The Fundamental Dilemma of the Modern West

The Credit Strategist - September 2025

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“Nations have built welfare and entitlement states that are so large they have outstripped the ability of slow-growing economies to pay for them. Yet because the entitlement cushion is so broad and reaches deep into the middle class, it has become nearly impossible to reform.”

The Wall Street Journal, August 26, 2025

German Chancellor Friedrich Merz dared to speak the truth that few politicians are willing to admit at a Christian Democratic Union Conference in late August when he identified the existential problem facing not only his country but other European countries and the United States: “The welfare state that we have today can no longer be financed with what we produce in the economy.” I’ve argued for years that the U.S. economy doesn’t generate enough income to service and repay its outstanding (and rising) debt burdens. The Wall Street Journal editorial page describes this as “the fundamental dilemma of the modern West.” Democrats campaign to expand the welfare state while Republicans fight to shrink it without telling though both parties support policies that drive up deficits and debt (and Wall Street spends 24/7 printing more private sector debt). Neither side tells the truth about the costs of government while refusing to admit that the cost is unsustainable, actively pushing the system to the point where it will break (at which point each party will blame the other). Both political parties as well as the media actively perpetuate false narratives while leading voters over the cliff, and there is little chance anything will change until everyone is lying in a heap at the bottom staring back up at those who pushed them over the edge.

A recent Financial Times article discussed that “[i]nvestors have warned that big economies are entering a new period of ‘fiscal dominance’ in which central banks are under growing pressure to keep interest rates artificially low to offset the cost of record government borrowing.” This applies not only to the United States, where President Trump is openly pressuring the Federal Reserve to lower interest rates to reduce debt servicing costs, but also Japan and the UK. These countries’ balance sheets are under tremendous pressure as their unsustainable debt burdens, like that of the United States, show no signs of easing. While these conditions are hardly new, attention on them intensified after pandemic borrowing skyrocketed. Higher long-term yields reflect concerns that interest rates will be kept lower than necessary to contain inflation and relieve government borrowing costs. This is likely why U.S. interest rates rose by roughly 100 basis points after the Federal Reserve lowered them by that amount in 4Q24 – and why they could easily rise again if the Fed cuts them by more than a modest amount by year-end 2025.

Societe Generale’s brilliant Albert Edwards writes that “there is a slow-motion crisis unfolding in the government bond markets that equity investors continue to ignore at their peril….The upward grind in long bond yields has been relentless but, notwithstanding the occasional sudden acceleration, equity investors have shrugged off this risk and focused instead on more bullish metrics such as the latest upbeat reporting season [more on this below – ed.] driven by the mega-cap IT stocks and that promised pot of gold at the end of the AI rainbow.” The chart below borrowed from Mr. Edwards’ report shows the trend. Lower long-term rates may temporarily relieve debt servicing costs, but it may just as easily backfire like last year.

An era of fiscal dominance portends higher, not lower, inflation, while further politicizing central bank policymaking. Fiscal authorities (politicians) will always favor lower, not higher, interest rates. That is why the system tries to put in place (nominally) independent monetary policymakers to lean against the worst political impulses of those who control the power of the purse (something that is ending with the Trump Administration). Lower interest rates lead to more private sector borrowing and speculative deal-making and investing while enabling governments to borrow more, not less, money. Lowering the cost of government borrowing will concurrently increase incentives for private sector borrowing for unproductive activities like leveraged buyouts, leveraged recapitalizations, and the like. Lowering short term rates in the current environment, however, will more likely lead the market to set long-term rates higher because it will raise inflation expectations. After all, this interest rate cut won’t happen in a vacuum; it will occur in an economy that can only be described as a public and private debt vomitorium. Without massive government deficits and trillions of dollars of borrowing on Wall Street, the economy would be in a depression.

At Jackson Hole, Powell pondered whether the “neutral rate” should be higher today than in 2010. In view of the fact that global debt today is more than twice as large as fifteen years ago, the answer to that question is affirmative. A highly leveraged world covets a lower neutral rate, but lenders seek greater compensation in a world rendered riskier by so much debt. Central banks can attempt to lower those rates through intervention, but markets will fight back. That is what last year and could very well happen if Powell & Co. sharply cut rates now. The debt fuse was lit years ago. It is picking up speed. Our economy believes the fuse can burn forever without blowing up. We told ourselves for years that our reserve currency will save us. Now we’ve added the AI fairytale to the argument why we can outgrow our debt. The facts tell us otherwise. Rather than outgrow our debt, debt is swallowing the economy. And the dollar in which all that debt is printed, and which is itself printed in mounting quantities every single day, is under attack from other forms of money. Everything politicians are doing is accelerating the burning of that debt fuse. Tell yourself it doesn’t matter and will just keep burning forever. On that pathway lies the road to hell.

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