Ray Dalio: We Need to Cut the Budget Deficit Now. Here’s How We Do It

Are there limits to a country’s debt and debt growth? What will happen to interest rates and all that they affect if government debt growth isn’t slowed? Can a big, important country that has a major reserve currency like the U.S. go broke—and, if so, what would that look like?

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These aren’t just academic questions for academic economists. They are questions that investors, policy makers, and most everyone must answer because the answers will have huge effects on all our well-being in the years ahead and what we should do. 

But definitive answers to these questions don’t currently exist. At this time, some people believe that there isn’t any limit to government debt and debt growth, especially if a country has a reserve currency. That’s because they believe that the central bank of a reserve currency country that has its money widely accepted around the world can always print the money to service its debts. Others believe that the high levels of debt and rapid debt growth are harbingers of a big debt crisis on the horizon, but they do not know exactly how and when the crisis will come—or what its impacts will be.

As a global macro investor for over 50 years, I have been through many debt cycles in many countries and have had to navigate and understand them well enough to bet on how they would go. To do my job well, I have carefully studied all the big debt cycles over the last 100 years, and superficially studied many more from the past 500 years. Because I am now deeply concerned about what I am seeing happening with debt in the U.S. and other countries, I feel a responsibility to pass along my research for others to judge for themselves. 

Based on an extensive study of past debt crises, including the 35 most recent cases when a nation’s government has gone broke, I have concluded what the U.S. needs to do to avoid experiencing a damaging debt crisis in the years ahead. The debt issue is a very big and intractable problem, and it certainly is a serious one. But the good news is that it is a very manageable problem—if we are able to navigate the political issues that stand in the way.

The budget deficit should be cut to 3% of GDP from what it is currently projected to be (about 6% of GDP), and these cuts can come from 3 sources (spending cuts, tax increases, and interest rate cuts, with interest rate cuts being the most impactful). If the president and those in Congress agree that they need to do that, and they agree on a bipartisan backstop approach to doing that (I will suggest an option), they will achieve the goal of greatly reducing the odds of the U.S. government going broke.

That’s it in a nutshell. I will now explain. 

The picture as I see it 

It appears to me that there are two big impediments to the debate on this issue. First, policy makers who are working on getting the debt issue under control (some have given up on the idea) are approaching the problem from the bottom up, by which I mean by working on which spending cuts and/or which tax increases are better than others, rather than working from the top down, by which I mean by looking at how much it will take in total to meet the goal, then looking at the three big levers that government policy makers can pull to reduce the deficit (i.e., spending cuts, tax increases, and interest rate reductions), and finally deciding which spending cuts, which tax increases, and which interest rate changes to make.

And second, policy makers are so tied up in arguing about the particulars to get exactly what they want that they have made the likelihood of a disastrous outcome—either not limiting the debt or having a bad government shutdown—much greater than the likelihood of an attainable good outcome.

To tackle this problem, I believe that they should 1) work from the top down, by which I mean agree on the size of the cuts to the deficit and the size of the deficit as a percentage of GDP that need to be made to stabilize the debt and 2) agree on a fallback plan that achieves the necessary budget cuts that would automatically happen if they can’t reach agreement on the particulars.

This fallback plan could be something like equal percentage cuts to all spending that can be cut and equal percentage increases on all taxes that can be increased so that combined they will achieve the goal if they can’t agree on anything else, so they will be assured of having a deal. Then, they can go on to try to create a plan that they can agree is better than that one. I will now propose a fallback plan that policy makers should be able to agree on.

What my 3%, 3-part solution looks like

The following chart shows the U.S. debt level as a percentage of government revenue. The current debt trajectory is shown with the red dashed line, and based on how I understand the mechanics to work and on indicators of what is most likely to happen, it appears to me that to prevent the central government from going broke, policy makers have to change the government debt level trajectory to the green dashed line. Changing that trajectory will require some cut in spending, and/or some increase in tax revenue, and/or some cut in the interest rate on the debt such that these three moves in total will add up to cut the deficit to it down to 3% of GDP. Such a deficit cut would lead to the debt burden being about 17% lower in 10 years than it would be if the U.S. were to continue on its currently projected path, (which amounts to debts being $9 trillion lower in 10 years). In 20 years, the 3% solution path would make government debt 31% lower, which is $26 trillion lower. Doing that would greatly reduce the risks of the central government, those who are lending to it, and all those who would also be affected by a big debt issue from suffering a “heart attack.”

There are three main types of levers that can be pulled to control the deficit: tax increases, spending cuts, and lower interest rates. To achieve the goal of stabilizing debt relative to income, it would take about a 11% increase in taxes, about a 12% cut in spending, or about a 3% cut in interest rates, all else being equal, if just one lever were used alone. Of course, any one of these numbers alone is way too large, so managing the adjustment will require a good combination of two or three of them.

Let’s look more closely at those numbers, which are interesting because they show how much more powerful a change in interest rates would be than a change in taxation. For instance, interest rates falling by 1% is about four times more effective at reducing the debt-to-income ratio over the next 20 years than a 1% increase in tax revenue. The numbers also show how much more powerful a change in taxation would be than a change in spending—a 1% increase in tax revenue is 1.2x more effective than a 1% reduction in spending over that same time frame. But these estimates of the direct effects understate what the total effects are likely to be after accounting for the likely secondary effects. More specifically, a cut in interest rates is even more powerful than the estimate I gave you because, besides lowering government debt service payments, interest rate cuts would boost asset prices, which would raise capital gains tax receipts and be stimulative to the economy, and raise inflation, which would raise tax revenues. It’s also worth noting that 1) the second-order effects of cutting spending would be negative for economic activity and thus negative for income taxes and 2) the second-order effects of raising taxes would also be negative because of the reduction in spending and economic growth.

In other words, there are two important takeaways. First, the biggest influence on the government’s deficit is ironically not Congress, which determines spending and taxes—it is the Federal Reserve, which determines interest rates. Second, while trimming the budget deficit and cutting interest rates both reduce the debt problem, they would have offsetting effects on economic growth, inflation, and taxes. This means that if these actions are balanced well, the budget deficit can be reduced significantly without creating unacceptable effects on the economy.

Given that, if I were deciding for the president and/or Congress, I would want the Federal Reserve to lower the interest rate. I expect that the president and Congress will pressure the Fed to do that, but, of course, Congress and the president don’t determine what the Fed does. If I were on the Federal Reserve board, I would be willing to work with the president and Congress to implement such a plan because a fiscal tightening (which would have the first-order effects of reducing the deficit and being a negative for economic growth and inflation) in conjunction with a monetary easing (which would also be deficit-reducing while being positive for economic growth and inflation) looks like a great plan. It is obvious that a fiscal tightening with a monetary easing would be a good thing. In fact, if Congress and the president enacted a significant deficit reduction, it would trigger a rally in bonds and a decline in interest rates that would help reduce the deficit. Some people worry about a cut in the fiscal deficit of that size being too negative on the economy, but that’s not my worry because if the fiscal tightening were too negative on growth and inflation, it would trigger a monetary easing to rectify that. So, what’s the problem with cutting spending and raising taxes other than the political problem of anger from those who are getting less money from spending or who are paying more in taxes? I don’t see it.

A fiscal tightening with a monetary easing makes financial and economic sense because the biggest imbalance that now exists that should be rectified is between the central government’s finances (it has dangerously too much debt and too much borrowing) and the private sector’s finances (which are in relatively good shape, particularly in the booming areas of the market and the economy). This state of affairs came about because the Fed helped to fund the large budget deficits that allowed the big spending and the central government’s debt problem to happen in the first place. So, the Fed cooperating to negate whatever pain that might come as a result of a large (3% of GDP) deficit cut would make sense, especially since the private sector has received lots of deficit-funded support, is now in pretty good shape, and could use some fiscal tightening, which the Fed could help manage with its monetary policy. It would bring the private and public sectors’ finances into better balance.

Who would suffer from the lower interest rate? While bond holders will get a lower real yield, they would benefit from interest rates falling because bond prices would go up, plus they would get a safer bond. The world would celebrate such an accomplishment, both because of the reduced U.S. government debt risk and because it would demonstrate that the American political system can work well to solve at least this big problem. Also, other major markets like equities would benefit from those changes. So, just about everyone other than special interest groups should like the immediate effects of this plan.

Let’s now play around with the numbers and these three levers to see what specific changes could get the 3% of GDP deficit goal achieved by making the adjustments come roughly equally from spending cuts, taxes, and interest rate cuts. That would take about a 4% cut in spending, a 4% increase in taxes, and a 1% cut in real interest rates. That way, they would spread out where they get the 3% of GDP from so it’s not too big for anyone, it is pretty politically agnostic, and the depressing fiscal effects would be offset by the stimulative monetary effects of the real interest rate cuts. That would be my solution to the problem with one possible modification: because those amounts of cuts in spending and increases in taxes would cause abrupt changes, I would phase these changes in over three years. As mentioned, I would try to make that a bipartisan fallback position to use if no other solution is reached because everyone would be relieved if policy makers could agree on an acceptable plan and negotiate the tweaks to it.

What if the Fed doesn’t go along with this?

Of course, the Fed can’t openly say that it will go along with this plan (though deals between the Fed keeping interest rates low while the government was cutting the deficit have been made in the past), so let’s look at the possibility that Congress and the president will have to make the changes come only from spending cuts and raising tax revenue by the same percentages. That percentage would be about 6% (i.e., cutting spending by 6% and raising taxes by 6%), which would also equal about a 3% of GDP deficit reduction. While those amounts of adjustments would be large by historical standards, I know that they can occur without problems if balanced well and I know that if they are too depressing to economic growth, the Fed will respond by lowering interest rates because that’s what the central bank does when the economy and inflation are too depressed. For these reasons I know that if this 3% 3-Part Plan is followed it will be worlds better than if it is not followed.

My proposed deficit cut compared with past deficit cuts

While many will say that these changes are draconian, my study of past deficit cuts leads me to believe that they are very manageable if monetary policy is managed sensibly at the same time. Phasing in that plan and assuming the Fed will run monetary policy sensibly would lead to the adjustment looking something like what is shown in the red dashed line, which is very close to the original 3% plan.

However, I need to point out a fly in the ointment. As mentioned, the numbers I showed are based on the bipartisan Congressional Budget Office’s numbers. These numbers are based on the existing plan for the Trump tax cuts to roll off so, if they are extended as President Trump has promised to do, the deficit will be larger by an estimated 1.5% of GDP, so the deficit cut will have to be over 4.5% of GDP rather than about 3% to stabilize government debt-to-income .

While such a budget deficit cut is large, it’s not very large by historical standards. The following table lists all major fiscal policy tightenings in all countries going back to 1960. It shows that big fiscal tightenings (3% of GDP or even much larger) went well if put into place when 1) growth was strong, 2) the monetary-currency policy was easy, and 3) debts were in currencies that the central bank could print. Notably, the fiscal tightening in these cases helped to lower bond yields, which reduced interest costs on the debt and encouraged private sector activity that raised taxes, and to the extent the fiscal tightening weakened the economy more than desired, it led to monetary easings that negated the fiscal tightening effects on the economy.

The most successful U.S. case of cutting the budget deficit happened in the 1992-98 period, which took the deficit from 4% of GDP to a surplus of 1% of GDP (a 5%-of-GDP improvement) over those seven years, which would be like cutting the deficit by $1.5 trillion today.My plan would cut the deficit by much less than that amount.

My timeless and universal principle, about this is: When there are large government debts that are growing quickly so that large cuts to budget deficits are needed, the most important things to do are to 1) cut the deficit by enough to rectify the problem, 2) cut the deficit when economic conditions are good so the cuts are counter-cyclical, and 3) have monetary policy be stimulative enough to keep the economy strong in the face of such cuts.

More specifically, what expenses should be cut and what taxes should be raised? 

While I am tempted to get into what I believe are the relative merits of the different specific types of spending cuts, tax increases, and interest rate cuts, I’m not going to do that because I don’t think there is any reason that my preferences should matter. It also would be too big of a digression and would lead to all sorts of arguing with all sorts of people who have different preferences. The problem of all sorts of people having all sorts of preferences that they will fight for and not being able to resolve their disagreements is to me the biggest problem that we face—i.e., as a country and a civilization which is that there is so much arguing over the exact ways to prevent the disaster that it won’t be prevented. That’s why I am recommending the equal and proportionate cut in spending and increase in taxes as the fallback plan if no other plan can happen. Then, once that is in place, as has been proposed in the past, they could authorize a bipartisan fiscal commission to examine the debt issue and propose specific alternatives that are preferable to the fallback plan. But frankly, I don’t care exactly how congressional policy makers do it nearly as much as I care that they do it.

(If you asked for my general approach to proposing cuts and tax changes, I would focus on  raising broad-based productivity. That means that I would make sure that spending cuts and tax changes not hurt those who can least afford them and not hurt high-productive functions like education that are shown to be most effective in increasing broad-based productivity. At the same time, where possible, I would want to cut taxes and regulations in areas that would free up productive spending and improve efficiency.)

Nonetheless, let’s look at the constraints that must be considered.

A selection of highly impactful potential spending cuts and tax increases and their impacts are shown in the next table. This is a list of items that came primarily from the bipartisan Congressional Budget Office that most policy makers refer to. Looking at that list tells me that tweaking existing spending programs and taxes in moderate, tolerable ways could achieve the 3% of GDP deficit goal without unacceptable pain. This list also shows the revenue that can be brought in by tariffs (which during many periods of history have been a greater source of government revenue than anything else). 

According to the Congressional Budget Office, 10% tariffs on all imports could bring in about 0.6% of GDP. Also, if Elon Musk’s claim that he can cut the budget deficit by $2 trillion is even half true (i.e., if DOGE can cut the budget deficit by $1 trillion), that cut would represent around 3% of GDP. I’m confident that one way or another they can make it, and I like some of their aspirations as I’m all in favor of radically improving the efficiency of the government and the economy. So, it’s not hard for me to imagine how a pragmatic “grand bargain” between reasonable Republicans and Democrats could be reached. My only question is whether the people involved will operate together logically to do sensible things.

Whatever form of grand bargain cuts the deficit to about 3% of GDP is good with me. But if our representatives in Washington don’t get a debt limit deal done, it will be because of their lack of reasonableness and their inability to compromise—not because a good, workable plan is beyond their reach. Because the failure to reach an agreement will produce a much bigger problem than reaching an agreement along the lines of my 3% solution, it seems to me that the electorate should hold their representatives in Congress accountable to get a debt limitation deal done.

In considering which spending to cut, when one looks at the possibilities, one quickly notices that about 70% of the non-interest spending is considered “mandatory”—i.e., it is either contractually required or politically nearly impossible to cut. The breakdown is shown in the following chart.

That said, in the “mandatory” spending part of the budget, there are a number of relatively modest changes that could have big impacts. For instance, two changes to Social Security (phasing in an increase to the retirement age from 67 to 70 and using a more realistic inflation measure to calculate the increase in benefits), which wouldn’t affect virtually anyone immediately, would produce about a tenth of the required spending cuts.

The roughly 30% of spending that is “discretionary” that Congress has to reauthorize every year (which is shrinking fast as a share of spending because entitlement programs are growing) includes defense spending (which is over half of the discretionary budget), veteran medical care, rental assistance for low-income households, funding for transportation, medical and scientific research, education transfers to states, and hundreds of other functions of the government. Because a bill needs to be passed every year to authorize this spending, these are the easiest to cut (though they have not been cut). If you cut just from these “discretionary” items to achieve the goal of cutting spending by about 4%, that would require 15% cuts in these on average. I find the distinction between discretionary and non-discretionary spending to be a bit arbitrary because cuts can be made from both. The important thing is getting to a reasonable mix that adds up to a deficit reduction of 3% of GDP to get the deficit down to 3% of GDP.

Do it now! Do it counter-cyclically!

To re-emphasize: When there are large government debts that are growing quickly so that large cuts to budget deficits are needed, the most important things to do are to 1) cut the deficit by enough to rectify the problem, 2) cut the deficit when economic conditions are good so the cuts are counter-cyclical, and 3) have monetary policy be stimulative enough to keep the economy strong.

Now is an exceptionally good time to implement a significant debt limit plan for a few reasons. First, it is much better to reduce government deficits in good economic times than to wait for a debt crisis to happen in bad times. The U.S. economy is near full employment, growth is moderately strong, inflation is a bit high, and the private sector’s income statements and balance sheets are in pretty good shape (mostly because the government took on the burden, which it probably should shift at least some of back). Second, if the plan is not implemented now, the debt problem will grow so it will be more difficult to deal with. That is especially true because the debt cycle is now at the stage in which borrowing and more debt are needed to service existing debts, so they are increasing in a self-reinforcing and compounding way. Finally, implementing this plan now would be a confidence booster that would have all sorts of beneficial knock-on effects for the economy.

It’s also worth noting that there are other, less-commonly discussed ideas out there that could have a big impact on the debt picture. I’m in favor of marking the government’s assets to market, creating a U.S. government sovereign wealth fund, and exploring a U.S.-backed stablecoin if these things can be done well.  Imagine if the government’s assets were managed economically—e.g., if they were valued, bought, sold, and/or developed economically rather than not even looked at economically as is the case now, and imagine there was a well-funded, well-run sovereign wealth fund behind the government’s financing and debt. That’s an interesting subject for another time.

In conclusion, I want to reiterate that even with the best of budget plans, there are very big uncertainties that can throw them off. For example, we don’t know if there will be wars that will cost more and worsen the budget deficits, or if there will be bigger-than-expected productivity gains from new technologies that will produce higher incomes and tax revenues that will reduce budget deficits. There are many such uncertainties that will undoubtedly disrupt these projections, so the ranges of possibilities around them are large. 

To me, that suggests that U.S. policy makers should be more, not less, conservative in dealing with the government’s finances because the worst thing possible would be to have its finances in bad shape during difficult times.

This article is a pre-publication preview chapter from the forthcoming How Countries Go Broke by Ray Dalio. Copyright © 2025 by Ray Dalio. Printed with permission of Avid Reader Press, a division of Simon & Schuster, LLC.

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