Thursday, July 2, 2009

MoneyWeek: How debt could sink the US economy

Many people still don't think the amount of debt the US government has amassed is anything to worry about, most commonly because it is still inconsequential relative to the US economy.

As much as the nominal debt may have grown, the growth in the US economy has ensured that servicing and carrying the debt is not a problem.

Stated another way, the US debt as a percentage of US GDP (gross domestic product) has not grown out of hand and therefore the nominal amount of debt is nothing to worry about.

Let us examine that proposition for a minute.

Below is a chart of the annual US GDP, the US government debt, and the US government's debt as a percentage of the US GDP.

us government debt and us gdp

The exploding debt during the Second World War is obvious, but notice how long it took the debt to GDP ratio to decline to pre-war levels. The level of actual debt has never declined, except for an insignificant $1 billion decline in 1946 and an equally insignificant $2 billion decline in 1949. The US debt has expanded every year since World War II.

Another interesting fact is that from around 1945 to about 1985 the US economy was growing at a faster pace than the US debt. This is evident from the decline in the debt to GDP ratio. Since 1985, however, the situation is exactly the opposite: the US debt is growing much faster than the US GDP.

The debt to GDP ratio improved during the late 1990s and the current rate of growth in the ratio is much less than it was during the eighties. But that reversal of the ratio in the late 1990s was due to the influx of foreign capital into the US and the subsequent stimulus this influx of capital had on the US economy. As a result tax receipts by the US government rose dramatically (all those capital gains during the tech bubble and stock market boom). That's over and the debt to GDP ratio is once again on the rise. Also, we have not seen the reversal of those international capital flows -- something that has been discussed at length in these pages -- and when that reversal occurs it will not only cause the dollar to decline, but will also cause the US debt to increase.

Regardless of what the Fed, the White House, the Senate or the press want you to believe, if China and Japan stop supporting the US dollar, US medium to long-term interest rates are going to rise. That would put a drag on the already anemic US economy, which means tax receipts by the US government will decline at the same time as the interest charges on the US debt will rise. The problem is that the US government is more likely to increase its deficit spending than to cut it, in an attempt to add stimulus.

The current debt to GDP ratio is almost twice as high as the debt to GDP ratio during the final stages of the Vietnam War and compared to Vietnam the US' current military adventures are skirmishes. If we combine increasing military spending with an increase in domestic deficit spending, higher interest rates and lower government tax receipts, then the debt to GDP ratio could rapidly approach World War II levels.

Anyone who is not alarmed by the increase in US government debt is living with his head in the sand.

First published on (

By Paul van Eeden

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