Debunking Three Common Myths Surrounding American National Debt
The past few years have seen significant changes in the financial landscape, with the US debt and deficit taking centre stage. In his newsletters "Fiscal-Driven Inflation" (May 2021) and "Fiscal Dominance" (July 2023), the author has been at the forefront of this discussion, warning about the increasing consequences of the spiraling debt and deficit situation.
The author refers to the current era as one where the total stock of debt and ongoing federal deficits have a real impact, using the phrase "nothing stops this train." This sentiment underscores the author's belief that these factors are not going away anytime soon and will have economic and investment implications that need to be considered.
One of the deflationary forces that helped lower interest rates in the past was the opening of China in the 1980s and the fall of the Soviet Union in the early 1990s. These events allowed for lower interest rates on the growing total stock of debt. However, with globalization reaching a potential peak and starting to reverse slightly, interest rates are no longer in a structural downtrend.
Interest rates were particularly high in the late 1980s, making interest expense a big share of GDP. Today, the US federal government owes over $36 trillion, a figure that has been growing steadily. This debt is divided among households, with each household owing an average of $277,000 in federal debt.
The cost of the federal debt is also felt in the foreign sector, where there is about $18 trillion worth of dollar-denominated debt, which is 3x as much as there are base dollars in existence. Foreign entities hold about $9 trillion in US treasuries, with about $4 trillion held by sovereign entities and $5 trillion held by foreign private entities.
The top 10 foreign holders of US Treasury bonds include Japan, China, the United Kingdom, Luxembourg, Ireland, Switzerland, Cayman Islands, Belgium, Taiwan, and Hong Kong, with Japan being the largest holder. However, defaulting on foreign entities could impair the ability for the US to convince foreign entities to hold their treasuries for a long time.
The author has also warned about the potential consequences of defaulting on certain entities such as retirees, insurance companies, and banks. In fact, a major currency devaluation is considered a type of default.
Despite the concerns, the author argues that the US is not running 70% of GDP deficits, but rather 7%. He emphasizes that magnitude matters, and that the US is still able to experience a ton of money supply growth before it would result in a true dollar crisis.
The author has been cautious about the idea of fiscal consolidation and potential recession, particularly as price inflation reached its peak and pandemic-era fiscal stimulus wore off. He wrote an article in 2019 titled "Are We in a Bond Bubble?" and concluded that we're likely in a bond bubble and that such a thing is likely coming in the next downturn.
In conclusion, the author's analysis of the US debt and deficit situation provides a sobering yet realistic view of the challenges ahead. He argues that taking these issues seriously since the trend changes began occurring has been a good way to avoid being surprised by certain events and to run a portfolio more successfully than a typical 60/40 stock/bond portfolio. It's an issue that is likely to be with us for a long time, and investors and economists need to take it into account if they're going to make accurate calls.
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