Rising U.S. Debt: What would Sherlock Holmes say?
He might point to the U.K.’s 1947 currency crisis as a sign of what’s to come…
By Roger Scher
“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts,” said Sherlock Holmes to Watson in A. Conan Doyle’s, “A Scandal in Bohemia”.
“If there is one common theme to the vast range of [financial] crises we consider in this book, it is that excessive debt accumulation, whether it be the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.” From Carmen Reinhart’s & Kenneth Rogoff’s book, This Time is Different, Eight Centuries of Financial Folly.
Today’s all-too-common dismissal of the risks of higher debt belies the data. The argument is made that, don’t worry, this time is different — be it because interest rates are low and will remain there, or because the international role of the U.S. dollar affords Americans the luxury to borrow without end.
Financial sleuths — Reinhart & Rogoff — like their fictional forebear, Britain’s notorious investigator of crime, draw conclusions from the facts. After compiling 800 years of data on financial crises, in which excessive debt has caused default, currency crashes, banking crises, and hyperinflation, they argue for caution when it comes to borrowing. And, they point out that, nearly every time, in the midst of a debt binge, there are experts who declare, “This time is different.”
This time — meaning looking forward from 2021 — things are different, the argument goes, largely because the U.S. dollar is the world’s reserve currency (i.e., central banks from China and Japan to Europe and the Middle East hold 60% of their reserves in U.S. dollars), and perhaps even more importantly, because the dollar dominates private commerce. The greenback is on one side of nearly 90 percent of all foreign exchange transactions on the planet. So, savers the world over will buy U.S. debt forever. No worries. This allows Americans the freedom to borrow in a way other people around the world wish they could.
Britain at the end of World War II
Britain — and its exalted pound sterling — had that same advantage for about a century, until this was squandered by the government running up debt from 27% to 270% of GDP in the 30-odd years to 1946. See the chart at the top of this article. These numbers are correct, folks — I did not leave off any zeros.
Britain had championed open markets and unfettered capital flows, financed other countries’ development and deficits, ruled the seas, and was the world’s most competitive exporter for most of the 19th century. Yet it experienced a currency crisis in 1947. The country almost ran out of money, after spending nearly all the proceeds of a $3.75 billion loan (sizable at the time), provided by the U.S. government a year before the crisis. You’d have thought the U.K. was Argentina and the U.S. was the IMF in 2001. The U.K. needed these funds because the country was importing more than it was exporting, plus capital outflows were accelerating.
As a condition of the American loan, Britain was forced to make its currency convertible, which by late summer 1947 had triggered a mass conversion of pound sterling into dollars. This nearly depleted the Bank of England’s forex reserves and was threatening its gold reserves as well. That’s right — this was the gold stock of the nation that had invented the Gold Standard.
Capital controls were imposed, and the U.K. requested more credits from the U.S. Now, in fairness, the source of the country’s debt binge was rather noble. It had financed the nation’s staving off of the global ambitions of first a militarist, and then a National Socialist, Germany. Likewise, borrowing got Britain through the Great Depression.
But, this pile up of debt had transformed the world’s leading nation, the global “hegemon”, the main international creditor, into the world’s largest debtor. This sounds a lot like the U.S. in the 21st century.
“Buddy, can you spare a dime?” U.K. officials might have asked in the forties. Literally a dime, as they needed U.S. dollars, the world’s new reserve currency, in order to finance imports of food and energy.
U.S. debt could rise to crisis levels
As the chart at the top shows, when you add the costs of President Biden’s American Rescue Plan to the long term debt projections of the Congressional Budget Office (CBO) calculated prior to the plan, America’s debt burden rises dangerously close to the level that Britain experienced the year before its currency crisis. U.S. general government debt could rise to close to 235% of GDP by 2051, or even higher, to say 260%, with a financial shock. This is largely because entitlements increase due to population aging and interest rates move higher, closer to their historical levels.
Debt levels in the U.S. are already high, at around 130% of GDP, higher than at any time since WWII, driven up by the costs of the global financial crisis (GFC) in 2008–12, Trump’s ill-advised tax cuts, and now the costs of the pandemic.
In contrast to the U.K., the U.S. is not running up its debts due to two world wars for national survival, though a large U.S. defense budget is part of the fiscal landscape. The U.S. is mismanaging its finances. Cutting taxes too deeply during Republican administrations (except for H.W. Bush) due to ideological rigidity. Not means-testing entitlement programs — both parties are guilty of this — in order to curry favor with the electorally-powerful middle class. Skimping on funding to support future economic growth by neglecting education, anti-poverty programs, R&D, and a transition to a low-carbon economy.
Still, a U.K.-style crisis is probably not imminent.
The “loss of confidence” scenario
The chart below shows that things could get worse sooner than expected though, if financial markets lose confidence in U.S. government finances. The downside scenario below includes a modest financial shock in 2023 causing interest rates to rise.
GGD. Sources: CBO, Fed, IMF, author calculations
Higher interest rates are assumed in these projections, in spite of the “This Time is Different” (TTID) logic of “Modern Monetary Theory” (MMT). MMT, with adherents on both left and right, argues that a country with a reserve currency like the U.S. can print money nearly without end to finance government spending. Rising U.S. deficits and debt, financed by such a loose monetary policy, would ultimately cause investors worldwide to flee the U.S. dollar (the way pound sterling was abandoned in the summer of 1947). More dollars floating around mean they will be worth less in other currencies. This could cause the dollar to crash, interest rates to rise, and economic growth to peter out. Next TTID theory, please?
The CBO also assumes higher interest rates, but not until later this decade, and not in a big way until the 2030s and 40s. The downside scenario in this article, a “loss of confidence in U.S. fiscal policy” narrative, modestly front-loads the interest rate hike (and largely assumes CBO forecasts persist in the later years). Markets get spooked by U.S. public finances and sell treasuries. This scenario also assumes a negative impact on GDP growth, lowering the somewhat optimistic economic growth forecast represented by the median of Federal Reserve policymakers released in March 2021.
The “loss of confidence” scenario causes government debt to rise to 260% of GDP, an historic high for the U.S., a level likely to provoke a large financial shock in the coming decades, whereby America’s role as leader of the global economy and the alliance system could be in doubt.
Financial markets may not wait
Trouble could come sooner, of course. In a 2012 article by Barry Eichengreen, Arnaud Mehl, and Livia Chitu, they present the chart that follows, showing that markets didn’t wait for Britain’s 1947 woes to react. International bond markets began denominating foreign public debt predominantly in U.S. dollars instead of pound sterling as early as right after WWI, accelerating with the Great Depression and WWII.
The other reason this could happen sooner is that fickle financial markets could initiate a “sudden stop”, where a government can no longer roll over its debts. This occurred during the Euro Area sovereign debt crisis in 2010–12, when countries in the south, including Italy which possesses the region’s third largest economy, had trouble refinancing maturing debt. This caused the European Central Bank (ECB) to step in and say, we will buy every country’s debt… we will do “whatever it takes”.
This is not an imminent problem for the U.S., as everyone from the People’s Bank of China and the ECB to investors around the world still strongly desire to hold U.S. treasury securities as a safe haven investment. But, is the U.S. vulnerable? One measure of vulnerability to a “sudden stop” is the level of debt maturing per year expressed as a percentage of GDP.
Fitch Ratings reports that the U.S. has the highest level for this metric among its AAA-rated sovereigns. See the chart below.
Note: From Fitch Ratings’ Sovereign Data Comparator, Dec. 2020. This is maturing GG debt for 2020. Notes: Singapore’s maturities are sizable relative to GDP; however, Singapore benefits from enormous and liquid Sovereign Wealth Funds that the U.S. lacks. Also, Canada, rated AA+ by Fitch, has an even higher level of maturities than the U.S. relative to GDP at over 50%. Canada benefits from higher sovereign assets than the U.S. in GDP terms as well, though much of this is not liquid. Fitch downgraded Canada to AA+ in 2020.
In part reflecting this fiscal vulnerability, Fitch put its AAA rating for the U.S. on a Negative Outlook in 2020, suggesting it might downgrade the credit rating on U.S. government bonds. Standard & Poor’s has had the U.S. rating at AA+ for nearly a decade, reflecting these fiscal woes. Moody’s remains at Aaa with a Stable Outlook. As long as the markets stay calm, then the U.S. will be able to “roll over” its debts. However, the relatively short-term maturity of U.S. government debt is another vulnerability.
American Rescue Plan
The American Rescue Plan makes sense. It is a bulwark against the pandemic morphing into a financial crisis and severely impacting the poor. But, it was probably too large and not focused enough on the neediest. America usually makes a pact with the middle class when it seeks to alleviate poverty and inequality. This is a costly compromise, but perhaps necessary in a democracy. The implicit assumption is that legislation focused on the poor wouldn’t attract enough support without goodies also for the middle class.
The size of the package was driven in part by the not-so-thoroughly-convincing argument that slow growth after President Obama’s impressive actions to counter the global financial crisis (GFC) was the result of Republicans not agreeing to a larger fiscal stimulus. The counterfactual will never be known; however, what is known is that the GFC was a banking crisis (the current crisis is not a banking crisis).
Growth recoveries following banking crises are notoriously long and sluggish, because the breakdown of the banking system, a country’s primary mechanism to channel savings to investment, holds back growth for years.
Our financial sleuths, Reinhart & Rogoff, also produced a report in 2014 that analyzed 100 banking crises, showing that in the median case it took 6 1/2 years for a country to reach its pre-crisis level of income. And, R & R also showed that the U.S. authorities did a pretty good job fixing the banks. A BIS study concluded the same. So, no, the primary reason for slow growth was not Republican intransigence, nor was it Obama’s policies, but rather weak banks. Like Holmes, we can rule out what wasn’t the cause, and then we are left with our culprit.
Ever since Keynes penned his famous treatise in 1936 arguing that government action is needed to temporarily replace aggregate demand that is lost in a depression, policymakers worldwide have recognized that this is a critical role for government in a crisis. That said, when banks are saddled with bad assets after a banking crisis, the critical thing to do is help them clean their balance sheets and then impose adequate supervision and regulation to make sure depositors’ funds are safe for the future. Stimulus alone does not fix banks.
During Obama’s time in office, more spending on infrastructure, R&D, and on anti-poverty programs was probably warranted, and Republicans did largely oppose this. But, in pursuit of optimal policies, the Democrats might have cut in half the generous payroll tax cut of 2009–10, a benefit heavily directed toward the middle class. Even by only doing the tax cut for one year, instead of two, more funds for investment and poverty alleviation would have been available. And, the poor tend to spend their cash infusions, while the middle class often saves theirs.
President Biden’s American Rescue Plan is sound in that it replaces lost aggregate demand, funds health care, opens schools safely, and seeks to address America’s woeful income and wealth inequality. The fact is that the neediest have borne the brunt of the pandemic. However, the package should have been both smaller (say, around $1.1 trillion) and more focused on anti-poverty initiatives.
Again, there’s that pact with the middle class. The $400 billion in checks sent to Americans as a tax rebate covers a lot of people who don’t need this money, many who were able to continue working online during the pandemic and some who are retired with ample 401k’s. Some of this largesse should have been cut and some of that reallocated to make the child and EITC tax credits, clearly directed to the neediest, larger and longer-lasting.
As for the Republicans, only politics can explain their opposition to the $362 billion funneled to the flat-on-their-backs state and local governments. These governments have been on the front lines of the pandemic, given their pivotal role in health care. And, they are indispensable to the safe opening of schools.
That said, a bipartisan deal could have been had. Arguing against one based largely on a history of Republican intransigence is only likely to prolong the miserable gridlock the country has been locked in for some time. Some centrists of good will have to take the first steps toward collaborative problem solving and deliberative negotiation.
Joe Biden should be the one to start this. He lost a good opportunity here. But, as Jesse Jackson used to encourage us to think, “Keep hope alive!” It was not a vain hope to believe that the Ds and Rs could cut a deal on pandemic relief, like they did last year. Somewhere between the ~$600 billion offer of the Republican Ten and Biden’s $1.9 trillion, say around $1.1 trillion, was not a pipe dream.
The reform scenario
Still, the U.S. is going to need a medium-term fiscal consolidation program anyway, that cuts deficits and slows, and ultimately reverses, the rise in debt. The chart above that shows this article’s base case, downside, and reform scenarios demonstrates that even a modest set of fiscal reforms can slow the increase in debt.
The reform scenario would keep debt at below 225% of GDP, still very high but well below the U.K.’s crisis level. This lower debt level would support somewhat stronger economic growth by giving room for private investment. The reform scenario cuts deficits while promoting growth by means-testing entitlements, funding anti-poverty programs, education and job training, R&D, and green investment, and raising taxes modestly without sacrificing the U.S.’s low tax climate. It follows the modest shock of higher interest rates in 2023.
Something even more aggressive in terms of controlling entitlements and mobilizing revenues would be even better.
The CBO has produced options for cutting deficits. See the paper this author co-wrote that addresses a new U.S. strategy, called Ten Point Plan: Strategic Planning for the U.S. here.
The U.S. — a wealthy country
Final point on debt and wealth. Government is responsible for only a portion of a country’s debt. Overall debt in the U.S. — including government, households and corporations — is also high relative to peers.
U.S. wealth is substantial. That’s the thing — the U.S. is a wealthy country and should be able to get the debt burden down, while funding programs that support growth and reduce inequality. Nevertheless, the favorable wealth position illustrated in the chart below remains highly dependent on confidence in the financial markets — that is, on equity and real estate prices remaining buoyant, and financing terms favorable for debtors.
Net Wealth of $114 trillion (4Q20) is sizable, which gives the country flexibility. It consists of $43 trillion of household non-financial wealth (>80% in real estate), $54 trillion in the market value of US firms, flattered by a massive runup in the stock market, and $32 trillion from other sectors, largely the government and small business, net of the US’s negative net investment position with the rest of the world, which was a negative $14 trillion in Q420. That means US liabilities to foreigners exceed its assets abroad. US overall debt is high as well, at $61 trillion or, nearly 300% of GDP, in all (non-financial) sectors (vs. Germany’s ~215% of GDP in 2018). Americans owe other Americans (and foreigners), but as long as market values of US assets remain robust, and incomes continue to grow, the relations between creditors and debtors should stay smooth. US leverage, and low national savings, creates a vulnerable fault line that can be aggravated by declining competitiveness. To be strictly comparable, Germany’s 2018 debt of 215% compares to a US figure of 318% of GDP per the IMF GDD, given a broader definition of debt than the Fed uses, to include (in addition to loans & securities) accounts payable, pension obligations, guarantees & other. Sources: Federal Reserve, IMF GDD
Many observers think equity and real estate valuations in the U.S. are stretched. A “market correction” — e.g. a fall in equities and real estate like what occurred during the GFC (when they fell over 50% and 25%, respectively), or even a smaller decline — could wreak havoc on U.S. debtors. Debt is high for nearly all categories of U.S. borrowers, except for households which appear to have learned their lesson from the GFC.
Given high economy-wide debt, America needs to increase its rate of savings. It is not easy for policymakers to raise the savings of households and corporations. But, they do directly control fiscal policy. So, cutting budget deficits remains the best lever by which to raise national savings and lower debt.
This way, America’s tenure as the leader of the global economy could endure.
Holmes might say, “Don’t fixate on the lessons you believe you learned from the last crisis — that the stimulus was too small. Look ahead, my dear Watson, to what might sink the boat in the future. And, my good doctor, please study the data — 800 years of human debt madness — in order to ground yourself!”
Notes and Sources:
IMF:
historical debt data: https://query.data.world/s/wgbryynoay6lyb5qzwvzx3azlg7mt4
https://www.imf.org/en/Publications/WEO
Reserve currency data (COFER): https://data.imf.org/?sk=E6A5F467-C14B-4AA8-9F6D-5A09EC4E62A4
IMF Global Debt Database: https://www.imf.org/en/Publications/WP/Issues/2018/05/14/Global-Debt-Database-Methodology-and-Sources-45838
CBO:
https://www.cbo.gov/publication/57066
https://www.cbo.gov/publication/56996
Federal Reserve:
https://www.federalreserve.gov/monetarypolicy.htm
https://www.federalreserve.gov/releases/z1/default.htm
BIS:
https://www.bis.org/statistics/rpfx19.htm
https://www.bis.org/publ/cgfs60.pdf
https://www.nber.org/papers/w19823
https://www.files.ethz.ch/isn/125515/1366_KeynesTheoryofEmployment.pdf
Really interesting and provocative article providing much to think about and react to even for an economics dilettante like myself