How much national debt is too much?
I fielded a question from a friend recently that ought to be on all our minds: “Does ballooning national debt matter?”
My quick answer: It doesn’t matter right now. It might, and probably will, matter later.
The national debt on the last day of January was either $21.6 trillion or $27.8 trillion.
The larger amount includes debt owned by the government, which will be used mostly to pay future Social Security obligations.
I see the smaller “net debt” of $21.6 trillion as the relevant number, but you can choose your own adventure.
If we call that $21.6 trillion number “Biden’s inheritance,” here is what other presidents inherited, what debt they bequeathed, and how much the national debt grew (or shrank)
on their watch.
Donald Trump: $14.4 trillion, which grew to $21.6 trillion, a 51 percent rise.
Barack Obama: $6.3 trillion, grew to $14.4 trillion, a 128 percent rise.
George W. Bush: $3.4 trillion, grew to $6.3 trillion, an 86 percent rise.
Bill Clinton: $4.2 trillion, fell to $3.4 trillion, a 19 percent drop.
George H.W. Bush: $2.7 trillion, grew to $4.2 trillion, a 56 percent rise.
Ronald Reagan: $934 billion grew to $2.7 trillion, a 189 percent rise.
Reagan, the darling of small-government conservatives, was the deficitexploding equivalent of a day-trader on Reddit. Clinton, loathed for his outsize appetites, was a thrifty shrinker of government debt. .
Today’s national debt is far bigger than ever. But is it too big? That depends on a few factors. The biggest are interest rates, cooperation, currency denomination and confidence.
How do we determine what’s too big?
A reasonable starting point is to compare the size of the national debt to the size of the economy. The debt at the start of 2021 was approximately 100 percent of this year’s projected gross domestic product. It was roughly 74 percent at the start of Trump’s presidency, 44 percent at the start of Obama’s first term and 32 percent for George W. Bush.
Back in the 1990s when I sold emerging market bonds for a living, we worried about weak countries entering financial death spirals when their debt-to-GDP ratios rose above 70 percent.
That’s obviously worrisome for the United States.
We also can compare the cost of debt interest to the size of the economy. Here, we find a much more optimistic story. For now.
The cost of interest on our national debt is about 1.7 percent of the size of the economy. That compares to 2.3 percent at the beginning of Trump’s presidency, 2.7 percent for Obama, 3.4 for George W. Bush, and 4.3 percent for both Clinton and George H.W. Bush.
So how does this odd miracle happen? Interest rates.
As of Jan. 31, the U.S. government paid an average interest rate of 1.7 percent on all its interestbearing debt, down from 2.4 percent just a year ago. About 20 years ago, the government paid an average 6.6 percent on its measly $3.4 trillion of debt.
That explains why we’re good for now. If inflation picks up in the future, or if confidence drops in our ability to repay bond investors, the debt could become unaffordable. If interest rates revert to historically normal rates of 4 to 6 percent, we’d be in a world of hurt.
The other major factors that determine debt sustainability are the attitudes of our debtholders and the currency in which our debt is denominated.
The vast majority of government debtholders are neutral. Just pay them their interest and principal as agreed, and all is well. They are not our friends, but they are not our enemies. They are banks, pension funds, insurance companies, money market funds, mutual funds and sovereign wealth funds.
But sometimes they are rival nations or quasinational financial institutions, such as the Central Bank of China or a conglomerate of Japanese banks. About one-third of U.S. debt is owned by investors outside the country. The largest foreign holders of U.S. debt are in Japan and China. They account for 18 percent and 15 percent, respectively, of debt held by foreigners.
Could relations with our foreign or domestic debt holders become antagonistic?
A cold war, or a hot war, with a major foreign debt holder would be problematic. Chinese-based institutions own less than 5 percent of all U.S. debt. We could imagine interest rates rising or the government having trouble rolling over debt maturities if relations with China became nasty. Still, it’s a bit far-fetched to worry about foreign debtholders holding us over a barrel right now.
What probably matters more is the currency our debt is denominated in. Ours is in dollars. This is incredibly important.
No less a sovereign debt genius than Trump made this clear when he declared during his 2016 presidential campaign, “I’ve borrowed knowing that you can pay back with discounts. I’d borrow (as president) knowing that if the economy crashed, you could make a deal.”
A few days later, he added: “First of all, you never have to default because you print the money. I hate to tell you, OK, so there’s never a default.”
And in his weird, only Trump-would-say-this-outloud way, he was right. The fact that we borrow in dollars and owe money in dollars means we don’t have to default on our debts.
But we might have to inflate away the value of the currency to avoid default. This has always been the fear about heavy government borrowing — that it runs up inflation in its own currency to get out from under a heavy debt burden.
The fact that interest rates are currently extremely low, however, indicates that bond markets believe broad-based inflation is not a real threat. That can always change. And if it does change, then the consequences of having sextupled our national debt in the past 20 years become far worse.