"A democracy cannot exist as a permanent form of government. It can only exist until the majority discovers it can vote itself largess out of the public treasury. After that, the majority always votes for the candidate promising the most benefit with the result the democracy collapses because of the loose fiscal policy ensuring, always to be followed by a dictatorship, then a monarchy."
-Elmer T Peterson
The problem with all democracies is that politicians must get elected. In the case with the U.S. president, every four years. With voters, a dollar today is worth ten dollars tomorrow. This is especially true if the benefits are not evenly distributed. When the opposing party can fundamentally change the direction of who gets taxed more and who reap the benefit of this tax, you vote your guy in to get the benefits today. As a result of this dynamic, democracies always spend tomorrow's money today.
U.S. national debt to gdp, courtesy of zfacts.com
The U.S. was very fortunate to have won the cold war. To do so, Reagan had to increase the national debt. We can see that in the red portion of the graph labeled Reagan/Bush I. Partly due to his luck, and partly due to his wisdom, Bill Clinton became the president to reap the benefit of winning the cold war. While gdp continue to grow at a good pace, budget deficit was getting smaller. At the end of his term, we actually had a budget surplus. W was the first president to squander this cold war dividend. During his presidency, we fought the Iraqis and the Afghanis, both of these wars cost money. What was even more significant was the housing bubble that happened under his watch. The fiscal impact lasted well beyond his presidency. Obama had to spend most of his first term dealing with the impact of this crisis. By the end of Obama's presidency, the national debt stood at 100% of GDP. When Trump took office, he accelerated this a notch by cutting taxes. As we can see from the graph, debt to gdp was approaching 120% in the short three years of his presidency. That was before Covid-19 hit. Today, in Sept. 7 2020, it stood at $26.5 Trillion. With the U.S. economy shrinking by at least 8% this year, we are now staring at 135% of gdp right now. To get some ideas what kinds of countries sport this kind of national debt, let's take a look at the highest debtor nations in the world.
Japan - 234.18%
Greece - 181.7%
Sudan - 176.02%
Venezuela - 172.08%
Lebanon - 160.57%
Italy - 127.51%
Eritrea - 127.34%
As we can see, these are not the most economically dynamic countries in the world. To be sure, our economy is not anything close to as bad as that of Greece or Italy. Even at the robust growth of 2+% of the past up cycle, 135% of gdp is very hard to pay back. Going forward, we are facing headwind in two areas. The first is that growth had slowed below the 2% norm that we used to see. During the entire up cycle from 2009 to 2020 before Covid hit, our gdp had indeed gone higher than 2%, but that was done with a lot of deficit spending. This means even during good times, debt to gdp ratio will continue to climb. Indeed, this has been the case as you can see in the first chart above. The second issue is that we are about a year away from getting Covid under control. We will see not only more deficit spending, we will also have more damage to the economy. Entire layer of the economy such as restaurants, travel are going through an extinction event. After Covid, it will take many years before these people and enterprises can recover. This means more deficit spending. We are staring down 150% gdp worth of debt by 2021 and maybe 200% by 2025.
There are two ways out of this mess. We can either tighten our belts after the economy steadied, or print our way out. Given that we are a democracy and belt tightening involve pain, the most likely path forward is that we will print our way out. Fortunately, we have the world's reserve currency. That means as we print and spend, the world (at least those that hold U.S. dollars) is partially subsidizing our spending. However, that is not without limits.
The reason the world uses U.S. dollars for trade happened after WWII. Before that time, the British pound was the reserve currency. As a result of fighting two world wars, the British was bankrupt, so they print money and devalued the pound. Since the U.S. was the most productive economy in the world after WWII, the U.S. dollar replaced the pound as the world reserve currency. Initially, the dollar was pegged to gold. During Nixon's time, this peg was removed. Still, up until Ronald Reagan, the status of reserve currency was carefully managed and not abused. Instead of coupling this to gold, we forced OPEC to trade their oil using only U.S. dollars. On the other side, the finished goods that the Chinese are selling are also done with U.S. dollar. This forced everyone who is not North Korea to hold U.S. dollars.
When potential bond buyers see the U.S. with 150% debt to gdp ratio and climbing, they naturally would demand a higher interest payment to compensate for the printing that will be done. However, on the ground, the interest rates are actually quite low and declining. That is because of two factors. Developing countries are taking a big hit from Covid and many may not be able to pay their debt. At the moment, they are scrambling to get more dollars so they could service the debt. Having people lining up to sell one of their good kidneys for more dollars will certainly drive down the yield. Eventually, many of these countries will run out of rope and have to default on their debt. At that time, the demand for the dollars will be lowered. Also the Federal Reserve can step in to buy U.S. bonds to drive the interest rates down. That is because the U.S. government, with our wobbly finance, can ill afford to pay the true interest rates that are determined by the market. The Fed acts as another source of bond demand, artificially lowering the interest rate.
In the longer run, U.S. bonds that pay little interest and a U.S. dollar that is losing its value due to currency printing will drive the other countries to find alternatives to the U.S. dollar. The Europeans are trying to do more trade with the Euro. The Chinese are cutting back their holding of the U.S. dollar. As the world (including the U.S. investors) sours on the dollar and dollar denominated assets, even if there is no substitute to the U.S. dollar as the reserve currency, there will be a flight away from U.S. bonds and U.S. dollar into other classes of assets. This will force the Fed to become increasingly the buyer of last resort for the treasuries. The last time we printed a lot of money was during WWII. Fortunately for us, in the 1950's, the U.S. was making everything for the world. Our strong economy relative to the world helped lowered our debt over time. Today, we are a slowly declining economic power. Once the general population realize the dollar is losing its value, inflationary behavior will set in where U.S. dollars are quickly traded for something that will hold its value and we will start to have spiraling inflation.
The generous benefits we voted ourselves with along with all the wars that we fought around the world have resulted in ever increasing national debt. Covid-19 and the inept handling of it by the Trump administration, our local governments as well as our citizens have only accelerated this debt built up. Like all other governments in this predicament, we are printing money to get out of this situation. The cost is partially born by other nations and companies holding U.S. bonds and U.S. dollars. However, we have so abused our reserve currency status that a reckoning is coming. When people lose faith on the U.S. dollar, a dumping of the dollar and dollar based assets will take place. We will go through a phase of rapid economic decline.
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