Your Nation's National Debt: 5 Things You Need to Know
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Get started risk-free at greenlight.com slash Wondery. Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 416. It's titled, Your Nation's National Debt, Five Things You Need to Know.

Since 2014, we have released 10 episodes on federal government national debt. The last time we looked at the topic in depth was episode 360 in September 2021. We do a lot of episodes on debt, national debt, because I'm still learning about it. My views on national debt have changed dramatically.

moderately over the years as I become more worried about it, as I have come to better understand government finances, central bank finances. And so I thought it would be helpful to review some very important principles when it comes to the national debt, because the national debt consists of government bonds that different governments issue, but most of us actually own some of that debt.

The government's debt is our asset. We're receiving interest income and we want to make sure that we get paid back.

We also should be very tuned in to what is going on with the national debt because the interest rate on that debt can influence the interest rate we pay to borrow, to buy a house for a mortgage or to borrow for a car because the government interest rate is sort of the baseline and then other borrowings are referenced off what the government is paying for debt. And so these are important concepts.

A lot has happened since September 2021 when we last looked at this. For example, the U.S. national debt is $3 trillion higher, approaching $31.4 trillion, which is very close to the debt ceiling. The debt ceiling in the U.S. is the maximum level of government bonds the U.S. Treasury has been authorized by Congress to issue. That's

That debt ceiling will need to be raised this year, and it's setting up to be a big political fight.

Another thing that has occurred is last fall in the UK, the market reaction to the Chancellor's spending proposal and tax cut was absolutely brutal. Interest rates spiked and the British pound sterling fell to an all-time low at 1.03 pounds to the dollar, almost at parity. In December 2021, the yield on the 20-year UK government bond was 0.9%.

In early August, it was up to 2.3% as the Bank of England had been raising its policy rate. But then when this whole budget fiasco hit, the yield on the 20-year UK government bond soared to over 5%. It has since eased to around 4.1% as the new UK Chancellor, Jeremy Hunt, announced a revised budget.

These are the type of interest rate moves we can see when bond investors get worried. And the UK government debt, national debt, isn't even that great. It's two and a half trillion pounds, only about 105% of GDP or gross domestic product, which is the measure of output. And that's one of the things that we'll discuss in this episode. What matters is what is the size of the debt relative to the economy?

Now, investors have been worried about the UK government because their public expenditures, public sector expenditures, reached over half of GDP, 53% in 2021. It's expected to be close to 45% of GDP this year with a budget deficit to GDP of over 7%. So the debt is growing significantly in the UK.

Another recent occurrence regarding national debt is the Bank of Japan surprised financial markets by announcing that they were widening the tolerance band that they would allow the 10-year Japanese government bonds, known as JGBs, to fluctuate.

Back in September 2016, the Bank of Japan announced a new policy that it would target the yield on the 10-year government bond in Japan to around 0%. That was near what the bond had already been trading at.

The Bank of Japan had already been in a policy of buying government bonds to keep interest rates down, but the Bank of Japan said, we'll do whatever it takes to keep yields going.

close to 0%. And that has been the case, but they've also had a tolerance ban. It was 25 basis points or 0.25%, and then they raised it to 50 basis points, and the yield shot up from 0.25% to 0.46%. And that allowed the Japanese yen to strengthen to 137 against the dollar from 132. The Bank of Japan owns 43% of Japan's

the Japanese national debt. Japan is the most indebted country, developed country in the world. Their public debt is around $9.2 trillion, equivalent to 1.3 quadrillion yen, over 250% of GDP. Their net debt, if we back out what's owed to the government, is about 140% of GDP.

There is a great deal of pressure on the Bank of Japan to stop doing what is known as yield curve control, controlling interest rates, which is one of the things that central banks can do, but it's not a free lunch. As other central banks around the world have been raising their policy rate, the Japanese central bank has not been, and that has put significant downward pressure on

on the yen, making imports more expensive for Japanese households and businesses. And that has raised inflation, which was something the central bank wanted. But still, there are trade-offs there. We'll see at the level of the Japanese government debt that interest rates are very, very important, particularly in a country like Japan that has population shrinkage. And it's difficult to grow the economy energetically

And the rate of economic growth relative to the yield on the debt is incredibly important for the sustainability of the debt. We'll look at that in more detail. Despite the very high levels of government debt in Japan, because interest rates have been so low, the interest payments only make up about a half a percent.

of GDP compared to close to 2.8% of GDP in the U.S. In the U.S., debt to GDP is only 120% compared to over 250% for Japan, yet the interest that the Japanese government pays on that debt as relative to the overall size of economy on a percentage basis is much lower than the U.S.,

Let's consider then the first principle when it comes to the national debt, be it if you live in the UK, Japan, the US or other nations. It's not the absolute amount of debt that matters. It's the ability to service the debt, to pay interest, to have enough confidence of bond investors to be able to refinance the debt.

Japan still has confidence of bond investors. Now, more and more bond participants say that the bond market in Japan doesn't function smoothly because the Bank of Japan owns so much government debt. But what's interesting with that yield curve control, just by announcing that they will keep the

the yield on the 10-year Japanese government bond at close to 0%, that promise, that commitment has actually meant that the Bank of Japan hasn't had to buy as much government debt.

Other nations that are highly indebted is Greece, 178% of GDP. Italy at close to 150%. The overall euro area looks pretty good at 93% government debt to GDP, but that's because Germany is at 71%.

Now, while Japan has the largest public debt burden of any developed country as a percent of the economy, the U.S. has the largest debt on an absolute basis of any country, over $31 trillion in debt. And that leads to our second principle. The national debt will never be paid off. The U.S. has had debt ever since it became a nation. The U.S. borrowed over $75 million to help finance the

the American Revolutionary War. The national debt grew over 4,000% during the American Civil War. It went from $65 million in 1860 to a billion dollars in 1863. And then by the end of the war, it was close to $3 billion. After World War I, the U.S. government debt was $22 billion.

When we look at the U.S. national debt, it's important to distinguish between, and this is a little confusing, what's known as the public debt compared to the debt owned by the public. The public debt includes debt held by the public, but also intergovernmental holdings. So the total public debt is all the debt outstanding, including debt that governs

The total public debt outstanding as of January 6, 2023 is $31.385 trillion, of which $6.8 trillion are intergovernmental holdings, and $24.5 trillion is debt held by the public. The total public debt outstanding as of January 6, 2023 is $31.385 trillion, of which $6.8 trillion are intergovernmental holdings, and $24.5 trillion is debt held by the public.

That public includes individuals, corporations, state and local governments. It also includes foreign governments and it includes the Federal Reserve. So of that $24.5 trillion, the U.S. Federal Reserve, the U.S.'s central bank, owns $4.7 trillion of it.

This debt held by the public is comprised of treasury bills, treasury notes, and bonds. It includes treasury inflation protection securities, or TIPS, floating rate notes, and savings bonds, including Series I savings bonds. Again, the debt is assets of individuals, you, me, as well as other entities.

The reality is it will never be paid off. They just refinance it. They roll it over. And what matters is how big is the debt relative to the economy so that the government can service it. And we'll look at in a few minutes how we can tell whether it's sustainable or not. A third principle on the national debt is how much it increases during economic downturns.

Most of the jump in the national debt occurs during recessions because that's when the economy contracts and government transfer payments increase. Unemployment benefits, for example.

If we look at the U.S. government debt, the total current debt is five times higher than it was in 2008. And if we look at the increase, again, we're close to $31 trillion in debt. The debt increased $5.1 trillion between 2009 and 2012, and that's money that had to be borrowed

to finance a lot of transfer payments and other expenditures. If we look at the increase in debt due to budget deficits in 2020 and 2021 as part of the response to the pandemic, that added another close to $6 trillion to the national debt. So over $10 trillion added to

Because of the financial crisis of 2008 and the recession due to the pandemic in 2020 and 2021.

Last year, the budget deficit was $1.4 trillion, about 5% of GDP, and that's required additional borrowing. What we need, though, is during boom times, the deficit should shrink, and it allows, hopefully, the debt not to grow as fast as the economy is growing. But after the taxed cuts of 2018, even before the pandemic recession hit in

In 2018 and 2019, the U.S. ran a budget deficit of close to $2 trillion, requiring additional borrowing. So again, it's during the bad times that the debt can increase dramatically. And hopefully in the good times, it's not. And size as a percent of the economy is shrinking.

The fourth principle, then, is it matters who owns the debt and, more importantly, what currency is it denominated in. If we look at the UK, Japan, and the US, most of the debt that they've issued is

is in their own currency. In the UK, it's denominated in pound sterling. In Japan, it's denominated in the yen, and the US is in the dollar, which means that it's easy for the government to pay off the debt in their own currency. They could print the money if they had to. They shouldn't, but...

But it's much easier than a lot of emerging markets, for example, that are forced to borrow in something outside of their home currency. And then if their currency weakens, it makes it even more difficult for them to borrow. So most defaults on debts has been debt denominated in

in some other currency than the nation's home currency. If we look at the U.S. national debt, the debt that is held by the public, about $7.1 trillion of the $24.5 trillion outstanding is owned by foreign nations, including their central banks, Japan.

Japan owns the largest amount, about $1.1 trillion. China owns $1 trillion. The UK owns $640 billion. Belgium, around $330 billion. So other nations will hold other nations' debt. Often it's to hold as reserves for the central banks, but it's less of an issue who owns the debt and more what currency it's denominated in, unless, for example, China decides to dump

all of their U.S. Treasury bonds that they own, and that would clearly put upward pressure on interest rates. We've talked about that, that in that case, maybe the central bank, the Federal Reserve, steps in to buy that. Before we continue, let me pause and share some words from this week's sponsors. Before we continue, let me pause and share some words from one of this week's sponsors, NetSuite.

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Ideally, most of the debt is owned by citizens in your own country, and that is the case with Japan. The vast majority of Japanese debt, Japanese government bonds, are owned by Japanese citizens, which puts less pressure on the government. Worst case scenario, if the Japanese government defaulted on their debt, some individuals and businesses in Japan would be poor and others would be richer because the debt is

is owed to its own citizens. Perhaps there'd be some redistribution, but the wealth of the nation wouldn't have changed that much. There would just be a shifting of who owed what to whom and how much their assets were worth. Now, I'm sure there would be a really deep recession, but it wouldn't be the end of the world.

The fifth principle is the interest rate matters significantly compared to the growth in the economy. For example, the average interest rate on U.S. debt, U.S. government bonds, is 2.3%. That's up from 1.4% at the end of 2020.

The average yield or interest rate the government has paid on Treasury bonds and notes and bills is 2.2% since 2013, and the average maturity is about six years. Now, U.S. Treasury has some flexibility. Do they want to issue more long-term bonds? Do they issue short-term bonds? I saw one estimate that 29% of the outstanding government debt will need to be refinanced over

over the next year. Now that will lead to higher interest rates and a higher average interest rate on the debt because interest rates are over 4% right now. If we look at the growth of the economy of GDP on a nominal basis, right now it's about $25.7 trillion. Back in 2008, before the financial crisis, it was at $14.9 trillion. And so it's had an

annualized growth rate in GDP of around 3.9% from 2008 through 2022.

Over that time, the debt held by the public has gone from $5.3 trillion to $24.3 trillion. So it's increased at 11% per year. But if the economy is growing at 3.9% on average, but the interest rate being paid has averaged 2.2%, then the debt is sustainable. And I did a quick spreadsheet just to confirm these numbers. Let's

Let's say a nation had total GDP, hypothetical nation, of a billion dollars, and the outstanding debt was a billion dollars. Then their debt to GDP would be 100%. But let's say the economy was growing very slowly. So on a nominal basis, it was only growing 2% per year. But the debt burden, the average interest rate, was 6%. And let's assume that country runs a balanced budget.

in terms of its primary budget deficit. So it's taking in tax revenue and it's matching its expenditures to tax revenue with the exception of the interest. And so if interest is at 6% and the economy is only growing at 2%, in 10 years, the debt to GDP would have gone from 100% to 141%. And in 25 years, the total debt outstanding would grow to $4 billion.

And the economy, GDP would be only $1.6 trillion. So debt to GDP would be 250%.

So when we talk about the sustainability of the debt, what matters is, and we can look at it on a nominal basis, which is how I typically look at it, but on a real basis also, what is the average nominal interest rate on the debt relative to the overall nominal growth of the economy? And if the economy is growing faster than that average interest rate, then the

The debt shouldn't be growing bigger as a percent of the economy based on interest rates. It can, as we've seen in the U.S., if the government runs a huge budget deficit. If it's running 10% of GDP of budget deficits as a financial crisis, then the debt is growing astronomically, and that's a risk.

At its current level, though, at its current average interest rate and current growth of the economy, and again, this was from 2008 to 2022, so it included two major recessions, the economy still averaged 3.9% per year.

I found a research paper by Carmen Reinhart and Belen Sabrancia. This was back in 2011. And they looked at numerous countries over hundreds of years and looked at what did they do when the debt to GDP got higher.

in order to reduce it. How do we reduce that debt to GDP balance? Because again, it's not the absolute level of the debt. It's the debt relative to the economy. And there's really five things that a nation can do. One, and probably the best course of action, if it can be achieved, is through economic growth. The economy is growing faster than...

the debt's increasing and hopefully as the economy grows, the budget deficit to GDP is narrow. It doesn't have to be a surplus. It just needs to be the deficit needs to be growing or the deficit needs to be less than overall economic growth on an absolute basis.

Another thing countries have done is they've done some type of austerity plan. They've reduced expenditures or raised taxes so that the budget deficit to GDP on an absolute basis is smaller than the overall growth of GDP on an absolute basis.

A third thing that nations have done is default. They've either restructured their debt or they refuse to pay it, and that clearly lowers their debt balance. And much of that's been done by emerging market nations over the years. And the fourth thing is higher inflation, a surprise burst of inflation where households and businesses weren't expecting it. And so that's

that was enough to work off the overall debt balance on a real basis, as well as on a nominal basis as a percent of the economy.

And then the fifth thing is financial repression, where a government is paying negative real interest rates on the debt. And because of that, the debt as a percent of the economy in more normal times would be shrinking. Now, if you recall, the average interest rate on the U.S. government debt, 2%.

2.3% got higher inflation here. We've seen negative real interest rates for much of the last decade. The real interest rates priced into tips right now are positive again, but for most of the time, we've had financial repression, and central banks can try to orchestrate that through their monetary policy, what they set the policy rate at, as well as quantitative easing programs.

Now, there isn't some magic way to get over the debt, to manage it. Ideally, the economy can grow to do that or some type of austerity, which better to have growth than to be cutting back because oftentimes austerity can lead to a recession and then the deficit balloons and then the debt increases even more.

Economist Ricardo Reis, and I've shared this quote a number of times. He's from the London School of Economics. He writes, people are only willing to lend to the government expecting a real return. Well, that's interesting, though, because people have been willing to lend to the U.S. government for a negative real return for much of the last decade. He continues, and almost all government spending programs require providing or paying for real services or goods.

Fiscal burdens are real, and it is an illusion to think that printing money makes them magically disappear. If central banks could magically create something out of nothing without bounds, then the whole of society could use monetary policy to solve any scarcity problem. Free lunches don't usually exist.

If we think about that list of how governments have managed to reduce national debt balances relative to the economy, quantitative easing wasn't on there. This program of central banks purchasing government bonds in order to keep interest rates low. Now, the Japanese government has done it. It has kept interest rates low, but in and of itself, it can't be a long-term solution. We

We've seen that, and that's probably one of the biggest takeaways that I've had over what has happened in the last decade. If we look at the money supply, which consists of cash, bank checking, savings account, retail money, market mutual funds,

It's grown from $15.5 trillion to $21.7 trillion in the last several years because the Federal Reserve bought over $5 trillion of Treasury bonds. And we've done episodes on this. When the government is running a budget deficit and the central bank is buying bonds, that's effectively sending out free money into the economy. The money supply increases.

wealth increases, but it's paper wealth. The real resources in the economy doesn't increase through quantitative easing, but they can stoke demand. And if there's supply constraints, then that leads to inflation. And we've seen very high inflation. And it's not a coincidence that we've had a high inflation after huge central bank quantitative easing programs.

Combined with federal budget deficits, so the debt increase because of the budget deficit, the central banks monetize that debt by buying it up, sending money into the economy, and that has led to higher inflation. And now it's leading to higher interest rates, which means the average interest rate on the national debt will be higher. And so global economies are going to need to grow even faster so that...

the overall economic growth is higher than that average interest rate on the debt. And if it doesn't occur, then the debt will become unsustainable and the risk of default increases.

Now, I don't see that happening this year by any means, but it's a longer-term risk, which is why we kind of have to go back to these principles. If you live in a particular area and you own government debt, we need to be mindful of this, that what's important is can the government service the debt? Do they have the confidence of investors? The debt itself will never be paid off, and during economic control,

It tends to increase dramatically, which means during good time, there should be more fiscal discipline keeping the budget deficit down. Who the debt is owed to is incredibly important. Ideally, it's owed in the domestic currency. But the most important thing is what are interest rates relative to the size of the economy and to monitor is the debt to GDP significant?

growing and is it growing quickly and as we saw in the UK when there's fear that it's going to get out of hand then interest rates could spike and that flows through the entire economy because then everybody's paying higher interest rates

Those then are our principles that we need to know to understand the national debt. We'll continue to monitor the developments with government finances around the world, with central banks. And if there's areas that, if risk is increasing, we'll certainly discuss it and share it on the podcast. That's episode 416. Thanks for listening.

I have enjoyed teaching about investing on this podcast for over eight years now, but I also love to write. There's a benefit to writing over podcasting, and that's why I write a weekly email newsletter called The Insider's Guide.

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Everything I've shared with you in this episode has been for general education. I've not considered your specific risk situation. I've not provided investment advice. This is simply general education on money, investing, and the economy. Have a great week.