This isn’t going to be one of those scare posts about the US debt level. Rather, my goal is to look at how the current US debt situation during and after Covid, how this compares to debt run ups of the past and what it means for all of us in the future.

The Current Situation

Right now, Covid-19, systematic racism and the economic situation dominate the headlines, and they have good reason to. These issues are a direct threat to our day to day well being for both Americans and people across the world. They will continue to be for some time in the near future. In the case of systemic racism, we may never be totally free of it, but there is reason for some hope given the proposed legislative changes and the embracing of the cause by the majority of Americans.

However, just because these are the most current and pressing problems doesn’t mean that they are the only problems lurking. In terms of economics, we are looking at both a contraction of output as well as an unprecedented run up in peace time debt for the US.

According to the Congressional Budget Office or CBO, US GDP is expected to fall by 5.6% this year. US debt, measured as the percentage of debt to GDP was already at 108% as of September 2019 according to the Fed. With the CARES act and fiscal stimulus implemented and announced so far, the CBO projects debt to GDP to hit 135% by the end of September 2020. The below shows that even at 108%, Debt had reached its highest levels since WWII.

For the immediate future, this isn’t necessarily cause for alarm. Again, we have very pressing immediate problems which have to be treated and solved. In addition to that, this is the first real global slowdown since the Great Depression. The financial crisis was really a US banking crisis, which eventually morphed into a European debt crisis but left other economies to pick up the slack (China and other emerging markets were not as severely affected). Now, we have lockdowns and slowdowns going global, with little to offset the crisis in the rich world.

This has produced a rush to quality and safety which has produced a drop in the 10 year yield’s to around 1%. Similar to the financial crisis, the immediate short term safety of treasuries has trumped the debt worries as the world seems to be crashing down around investors.

Why Debt Still Matters

There have been some proponents of an esoteric economic theory called modern monetary theory, that think the US has the ability to just print it’s way out or quantitatively ease it’s way out of any debt problem. In the short term, the continued low interest rates and Fed balance sheet would seem to make a case for their cause.

Source: St. Louis Fed

The Fed balance sheet increased by almost $2 trillion in a matter of a few months due to the debt issues by the Treasury. The Fed ended up buying much of this and was already holding about a quarter of domestically held debt as of September of 2019.

According to a study by the BLS however, high levels of sovereign debt greatly increase the chance of a future financial crisis. The consequence of a federal debt crisis would include:

• Lower national savings
• Lower national income
• Large tax hikes
• Spending cuts
• Decreased ability to respond to economic deterioration

In short, if countries don’t get things in order when debt is high, they set themselves up for failure later.

There are some who argue though, that the US is a special case because the dollar has the reserve currency of the world status. Indeed this is important, the US treasury market is the most liquid financial security market in the world and central banks around the world hold US treasuries as part of their foreign currency reserves. In addition, a number of large economies are export dependent on the US as a consumer and buy large amounts of US debt to keep their currencies cheap in terms of dollars so that they can continue to sell their goods to the US (China and Japan).

As long as the US remains open and growing, investors and governments seem more than happy to lend to the US. The tech rally of the past few years and the lack of fast growth elsewhere in the rich world seem to continue to fuel the desire to keep invested.

So if the reserve currency status, foreign investment and interdependence of world economies keeps US debt in demand and cheap, what is the upper limit of US debt and when could it start to become a danger? Are there any examples in the past we can look to for guidance?

Britain and Sterling

The answer is yes, with an important caveat. Prior to WWII and especially prior to WWI, the British pound, or Sterling, was the reserve currency of the world. Governments would come to London and issue debt in Sterling. They kept their proceeds in London banks and depended on its well functioning and deep financial system in order to be able to access international investors.

In a 2005 paper, Barry Eichengreen takes a look at the preeminence of Sterling prior to WWII and discusses the motivations for investors to stick to Sterling at the time. He argues that the financial system and a deep interdependence of British colonies on the value of their currencies versus the pound helped keep the importance of the currency in place. Many countries linked either through their colonial ties or through the Commonwealth, were dependent on the success of the British economy for their own well being. Sound familiar?

The catalyst that set a change in motion was at times sudden and at other times gradual. The US was not even in the game when it came to international reserve currencies at the time, only the French Franc and Deustchemark could offer any competition to Sterling and that was more based on the mainland and French colonies.

Source: Sterling’s Past, Dollar’s Future

However, the emergence of the US as a large, stable and growing economy, as well as the establishment of the Federal Reserve there in 1914, which provided a stable lender of last resort and liquidity provider, started to lay the groundwork for an alternative to Britain. It wasn’t until WWI that the situation began to shift.

The war saw Britain’s debt to GDP jump above 150%, a level not seen since its existence was last threatened during the Napoleonic Wars. Still, during the interwar years, it managed to maintain its status but other foreign currencies started to gain in prominence.

Source: economicshelp.org

At one point or another, due to WWI, Britain, France and Germany all suspended convertibility of their currency to gold, while the US maintained it. The US was also able to dictate a lot of terms in any economic situation to the European powers because it was the primary debt holder of much of their national debt. WWII just accelerated these changes and by the time Bretton Woods arrived in 1946, the US had a viable argument to be at the center of a system based on convertibility to gold.

No Alternative

This system lasted less than 30 years until the stresses of printing dollars to fund the Vietnam war culminated in Nixon taking the US off the gold standard in 1973. At that time almost 85% of international reserves were in dollars and although that figure has come down, a viable alternative to the dollar has not emerged.

Source: Sterling’s Past, Dollar’s Future

This is mostly because the old answer to floating currencies and high debt was to go back on the gold standard. Now that we know the downsides of the gold standard, which are not often discussed (constant deflation and more frequent crises from booms and busts), no one has a logical alternative to the dollar. In theory, debts can go up as long as there is someone to buy them.

Asian economies have not pivoted to create an internal demand and still depend on demand in the US to grow their economies. There is a lack of a large, stable and open growing economy to provide an alternative to the US today. Although China checks 2 of those boxes, it’s capital controls while it grows are what differentiate it from the US when it was in its growth phase. Europe has proven still too fractured to be a viable alternative and is barely growing, much like Japan.

Even if investors were to ditch treasuries, the Fed could simply buy them and replace them with dollars. This would be the equivalent of a run on the bank to get their gold back, but in this case, the US can just print the gold. The result may be a steep drop in the dollar and huge inflation. Imagine if all the goods from China were now triple or quadruple the price, the US isn’t beyond imported inflation when it now depends on so many goods from abroad. Foreign governments may understand this and that by wrecking US debt and the dollar, they may shoot themselves in the foot in the process, so they have a vested interest in keeping the debt spiral going.

Lab Rats

Essentially this means we are all lab rats for one of the great macro-economic experiments of modern times: how much debt can a reserve currency country sustain in peace time with no viable alternative in terms of openness and growth? We’ve survived past the 100% Debt to GDP mark and will see it climb dramatically in the next few months. The years going forward will be very important to seeing if we will experience a debt spiral, a climb back down or a vicious sustained debt and low growth circle like Japan.

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