Putting the U.S. Debt into Proper Perspective
Putting the U.S. Debt into Proper Perspective
It is time to focus on the real story.
By Nino Boezio
The United States has received severe negative press the last several years regarding its massive U.S. federal government debt, currently estimated (as of April 2007) at about $8.9 trillion. This has scared many foreign investors away from U.S. dollar denominated investments, since even if these investments were expected to provide attractive returns, these returns would be hurt significantly by a further currency depreciation in the U.S. dollar.
What is the true story behind the U.S. debt? Is it really an issue to worry about? Can we put the U.S. dollar, and the United States, into a proper perspective relative to the rest of the world? These questions are very important, as they have factored significantly into the asset allocation and currency exposure decision (particularly for foreigners) the last few years, and will continue to do so.
Even though there might be some differences in reporting dates and the way figures are estimated between countries, we note (Table 1) that the United States in 2006 was ranked first in world GDP ($13.0 trillion) and was ranked first in total debt relative to other countries and economies (approximately $8.4 trillion), but it ranked only 32nd in terms of its debt to GDP ratio, with a ratio of 64.7 percent. In other words, the United States is a very dominant factor on the world scene, constituting about one–fifth of the world's economic activity, and about one–quarter of the world's debt. However, it does not rank first in its debt to GDP ratio. Interestingly, Canada had a far worse debt to GDP ratio, ranking 27th (a ratio of 65.4 percent). We wish to note that other countries were far worse, such as Italy with a ratio of 107.8 percent, Germany with 66.8 percent, and Japan with a huge 175.5 percent.
We should note that the United States did have a significantly higher debt load following the wartime spending for WWII (see Table 2). Of course, thanks to the war effort, the United States was able to ratchet up capacity and productivity, which benefited its economy for years to come.
We should also ask the question as to what amount of U.S. debt would otherwise be considered reasonable and comfortable for the global community to accept. If the U.S. debt was one–half of what it is now (say $4.5 trillion) many would likely still shudder (because of its magnitude), yet it would then be only 32 percent of GDP, which is lower than what the majority (two–thirds) of the countries tracked show. When the U.S. debt was in the range of $5–$6 trillion not too long ago, many still found it disturbingly high, yet on a percentage basis, it was not bad relative to other countries. We also note in White House projections (Table 3), the debt could hit $10 billion by 2009, which could make us even more concerned. Yet even under that scenario, such a debt would still be under 70 percent of GDP. Debt is considered an important factor (and considered to be an essential element) to the functioning of any country today, whether we appreciate that fact or not.
We also wish to cite that with the advent of the Euro currency and the U.S./global slowdown that took place after Y2K, central banks around the world took policies to diversify their currency holdings, hence shifting to greater holdings of the Euro and away from the U.S. dollars. Unfortunately however, some in the media inappropriately assigned too much emphasis on the U.S. dollar decline as a reflection of concerns about the U.S. debt and economic viability, not on the shift in central bank reserve currencies.
The Appeal of Borrowing
Many countries have learned the power of debt. One of the best ways to improve economic performance in a region or sector is to build infrastructure. This attracts investment and in turn improves the tax base. And countries, provinces, states, regions and even municipalities have learned over time that if they do not have the money, then borrow it. The interest servicing cost is often a small price to pay for a greater economic (and thus tax) base from which to work. Of course there is a limitation to economic development, and there will be a point where borrowing is both unnecessary and unwise.
But we note that generally there is often little backlash in the media regarding borrowing. The public is often not vocal enough about debt to make it an issue of concern. Also, politicians have found that if they are fiscally responsible and pay down debt, it may go unnoticed and unrewarded, but if they spend it on their constituents, they receive credit and votes. Hence any spending does often benefit governments and politicians, while cutting back spending often does not.
Of course, debt can eventually cross a line where the government can no longer support the debt servicing (i.e., the interest payments) and even comfortably pay back the maturity values, and hence taxes may need to increase, services need to be cut, and/or some debt may need to be restructured (or new debt re–issued or old debt rolled–over). Some of these problems can also arise when the economy takes an unexpected downturn, hurting tax revenue and increasing the costs of social services.
Of course governments also take risks, in hopes of a greater reward. Japan got into heavy debt during the 1990s, because it tried several times, to spend its way out of recession and failed, so it just increased debt without any immediate result or benefit. The United States in a certain respect, has also been gambling with higher debt, expecting its current spending and its current domestic and foreign policy, to pay handsome dividends down the road. This has yet to be seen.
Focus on the Relative Not the Absolute–But Also Consider The Trend
The United States is not a country that should be ignored, or its currency now considered as a bad medium of exchange. However, we do need to assess the relative performance of currencies, based on the relative prospects of the countries they represent. We have been noting in particular, that Canada and Australia for example, have been highly sensitive to the demand for commodities and energy. Hence, when the demand for these commodities is strong, the Canadian dollar and Australian dollar also tend to be strong.
The absolute size of the U.S. debt may be shocking and troubling, but it has to be put into the proper perspective (even though in absolute terms it will increase, it is still expected to hover around 65– to 70–percent of GDP). The Japanese government, with a much larger debt burden as a percentage of GDP, is still able to function today, thanks in part to a large pool of domestic saving. Japan's currency has also been able to hold considerable value, despite some weakness in recent years. Investors in Japanese debt are also still willing to hold such investments, and at yields much lower than those available in the United States. (0.5– to 2.0–percent as we move out in maturity on the Japanese yield curve, versus 4.5– to 5.0–percent in the United States). Conversely, given that the yields on Japanese debt are relatively quite low, the Japanese government has less of a debt–servicing issue than a country like the United States would have (but this gap can also still narrow over time, if U.S. rates gradually go down further). In addition, the desire to increase taxes in order to reduce debt is not always taken as a serious consideration (but it can be introduced as a future option by the U.S. government), and it is a significant factor in any debt build–up or pay–down.
We therefore need to evaluate the United States on its merits as an area of investment like any other. To overly focus on the potential for a further dramatic U.S. dollar decline and the demise of the United States as an economic force in the world, is still premature. Also the claims that foreigners will pull out of their U.S. dollar–denominated investments due to the U.S. debt level, or due to some sort of a currency panic, does not represent a well–rounded view of all of the factors that can impact the fundamentals of the U.S. economy and its financial strength (even though we do admit that much of the U.S. debt is held by foreigners, unlike the case for other countries). We will, however, find that as time moves forward, there will be various countries that will act as niche players, who either through their strength in harbouring cheap labor, their large availability of resources, special technological positioning or their physical proximity to various other countries in the world, will have some relative advantages to the United States, and such advantages can be reflected in their relative currency appreciation, or through their investment prospects as viewed by outsiders (say, via emerging market equity exposure). But the doom and gloom scenario that some have portrayed for the United States is likely more emotional in nature than most are currently willing to admit.
Nino Boezio, FSA, CFA, FCIA, is a consulting actuary for CIBC Wealth Management.
Please note that portions of this article were cited in the paper, "Long Term Strategic Asset Allocation–Update for 2007," by Nino Boezio, Ghattas George Dallal, CIBC Wealth Management/ CIBC World Markets, January 2007.