We are programmed from an early age to know debt as a bad thing. Consequences of uncontrolled debt can undoubtedly bring ruin at a personal level. Is the same true for nation states? In America it took from the days of the Founding Fathers to October 1981 to accumulate $1 trillion national debt, compared to 2024, where the United States racks up $1 trillion debt every 90 days. In July 2024 the US national debt hit an all-time high of $35 trillion. As of 2023, global debt was the equivalent of $305 trillion. That’s 13 zeros! This includes debt by both public and private debtors, and continues to grow.
In the US, neither presidential candidate seems willing to talk about indebtedness – the Republicans believe in extending tax cuts, while the Democrats advocate for continued federal government spending programmes. The size of accumulating debt is not simply a US phenomenon though. In many markets debt sits at eye popping levels. In China, the state backed property developer Evergrande collapsed in early 2024 with $330bn debt to name but one unsuccessful venture. In France, the latest government formed by the National Popular Front will pursue policies including extending social and welfare programmes, reducing retirement age for public servants from 64 to 60 whilst implementing a 10% pay rise simultaneously. Any government will struggle to deliver on fiscal consolidation. The new UK Labour government has identified a financial black hole and will raise taxes and likely borrowing to meet obligations, particularly where economic growth so eagerly promised pre-election fails to materialise from an economy and populous overburdened with taxation. Current UK national debt stands at £2.7 trillion, equating to 98% of GDP.
We know excessive debt is unhealthy for countries and case studies from various South American nations spring to mind, most notably Argentina. Zimbabwe offers another route map showing how not to do it.
There are also lessons from history. The Dutch guilder, also known as the florin, was the world’s reserve currency during the 1700s. A combination of excess debts accumulated through state owned companies such as the Dutch East India Company, followed by the Anglo-Dutch war led to its decline. The United Kingdom's pound sterling was the primary reserve currency of much of the world in the 19th century and first half of the 20th century. That status ended when the UK almost bankrupted herself fighting World War I and World War II and its place was taken by the United States dollar. Goldman Sachs does not believe US debt dynamics are a near-term or even medium-term threat to the economy. This is due to the exorbitant privilege of operating the world’s reserve currency. When it comes to US debt, “we see no sign of a buyers strike” Goldman says. However, the impacts of greater debt will continue to be managed.
How are nations, their central banks and finance ministries handling and managing the ever-growing debt burden and what are implications to investors?
The debt inspired meltdown in 2008 became known as the Great Financial Crisis (GFC). Implications for the west (particularly) and capitalism in general were genuinely existential which became apparent following the collapse of Lehman Brothers and other well known, sizeable institutions. A debt jubilee followed whereby impacted nations rescued many banks and bad debts were syphoned and dealt with by taking the debts onto the balance sheets of nations, effectively nationalising the problem. National debt like any debt is easier to service when interest rates are lower – so a rate of approximately zero percent around much of the world helped a good deal. The balance sheet debt had to be restructured and the debt was reconfigured into parcels with terms of typically 1-5 years, meaning the debt needed to be repaid or refinanced and rolled at the end of each term,
Over time, some of the debt relating to the GFC has been repaid, however further debt has been created and sits on national balance sheets. Interest rates have crept higher over the past 16 years, whereby American rates have peaked at 5-5.25% in 2024. Clearly there is an economic imperative to keep debt interest payments at affordable level, less than the prevailing rate of GDP, otherwise further debt must be created simply to fund interest payments. Central banks with their own fiat currency can create / print money with a few keystrokes. There is also a great incentive to reduce the burden of debt in real terms. How can this be delivered?
Inflation reduces the size of debt in real terms. We know this from the 1970s and 80s and of course most recently following the hangover from the Covid-19 pandemic supply shock. The impacts of inflation are painful for the public and are particularly visible. Implications for governments are equally painful at election time when they tend to get replaced as a form of democratic punishment for what is seen to be economic mismanagement. Currency debasement is far less obvious, and arguably invisible to private citizens, yet offers the same impact delivering real debt erosion over time. Debasement like quantitative easing (QE) is a form of financial repression. Unlike QE however debasement relies on the excess supply of money in a controlled form such that it does not leak into the main economy, thus creating inflation.
Instead, debasement creates asset inflation which manifests in the form of rising prices of real assets over time. Longer duration assets considered to offer greatest long-term value tend to be most sensitive to currency debasement. Debasement takes the form of liquidity which in real terms is financial engine oil, designed to lubricate the banking and economic systems and prevent seizures such as those witnessed in the GFC and is important around periods of refinancing significant debt. The reduction of interest rates, successful funding of government bond issuance, selling of short-dated Treasury Bills, use of the state banking system (Treasury General Account in America) to fund projects all provides liquidity. Curtailing of quantitative tightening programmes and offering greater scope for long duration asset access – for example pensions and mortgaged assets such as real estate is a boost to liquidity too.
Debt issued by central banks in the form of government bonds will find buyers due to a conveniently announced global banking regulation Basel 4 which requires banks to post more capital on their balance sheets in the form of sovereign debt. Basel 4 implementation in the United States is likely during early 2025.
As debts tend to be refinanced and “rolled” on average every 3-4 years we can pinpoint a liquidity cycle which supports the refinancing programme. Because of the effect on real asset prices, we can also estimate an approximate asset class market cycle. Looking closer, we can also identify a link with the business cycle which on average offers peaks and troughs approximately every 4-years or so. The Institute of Supply Management (ISM) offers a sensible proxy for the business cycle in America, which as the world’s largest economy, tends to lead other nations. See the chart below, you will identify a coincident cycle broadly (but not precisely) in line with the debt refinancing cycle.
Source: Bloomberg So, taking a rule of thumb, considering perhaps debasement of currency in the order of 6-8% per annum and a prevailing inflation rate over the longer run post Covid of say 3 – 3.5% per annum, an investor would need to secure around 10% per annum to stay in touch with current values (not price). One then asks, which asset classes are most likely to offer the most attractive returns in line with investor risk appetite over the long run?
In conclusion, we know the 21st century world will prove to be a higher debt fuelled place than previously. Likewise, we know uncontrolled debt for the public and for countries is likely to end badly – there are enough case studies to draw upon. However, living with debt and managing it effectively does appear to be possible for the very largest economies with their own fiat currencies and ideally the exorbitant privilege of owning the world’s reserve currency (US dollar). The modern method of controlling the debt mountain via debasement and holding borrowing costs at or below GDP levels is crucial over the medium to long run. There are ways investors can work with their chosen asset manager to aim for a portfolio return that might preserve or even perhaps expand the real terms value of money when set against a backdrop of ongoing financial repression, within their risk appetite.
Key takeaways:
This table summarises the key points about debt in the 21st century, the potential consequences of uncontrolled debt, the capability of large economies to manage debt, the methods of debt control, and strategies for investors.
21st Century Debt Levels | The 21st century world will have higher debt levels than before. |
Uncontrolled Debt Consequences | Uncontrolled debt for individuals and countries is likely to end badly, with ample case studies as evidence. |
Managing Debt in Large Economies | The largest economies with their own fiat currencies, especially those with the world’s reserve currency (US dollar), can potentially manage debt more effectively. |
Modern Debt Control Methods | Controlling the debt mountain through debasement, financial repression and maintaining borrowing costs at or below GDP levels is crucial. |
Investor Strategies | Investors can collaborate with discretionary managers to aim for portfolio returns that preserve the real terms value of money amidst ongoing financial repression. |
Jargon buster:
Fiat currency | A fiat currency is a type of currency that is issued by a government and is not backed by a physical commodity like gold or silver. Instead, its value is derived from the trust and confidence that people have in the stability and authority of the issuing government. |
Global Reserve currency | A global reserve currency is a currency that is held in significant quantities by governments and institutions as part of their foreign exchange reserves. It is used in international trade and financial transactions, serving as a common benchmark in the global economy. The most prominent global reserve currency is the US dollar (USD). |
Long duration assets | A long-duration asset is an investment or financial instrument that has a long-term horizon, typically characterized by its extended maturity or holding period. These assets are sensitive to changes in interest rates, and their value can fluctuate significantly with varying interest rate environments. |
Currency debasement | Monetary debasement refers to the reduction in the value of a country's currency. This can occur through several mechanisms: Increase in Money Supply, Devaluation, Currency Dilution. |
Financial repression | Financial repression refers to measures used by governments to channel funds to themselves as a form of debt reduction. These measures often result in savers earning returns below the rate of inflation, effectively reducing the real value of their savings. Financial repression can take various forms and is typically used to manage high levels of government debt. |
Quantitative easing | Quantitative Easing (QE) is a monetary policy tool used by central banks to stimulate the economy when conventional monetary policy, such as lowering interest rates, becomes ineffective. It involves the central bank purchasing large quantities of financial assets, typically government bonds, from the market. This process increases the money supply and lowers interest rates, aiming to boost lending and investment. |
Quantitative tightening | Quantitative Tightening (QT) is the opposite of Quantitative Easing (QE). It is a monetary policy tool used by central banks to decrease the amount of money circulating in the economy. This is typically achieved by selling government bonds and other financial assets that the central bank had previously purchased during QE, or by allowing these assets to mature without reinvestment. The goal of QT is to normalise monetary policy after a period of economic stimulus and to curb potential inflationary pressures. |
GDP | Gross Domestic Product (GDP) is a comprehensive measure of a nation's overall economic activity. It represents the total monetary value of all goods and services produced within a country's borders over a specific period, typically quarterly or annually. GDP is a crucial indicator used to gauge the health of an economy, track economic growth, and compare the economic performance of different countries. |
Further reading suggested: Capital Wars, Michael Howell.
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