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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management biweekly geopolitical report for November 4, 2024. I'm Phil Adler. We're talking big numbers today. US National Debt Numbers. Back in July, the Treasury Department reported our national debt exceeded $35,000,000,000,000 for the first time, and at the current pace, will top 56 trillion by 2,034.
Phil Adler:It's hard to get your mind around numbers like these. No wonder many commentators are sounding the alarm. Confluence associate market strategist, Daniel Ortworth, joins us now to take us on a deeper dive into our debt situation with the goal of adding some perspective. 1st, Daniel, what is the best way statistically to approach the subject of National Debt?
Daniel Ortwerth:Hi, Phil. Good to talk to you again. It is a good question to start the discussion because there are so many ways that people approach this question. The best way to evaluate the national debt is by measuring the debt as a percentage of gross domestic product or debt to GDP. Let's take a minute or 2 to illustrate this concept with a relatable personal comparison.
Daniel Ortwerth:Consider an individual who owns a $300,000 house with a $150,000 mortgage. Is this affordable? If the person has an annual pretax income of $150,000 and no other debt, then his or her debt to income ratio is 100%. What if that same person's pretax income is only $100,000? This raises the debt to income ratio to 150%.
Daniel Ortwerth:Even if the person is managing to make the payments, he or she is at a greater risk of failure to make the payment if a crisis, such as a major medical expense, suddenly arises. Affordability depends on a list of factors. But generally, the higher the ratio, the greater the risk that the debt is unsustainable. These same principles apply to countries. Although GDP is actually a measure of output, not income, it is much more broadly available than national income measures.
Daniel Ortwerth:And on the national level, the two measures are practically equivalent.
Phil Adler:Is debt to GDP the approach most economists take?
Daniel Ortwerth:Economists are known to take a variety of competing approaches to nearly any subject of their analysis, and the range of approaches is certainly broad and varying on national debt levels too. However, we feel confident that debt to GDP is the most broadly used and well respected approach. Several major institutions in the US and around the world employ this statistic as their foundational measure of debt.
Phil Adler:How does our current debt to GDP ratio compare to past times in our nation's history?
Daniel Ortwerth:Phil, we need to clarify an important point before we go further. For this analysis, we focused on total country debt to GDP, not just government debt to GDP. This means that we took the measure of the statistic for the government and private sectors combined, the private sector being a combination of all corporations except the banking sector and all households. History shows that this total measure of a nation's debt is the best indicator of its financial health. This is partly because history also shows examples of how debt can be transferred from one sector to another by changes in laws, regulations, and incentives.
Daniel Ortwerth:We touch on the government's debt along the way since it is clearly a concern today, but we emphasize total national debt in our analysis. Now to your question, the US entered the 21st century with a total national debt to GDP of 188%. By 2023, that measure had increased to 256%. However, most of that increase occurred between 2 1,021,011, and it was associated with the events that led to the global financial crisis that began in 2008. Since then, the debt burden in each sector of American society has shown signs of moderation and even discipline in certain areas.
Daniel Ortwerth:Now the government itself did more than double its debt to GDP this century from 51% to 106%. Again, however, we need to look at how the trend evolved over the years. It crossed the 100 threshold all the way back in 2011, again, due to measures taken in response to the global financial crisis. And since then, it has held remarkably steady in the low 100. Even the COVID response caused spike has almost completely reversed.
Phil Adler:Daniel, is reliable debt to GDP data available for enough other countries to allow useful international comparisons?
Daniel Ortwerth:Indeed it is. Historical debt levels and their percentages of GDP are available for 43 countries including those of the largest developed economies and the most prominent emerging economies. Advanced economies include the United States, Canada, Japan, Australia, New Zealand, and 16 European countries. Emerging economies include a broad variety of less developed nations ranging from China, Russia, and India to several countries in Southeast Asia, South America, and Eastern Europe. The Bank For International Settlements in Switzerland compiles and publishes this information for each of these countries according to standardized uniform methods enabling comparison among countries and across time.
Phil Adler:Well, the numbers then do allow us to compare US debt with other countries both in terms of the total debt to GDP ratio and also how much this ratio is growing. Now, how does the US compare to other countries in terms of total debt?
Daniel Ortwerth:Phil, the US is right in the middle of the pack. It entered the century ranking 15th among the 43 countries in terms of total debt, and at the end of 2023, it was 14th. Virtually no change. The US government's debt to GDP registered the 6th largest increase in the group, but the private sectors increase ranked 31st, well below the average. In particular, US households reduced their debt to GDP by 20%, the 6th largest decline of the group.
Daniel Ortwerth:US government debt to GDP is now the 7th highest in the group. However, even at this level, it is less than half of Japan's level back at the turn of the century, and its change over the period is just more than half of Japan's change. We emphasize this point because Japan's economy is broadly similar to ours, and its debt burden has not led to catastrophe.
Phil Adler:Which countries face the most severe debt challenges?
Daniel Ortwerth:There are 6 countries that have registered debt to GDP increases that stand out from the rest. China, Hong Kong, which reports separately from mainland China, Luxembourg, France, Greece, and South Korea. All of these reported greater than 100% increases with 2 increasing more than 200%. Hong Kong and Luxembourg are rather special cases because they have debt friendly law codes and regulatory policies that incentivize corporate borrowers often from other countries to issue their debt in these countries. This artificially inflates their numbers.
Daniel Ortwerth:France and South Korea both saw high increases in both the government and private sectors. Greece exemplified a pattern observed in several countries, Japan being another notable example in which the government increased its debt in an extreme amount relative to the entire group while the private sector restrained itself. Greek households in particular reduced their debt to GDP by 11%. Finally, China's rising debt to GDP reflects notable increases in each sector. We especially note that it registered the highest increase of household debt in the entire reporting group.
Phil Adler:Daniel, since China has emerged as our major geopolitical rival this century, let's stay on China for a moment. How does the US compare to China in terms of debt?
Daniel Ortwerth:In 2023, the Chinese total debt to GDP surpassed that of the US for the first time. This marked a major change from the turn of the century when China's debt to GDP of 128% was 60% less than the US debt burden at that time of 188%. US debt to GDP rose from that level to 250% in 2009. But from that point, it has remained extremely stable between 250256 with the exception of the now reversed COVID spike. Meanwhile, after remaining stable through 2008, China's debt to GDP began a long march upward in 2009, nearly constantly rising to its current level of 271%.
Daniel Ortwerth:If anything, total US debt to GDP currently displays a slight downward trend whilst the Chinese trend remains clearly upward. At this point in history and as a nation, China is more indebted than the US. Now to briefly touch on the sectors, Chinese government debt to GDP was 28% less than that of the US back in 2000. It is 20 3% less now. And if current trends continue, it will eclipse US government debt to GDP by the end of the decade.
Daniel Ortwerth:Chinese corporate debt to GDP has gone from just less than 100% to 100 40% during a time when US corporate debt very modestly increased from 67% to 77%. Perhaps most strikingly, US household debt to GDP, which peaked at nearly 100% on the eve of the global financial crisis, has dropped to 73%. During that same time, Chinese households rose from a little bit less than 10% to nearly 70% or about the same level as US households.
Phil Adler:Daniel, I I imagine that this comparison we've been doing with other countries may offer some relief for investors who have been worried about our debt. But the fact is that our national debt does continue to increase, and paying off the interest every year does seem to command a growing percentage of our revenues, leaving less available for defense and key projects, and perhaps leading sometime in the future to an economic crisis. Am I right?
Daniel Ortwerth:Phil, this is a very understandable fear. Anytime we hear the words trillion and deficit in the same phrase, it is perfectly reasonable to feel a sense of concern or even alarm. However, the numbers tell a different more reassuring story. By the most important measure, debt as a percentage of GDP, the level and trend of US debt as a nation appears manageable and relatively stable. Even US government debt, which has clearly risen and probably requires some measure of curtailment, has been surprisingly stable for more than a decade when measured against the growing US economy.
Daniel Ortwerth:Meanwhile, private sector US debt is remarkably healthy. Taken as a whole, the US economy has unmatched strength, diversity, and versatility, and this gives it and national leadership options for how to manage this debt.
Phil Adler:Daniel, it does make sense though that as the debt rises, the government must offer more bonds at higher interest rates to avoid default. Couldn't this lead to a buyer's strike where demand fails to keep up with the available product?
Daniel Ortwerth:Theoretically, yes, Phil. This is possible, and the continued high rate of debt issuance by the government does raise exactly that risk. However, the availability of US treasuries is vital to the functioning of financial markets at home and throughout the world. Treasuries act as a virtual currency in many parts of the global credit market. Too much of a buyer's strike would cripple those markets.
Daniel Ortwerth:The major players understand that, and no one wants that to happen. So there is a limit to how far a buyer's strike would go.
Phil Adler:If the debt keeps growing at present levels, what are the government's options in the event of an eventual buyer's strike?
Daniel Ortwerth:In these kinds of situations, governments and central banks sometimes resort to what is known as financial repression. This means that in a scenario of sustained high debt issuance, the government might act to limit the resulting interest costs. Agencies such as the US Treasury and the Federal Reserve might adopt policies to keep bond yields artificially low such as by forcing banks by regulation to buy and hold more Treasury bonds. The Federal Reserve could also adopt what's known as yield curve control in which it would cap long term yields by buying up treasuries. While this may seem implausible to many investors, it is important to remember that there is a precedent for this policy.
Daniel Ortwerth:Financial repression was the way that the US used in the decades right after World War 2 to help the US government weather the debt overhang left over from the war.
Phil Adler:Couple of more questions. What are the implications of the growing national debt for investors?
Daniel Ortwerth:Phil, the most immediate implication is that the yields on future government bonds may not keep up with consumer price inflation, and the purchasing power of those who invest in them may slowly erode over time. To understand the longer term implications, we think it is important to look beyond just the US debt situation to the broader context of the global debt situation, especially that of our main geopolitical rival, China. As we have emphasized in previous reports, we see the global economy fracturing into competing blocks led by the US and China. And as the report we have discussed today shows, the Chinese debt situation and its apparent trend are truly disconcerting. As the global economy fractures, so will access to the investing in capital markets of the 2 blocks.
Daniel Ortwerth:Since the foundation of the US led market is much more stable and durable than the increasingly questionable Chinese market foundation, we expect the financial markets of the US block to increasingly win the global competition for investment capital.
Phil Adler:Daniel, as as we wrap up, is it fair to say that you are concerned and watchful, but not alarmed, at least not yet, about our national debt? Yes,
Daniel Ortwerth:Phil. That is a very fair way to state it. The rise in US government debt is a cause for concern, and we should pay close attention to the policy choices of US national leadership. As I said before, the pace of new debt issuance probably needs to be curtailed at some point in the relatively near future. However, our analysis of the data clearly shows that the situation simply does not justify the alarmist views that some are voicing.
Daniel Ortwerth:Rather, in consideration of all the data that we have gathered and analyzed, if there is one place where perhaps the debt burden alarm should be sounding, that place is Beijing.
Phil Adler:Thank you, Daniel. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll.
Phil Adler:I'm Phil Adler.