Here’s a special research report on a timely topic. The recent rise in interest rates and US government debt surpassing $40T has sparked worries about sovereign default. The logical response to these fears is that today’s interest rates aren’t actually that high in historical terms (they’re actually lower than the 50 year average of 5.8%) and that you can’t focus on debts without also considering the unparalleled size of assets in the USA. But debt sustainability isn’t purely a balance sheet item. It’s also sensible to consider the debt to income analysis, and by that metric you could argue the USA is worse off than it has ever been, with debt to GDP fast approaching 130%. But is that metric even useful and is there an empirically supported level at which it is problematic? Let’s dig in and actually apply some historical analysis instead of relying on big, scary sounding numbers.
The whole research piece is also attached below. If you’re short on time here’s the TLDR version:
• I can’t find any consistent debt to GDP level that reliably predicts default or high inflation for a country that borrows in its own currency. The UK ran debt near 250% of GDP after WWII. Japan sits around 230% today. Neither defaulted. The UK had modest inflation and Japan had a well known deflation. More recent cases (like Italy, Singapore and Greece) all coincided with low to modest inflation. Meanwhile, Lebanon, Venezuela and Sudan had the opposite. But there is no consistent causality here and in larger developed economies the causality often runs backwards while hyperinflations often appear in nations with lower debt to GDP.
• The US government isn’t a household. It issues the currency it borrows in, and its debt is the private sector’s asset. The real constraint is inflation, not running out of money. When people use the word default to mean “inflation” they are shifting goal posts and being unclear about outcomes. Inflation is not default and the nuance matters for how you manage risks in your portfolio.
• The US is also enormously wealthy and experiences an exorbitant privilege because of this. Household net worth is roughly six times GDP and about five times the federal debt. Out of all the countries in the world that could have a debt crisis the wealthiest country in human history surely isn’t the most obvious (or logical) choice. Most people discussing this topic focus on the debt side of the ledger and gloss over the gigantic asset side of the ledger. This is important since almost every other fiat currency issuer has a more fragile overall balance sheet position than the USA. If the USA is a dirty shirt then every other shirt in the fiat currency closet is dirtier.
• I actually think the risk is that 130% goes systemically higher, not that it’s a cliff. Demographics, inequality and technology are going to push the government to spend more in the decades ahead because these are gigantic secular disinflationary headwinds. And whether that causes high inflation is much more complex than simply looking at the size of the debt. It’s a complex interplay of disinflationary long-term headwinds versus a government that tries to offset them.
• The current burst of inflation and rise in rates isn’t the start of a sovereign debt default or even the return of Covid level inflation. It’s primarily an adjustment to higher inflation expectations as the war in Iran continues to push commodity prices up. Energy alone accounts for the majority of the difference in current core and headline CPI.
• The real historical cost is quieter. Slower growth and years of negative real returns could continue for people holding long bonds, but rising rates also make short-term options more attractive as you can earn real returns in things like TIPS and Tbills with little to no interest rate risk. That argues for ALM strategies that should be short duration in bonds, avoid long bonds, add a little portfolio insurance where appropriate and keeping your long duration assets matched to real assets and, at a minimum, multi asset instruments that capture diversification and equity risk premia in the long-run.