of war

At the fourth anniversary of Russia’s invasion of Ukraine, we look at the effect of the war on the Russian economy. Two years ago, in the blog The Russian economy after two years of war, we argued that the Russian economy had seemingly weathered the war successfully.

Unlike Ukraine, very little of its infrastructure had been destroyed; it had started the war with a current account balance of payments surplus, a budget surplus and a low general government debt-to-GDP ratio; it had achieved a lot of success in diverting its exports, including oil, away from countries imposing sanctions to countries such as China and India; it was the same with imports, with China especially becoming a major suppliers of machinery, components and vehicles; it has a strong central bank, which engenders a high level of confidence in managing inflation; the military expenditure provided a Keynesian boost to the economy, with production and employment rising.

The situation today

But two years further on, the Russian economy is looking a lot weaker and on the verge of recession. GDP growth fell to 0.6 per cent in 2025 and is forecast to be no more than 1 per cent for the next two years. (Click here for a PowerPoint of the chart.) And despite growth still being positive (just), this is largely because of the growth in military expenditure. Retail and wholesale trade fell by 1.1% in 2025, reflecting supply chain problems and high inflation dampening consumer demand.

With labour being diverted into the armaments and allied industries or into the armed forces, this has led to labour shortages. This has been compounded by the emigration of up to 1 million people by 2025 – often young, educated and skilled professionals.

Official CPI inflation averaged 8.7 per cent in 2025, although the prices of food and other consumer essentials rose by more, especially in recent months. At the beginning of 2026, supermarket prices rose by 2.3% in just one month, made worse by a rise in VAT from 20% to 22%. The central bank has responded to the high inflation with high interest rates, which averaged 19.2% in 2025, giving a real rate of 10.5%. With such a high real rate, the response of households has been to save. This has masked the constraints on production, or imports, of consumer goods. Savings have also been boosted by large payments to soldiers and bereaved families, with the money saved by the recipients being used in part to fund future such payments. So far there has been trust in the banking system, but if that trust waned and people starting making large withdrawals of savings, it could be seriously destabilising.

Whilst the high real interest rates have helped to mask shortages of consumer goods, they have had a seriously dampening effect on investment by domestic companies. Gross capital formation fell by 3% in 2025, not helped by an increase in the corporation tax from 20% to 25%. At the same time, foreign direct investment remains subdued due to high perceived risks. The lack of investment, plus the labour shortages, will have profound effects on the supply side of the economy, with potential output in the non-military sector likely to decline over the medium term.

The balance of payments and government finances are turning less favourable. The balance of trade surplus has declined from US$173bn in 2021 to US$67bn in 2025. This could decline further, or even become a deficit, if oil prices continue to be weak, if Western sanctions are tightened (such as stopping the flow of Russian oil exports in the ‘shadow’ fleet of tankers) or if major importing countries stop buying Russian oil. Indian refiners have announced that they are not taking Russian crude in March/April as India seeks to finalise a trade deal with the USA.

The budget balance has moved from a small surplus of 0.8% of GDP in 2021 to a deficit of 2.9% in 2025. Although the government debt-to-GDP ratio remains low by international standards at 23.1% of GDP in 2025, this was up from 16.5% in 2021 and is set to rise further as budget deficits deepen. Nevertheless, as long as the saving rate remains high, the debt can be serviced by domestic bond purchase.

Russia’s economy is definitely weakening and labour shortages and low investment will create major problems for the future. But whether this deterioration will be enough to change Russia’s stance on the war in Ukraine remains to be seen.

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Questions

  1. What constraints are there currently on the supply side of the Russian economy?
  2. Some economists have argued that the economic effects of a stalemate in the Ukraine war would suit the Russian leadership more than peace or victory. Why might this be so?
  3. Under what circumstances might a deep recession in Russia be more likely than stagnation?
  4. In what ways does Russia’s current financial system resemble a pyramid scheme?
  5. What cannot a Keynesian boost contunue to support the Russian economy indefinitely?
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Fed independence under attack

Donald Trump is keen to lower US interest rates substantially and rapidly in order to provide a boost to the US economy. He is also keen to reduce the cost of living for US citizens and sees lower interest rates as a means of reducing the burden of debt servicing for both consumers and firms alike.

But interest rates are set by the US central bank, the Federal Reserve (the ‘Fed’), which is formally independent from government. This independence is seen as important for providing stability to the US economy and removing monetary policy from short-term political pressures to cut interest rates. Succumbing to political pressures would be likely to create uncertainty and damage long-term stability and growth.

Yet President Trump is pushing the Fed to lower interest rates rapidly and despite three cuts in a row of 0.25 percentage points in the last part of 2025 (see chart below), he thinks this as too little and is annoyed by suggestions that the Fed is unlikely to lower rates again for a while. He has put great pressure on Jerome Powell, the Fed Chair, to go further and faster and has threatened to replace him before his term expires in May this year. He has also made clear that he is likely to appoint someone more willing to cutting rates.

The Federal Reserve headquarters in Washington is currently being renovated. The nine-year project is costing $2.5 billion and is due to be completed next year. President Trump has declared that the project’s costs are excessive and unnecessary.

On 11 January, Federal prosecutors confirmed that they were opening a criminal investigation into Powell, accusing him of lying to Congress in his June 2025 testimony regarding the scope and costs of the renovations.

Powell responded by posting a video in which he claimed that the real reason that he was being threatened with criminal charges was not because of the renovations but because the Fed had ignored President Trump’s pressure and had set interest rates:

based on our best assessment of what will serve the public, rather than following the preferences of the President. This is about whether the Fed will be able to continue to set interest rates based on evidence and economic conditions – or whether, instead, monetary policy will be directed by political pressure or intimidation.

The Fed’s mandate

The Federal Reserve Board decides on monetary policy and then the Federal Open Market Committee (FOMC) decides how to carry it out. It decides on interest rates and asset sales or purchases. The FOMC meets eight times a year.

The Fed is independent of both the President and Congress, and its Chair is generally regarded as having great power in determining the country’s economic policy.

Since 1977, the Fed’s statutory mandate has been to promote the goals of stable prices and maximum employment. Because of the reference to both prices and employment, the mandate is commonly referred to as a ‘dual mandate’. Its inflation target is 2 per cent over the long run with ‘well anchored’ inflationary expectations.

The dual mandate is unlike that of the Bank of England, the European Central Bank, the Bank of Japan and most other central banks, which all have a single key mandate of achieving a target of a 2 per cent annual rate of consumer price inflation over a particular time period.

With a dual mandate, the two objectives may well conflict from time to time. Moreover, changes in monetary policy affect these objectives with a lag and potentially over different time horizons. Hence, an assessment may have to be made of which is the most pressing problem. This does give some leeway in setting interest rates somewhat lower than if there were a single inflation-rate target. Nevertheless, the assessment is in terms of how best to achieve the mandate and not to meet current political goals.

Statement by former Fed Chairs and Governors

On 12 January, three former Chairs of the Federal Reserve (Janet Yellen, Ben Bernanke and Alan Greenspan), four former Treasury Secretaries (Timothy Geithner, Jacob Lew, Henry Paulson and Robert Rubin) and seven other top former economic officials issued the following statement (see Substack link in the Articles section below):

The Federal Reserve’s independence and the public’s perception of that independence are critical for economic performance, including achieving the goals Congress has set for the Federal Reserve of stable prices, maximum employment, and moderate long-term interest rates. The reported criminal inquiry into Federal Reserve Chair Jay Powell is an unprecedented attempt to use prosecutorial attacks to undermine that independence. This is how monetary policy is made in emerging markets with weak institutions, with highly negative consequences for inflation and the functioning of their economies more broadly. It has no place in the United States whose greatest strength is the rule of law, which is at the foundation of our economic success.

Response of investors

What will happen to the dollar, US bond prices, share prices and US inflation, and what will happen to investment, depends on how people respond to the threat to the Fed’s independence. Initially, there was little response from markets, with investors probably concluding that President Trump is unlikely to be able to sway FOMC members. What is more, several Republican lawmakers have begun criticising the Trump administration’s criminal investigation, making it harder for the President to influence Fed decisions.

Even if Powell is replaced, either in the short term or in May, by a chair keen to pursue the Trump agenda, that chair will still be just one of twelve voting members of the FOMC.

Seven are appointed by the President, but serve for staggered 14-year terms. Four have been appointed by President Trump, but the other three were appointed by President Biden, although one – Lisa Cook – is being indicted by the Supreme Court for mortgage fraud, with the hearing scheduled for January 21. She claims that this is a trumped-up charge to provide grounds for removing her from the Fed. If she is removed, President Trump could appoint a replacement minded to cut rates.

The other five members include the President of the New York Fed and four of the eleven other regional Fed Presidents serving in rotation. These four are generally hawkish and would oppose early rate cuts.

Thus it is unlikely that President Trump will succeed in pushing the Fed to lower interest rates earlier than they would have done. For that reason, markets have remained relatively sanguine.

Nevertheless, Donald Trump’s actions could well cause investors to become more worried. Will he try to find other ways to undermine the Fed? Will his actions over Venezuela, Cuba, Greenland and Iran, let alone his policies towards Ukraine and Russia and towards Israel and Gaza, heighten global uncertainty? Will his actions towards Venezuela and his desire to take over Greenland embolden China to attempt to annex Taiwan, and Russia to continue to resist plans to end the war in Ukraine or to make stronger demands?

Such developments could cause investor confidence to wane and for stock markets to fall. Time will tell. I think we need a crystal ball!

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Questions

  1. What are the arguments for central bank independence?
  2. What are the arguments for control of monetary policy by the central government?
  3. Assess the above arguments.
  4. Find out what has happened to interest rates, the US stock market and the dollar since this blog was written.
  5. How do the fiscal decisions by government affect monetary policy?
  6. Compare the benefits of the dual mandate system of the Fed with those of the single mandate of the Bank of England and ECB.