We have seen outsize investor focus on inflation and the Federal Reserve’s response to it. But while monetary policy gets most of the headlines, the much bigger long-term economic threat is our rapidly growing federal debt.
The deficit is around $2 trillion out of a $7 trillion federal budget (about 30% of spending!), which must be financed through Treasury issuance. Worse, more than half of the budget deficit reflects interest on debt. We have entered an unsustainable “compounding cycle” in which rising debt and interest rates produce ever-higher interest expense, requiring further borrowing.
Estimates show that the average interest rate on federal debt was just 1.70% in 2021, versus 3.44% today. According to the Congressional Budget Office, gross interest expense has risen from $565 billion in fiscal 2021 to $1.22 trillion in fiscal 2026 on $10.8 trillion in added debt (and growing fast). Moreover, nearly half of GDP is eaten up by the combination of government spending at all levels plus the costs of regulatory compliance.
In my view, the debt problem can be addressed in three ways: 1) cutting away the debt by keeping spending growth below the rate of GDP growth, while rooting out waste and fraud; 2) inflating away the debt through modest inflation of perhaps 2.0%-2.5%, which gradually reduces the real value of existing debt; and 3) growing away the debt through robust real GDP growth, given that tax receipts historically average 17% of GDP since 1960 no matter the tax rates.
We cannot tax our way out of this problem, nor is drastic austerity or high inflation politically realistic or even economically desirable. And Federal Reserve rate hikes can’t fix the event-driven supply shocks and inflationary pressures, short of inducing recession. In fact, I believe inflation has seen its peak, and elevated Treasury yields are likely driven more by hawkish signals from the Fed and massive bond issuance (by both governments and corporations) than by actual concerns about entrenched structural inflation. So, growing our way out of debt is both the most important and the hardest approach.
This is where artificial intelligence becomes much more than just an investment theme. Fed Chairman Kevin Warsh and Treasury Secretary Scott Bessent are optimistic about AI improving the outlook for both the economy and inflation, with investment in data centers, software, and infrastructure raising productivity and increasing noninflationary growth potential.
Indeed, a sustained productivity boom boosts real GDP, raises real wages, widens profit margins, and expands the tax base — without raising tax rates, which would only stunt growth. This is precisely what our indebted nation needs.
Like the internet, electrical grid, highways, railroads, and sanitation systems before it, AI is becoming foundational infrastructure that can make life easier, healthier, safer, and more productive. It reduces both physical and cognitive friction and expands our individual and collective capabilities.
Suppose real GDP can sustainably grow at 3%-4% rather than the 2% pace to which we are accustomed. Add modest inflation, and nominal GDP — and associated federal tax receipts — might expand at 5%-6%. If Washington can simultaneously keep spending growth well below nominal GDP growth, deficits and the debt-to-GDP ratio (now at an unacceptable 125%) will shrink.
This is why we need policies that encourage and streamline the AI buildout and the energy to power it — the best hope for a productivity boom that energizes noninflationary economic growth. This is no time for AI backlash and not-in-my-backyardism. Through the end of this decade and likely beyond, I expect to see less low-return-on-investment government spending and more high-ROI capital allocation from an unleashed private sector, supported by favorable tax policy, deregulation, and other supply-side incentives that expand productive capacity.
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We aren’t likely to cut, tax, or inflate our way out of a $40 trillion debt burden. No, our best hope is to grow our way out of it by steadily growing the denominator of the debt-to-GDP ratio faster than the numerator.
As such, I continue to pound the table on two things: 1) fiscal policy that keeps federal spending growth below the rate of GDP growth while pursuing policies that maximize private investment, productivity, and real economic growth; and 2) monetary policy that lowers the Fed funds rate closer to 3% to provide relief to the lower leg of our bifurcated “K-shaped” economy (small business, housing, low/middle-income consumers, and the alarmingly low personal savings rate of 2.7%) while gradually reducing interest expense as federal debt rolls over.
Scott Martindale is CEO of Sabrient Systems, an independent equity research firm and registered investment adviser.