Point of No Return: 90% Debt/GDP

When a nation’s debt reaches 90% of its GDP, it crosses a bright red line after which recovery is nigh impossible. We explain why that is true.
Point of No Return: 90% Debt/GDP
By: George Noga – February 18, 2018

       Our last post (Fiscal Gorillas) was a lead-in; if you missed it, try to read it first here. It is accepted economic wisdom that once a nation’s debt exceeds 90% of its GDP, there is no recovery. Is 90% an arbitrary ratio plucked from the ether? No. Governments have been borrowing money for 600 years and not one has recovered from a 90% ratio without experiencing social and economic upheaval and a lost generation. Why is this so and why is 90% the magic threshold?

       We begin with some numbers. The US public debt is now $14.8 trillion (total debt is $20.5 trillion) and GDP is $19.7 trillion. This makes the public Debt/GDP ratio 75%. The total Debt/GDP ratio is 104%, but that is not the relevant metric, as the $5.7 trillion difference between public and total debt consists mainly of non-interest bearing intra-government debt. If GDP grows at 2% (it is growing faster, but we must factor in recessions) and if debt grows at 5% (its current rate), the ratio will reach 90% in 2023 and 100% in 2027. Even if my assumptions are off, it is clear the US is on a trajectory to breech 90% and then 100%  in about 5 and 10 years respectively.

Mathematics of a 100% Debt /GDP Ratio

      I discovered a simple but gripping way to look at the Debt/GDP ratio. When the ratio is at 100%, i.e. debt and GDP are equal, it is easier to grasp the crisis. In 2027 both GDP and public debt are projected to be $24 trillion. When these metrics are equal, the economy must grow at an identical rate as the debt to prevent a death spiral.

     If GDP increased only 2%, we would have to limit the debt increase to the same 2% merely to maintain the ratio at 100%. However, if debt continues to grow 5%, there would be added debt of $720 billion per year (compounded) and the ratio would skyrocket. Given our aging demographic, out of control Social Security and pensions along with exploding health care costs, we will be lucky if debt grows only 5%.

     GDP historically has grown about 3% – but much less in recent years. The debt is growing at 5% and that is under highly sanguine economic conditions. When we have the inevitable recession (we are now in the 9th year of an expansion), GDP growth will turn negative and debt will balloon to 8% of GDP or even higher. It doesn’t take advanced econometrics to quickly see this is a recipe for disaster.

      Then there is the matter of interest rates on the national debt. As the US slouches toward a 100% Debt/GDP ratio, buyers of Treasury bonds will require ever higher interest rates to compensate for the greater peril. The historic average composite rate (across all maturities) on Treasury debt is 6%; if that went to just 7.5%, it would mean interest on the debt would constitute $1.75 trillion per year, or over 30% of the budget. Long before that happened, the Minsky Moment (point of no return) would have passed and the United states would begin to resemble Greece, Zimbabwe and Venezuela.

      The only possible ways to avert default are: (1) massive spending cuts on the order of 30% which would shatter the social contract; (2) draconian tax increases which would halt economic growth; (3) runaway inflation, the cruelest tax of all; and (4) repudiation of the debt. The ensuing crisis would not be limited to the economy. We will be lucky to maintain the rule of law and America as we know it will disappear.

    The World Bank asserts that the Debt/GDP tipping point is reached at 77%. No nation has ever escaped a 90% ratio. The United States of America today stands at 75% and will reach 90% circa 2023. The clock is ticking but the band plays on.

Our next post February 25th revisits Antifa and fascism.