Are the US and UK heading towards debt crises?

The answer is: not likely, as long as there is no premature monetary tightening. The reason is that the debt services burdens in both the US and the UK are still low.

With massive amounts of fiscal stimulus and financial bailouts, as well as costly healthcare reform programmes, US public sector debt is projected to rise by at least 40% in the next five years (to over 100% of GDP from the current 70%). This has raised fears that the US may soon hit a "debt wall", when no one would want to buy its Treasury debt. In such a case, US interest rates would soar and the loss of confidence in the US would lead to a US dollar crash. Similar concerns have arisen in the UK, where the HM Treasury estimates that its public debt, after rising from 30% of GDP in 2000 to 65% now, will continue to rise towards 80% of GDP by 2014. Like in the US, UK politicians are rushing out plans to pare the fiscal deficit and public debt burden by cutting public spending and raising taxes.

As far as a debt crisis is concerned, though, it is the debt-service cost that counts, not only the level of indebtedness. If total interest payments exceed a certain threshold of a debtor's income, default becomes inevitable. Thus, the debt-service cost-to-income ratio is the critical indicator of a borrower's financial stress and default risk. On this count, the public sectors in both the US and the UK are far from any debt crisis levels, even though total public debt has been rising swiftly since the subprime crisis.

No imminent public debt crisis

Official data show that the US government's debt-service cost-to-income ratio has actually fallen sharply and steadily since the mid-1990s, and the current ratio is the lowest since the late 1970s (Chart 1). This is remarkable, since the fall in the debt-servicing ratio has come on the back of a rapid run-up in the public sector debt burden. The absolute level of public sector indebtedness was higher in the 1990s than in the 1970s and 1980s. The key reason for the fall in the US debt-service cost is the persistent decline in interest rates since the 1980s (Chart 2).

But falling interest rates alone cannot lead to a fall in the debt-service cost ratio. For example, US interest rates began to fall in the early 1980s, but the public sector debt-service cost ratio rose in most of the 1980s and peaked only in 1990 (Chart 1). The reason for this rise in the public debt-service cost ratio in most of the 1980s was that the Reagan administration dramatically increased public sector borrowing to fund its aggressive tax cut programme and the resultant large fiscal deficit. The sharp rise in the net interest payments, due to the higher debt load, far exceeded the cost savings from lower interest rates.

However, since the early 1990s, the fiscal deficit pressure and escalating public debt burden forced the US government to improve its public finances by raising taxes and cutting spending. This combined effort coupled with the economic boom (which led to a sharp increase in government revenues) under the Clinton administration dramatically cut the public sector debt-service cost ratio.

Over to the UK, which is one of the countries that have been hit the hardest by the subprime crisis. Its public debt-service cost ratio (at 6.3% of government revenue) is even lower than the that in the US (10% of revenue). This means that the British government's financial stress is even lower than the American government's.

Like the US, the UK public debt-service cost ratio has been on a secular downtrend (Chart 3). Even if the IMF turns out to be right in its projection that UK public debt will rise from the current 65% of GDP towards 80% of GDP by 2014, these debt ratios are not unprecedented and might not necessarily lead to a debt crisis. In the early Victorian age, for example, the government's debt-to-GDP ratio was almost 200%. It almost reached that level again in the early 1920s, and in 1956 it was just a little under 150% of GDP.

The point is that the current public debt situations in both the US and the UK are far from dire. As long as interest rates stay low, their public sector financial stress is still manageable, which means a public debt crisis is not imminent. Rather, the danger is premature policy tightening. The impact of such a policy mistake was well illustrated in the US in 1936-37, when fiscal tightening and tax hikes helped push the economy back into a recession at a time when the recovery from the Great Depression was far from complete. This cut government revenues sharply and sent the US debt-service cost ratio soaring.

The household sector is the culprit

The debt-service cost of US households has climbed steadily since the 1990s from around 10% of disposable income to over 13% recently (Chart 4). This steady rise has been caused by a large and sustained increase in the total cumulative debt load throughout the 1990s and in the 2000s till the eruption of the subprime crisis. The scale effect of this debt accumulation was so big that it overwhelmed the benign positive effect on the debt-service cost from falling interest rates. Thus, it is not surprising that the household sector was hit the hardest in the subprime crisis, with soaring real estate foreclosures and personal bankruptcies. The household debt stress in the UK is even worse, with the household debt-service ratio hovering at over 20% as of the second quarter 2009, according to Moody's.

The risk of a debt crisis clearly lies with the household sector, rather than with the government. The debt service cost burden of the household sectors in both the US and the UK are at multi-decade highs, suggesting that interest rates are the most important variable in controlling debt costs and financial stress and, hence, for preserving economic stability in the post-subprime crisis era. It is thus of utmost importance that the authorities do not hike interest rates prematurely.

The post bubble world is going through a major structural adjustment, which will feature a saving glut (with both the developed and developing worlds saving at the same time), deficient demand and a large output gap. All this will work to keep inflation and interest rates low for some years. This low interest rate environment will help the American and British consumers de-leverage. It will also strengthen the public sectors' borrowing capability so as to facilitate fiscal activism to offset the private sector contraction and keep the global economy from imploding.

Message for the bond market

At 10% in the US and 6.3% in the UK, these public debt service cost ratios are both at multi-decade lows, and suggest that the US and UK sovereign financial stress is still manageable. In fact, the US and UK governments may continue to increase their debt loads without adding stress to the debt markets, provided that interest rates will stay low for a prolonged period of time. Currently, the government bond markets are not showing any concerns about the US and UK running into a debt crisis anytime soon. Long-term US and UK government bond yields have not risen in the face of escalating public borrowing (Chart 5), mainly because the recent deterioration in the public sector finances started from a much-improved position. 
Chi Lo is a research director at Ping An of China Asset Management (HK).

¬ Haymarket Media Limited. All rights reserved.
Share our publication on social media
Share our publication on social media