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4 reasons why US debt may not spin out of control
Darrell Spence
Economist
Greg Garrett
Fixed Income Investment Director
KEY TAKEAWAYS
  • The COVID-19 pandemic has accelerated rising debt trends around the world, not just in the US.
  • As long as the nominal interest rate on the debt is less than the nominal growth rate of the economy, the upward spiral can be avoided. That is the situation in the US today.
  • Traditional analysis suggests that debt levels are sustainable as long as the cost of debt remains below the level of economic growth, but there are still likely limits.
  • The Fed’s recent move toward average inflation targeting, plus its signals that low policy rates and asset purchases will remain in place, support higher nominal GDP growth and low interest rates, a dynamic that makes the level of federal debt more tenable.

Is surging US debt sustainable, or will it spin out of control?


It’s a question many are asking. US government debt is on a sharp upward trend, and current policy proposals suggest that will continue. The recent passage of a $1.9 trillion pandemic relief package has helped drive the trailing 12-month federal deficit to 18.6% of gross domestic product — the largest shortfall since 1945. This will almost certainly push America’s public debt above the World War II‒era peak of 106% of GDP.


While we are moving into uncharted territory, there are many factors that can influence whether — or when — this debt will ever become a real problem. Here are four reasons why we believe the federal debt should be manageable for the foreseeable future.


A rising tide of debt: US debt-to-GDP ratio1

1. Interest rates are lower than GDP growth


Many economists believe that debt crises arise when the debt-to-GDP ratio crosses 100%. Above that level, the debt stock can begin to spiral upward by itself, even without further additions from ongoing deficits. Italy and Greece are the most recent examples of this phenomenon. US debt is currently crossing this threshold.


However, this debt-spiral maths only works if a country’s interest rate is higher than its growth rate. As long as the nominal interest rate on the debt is less than the nominal growth rate of the economy, the upward spiral can be avoided. That is the situation in the US today, and it is likely to remain the case for the foreseeable future.


Nominal interest rates have been lower than the nominal growth rate for most of the time since the early 1960s. However, this relationship has fluctuated. During the 1960s, nominal growth regularly exceeded the interest rate on 10-year US capitalgroup.com Treasury bonds, but that flipped during the 1980s and into the 1990s as inflationary pressures drove interest rates sharply higher.


In the 2000s, the relationship reverted to its more sustainable form, although at lower levels of nominal growth and higher levels of government debt relative to GDP. Looking ahead, this suggests that the biggest risk could be a sustained surge of inflation that drives interest rates well above the GDP growth rate.


Sustaining the US debt: GDP growth vs. interest rates2

Notably, while a 100% debt-to-GDP ratio has proven to be a trigger point in some past debt crises, there are exceptions to this rule. Japan is the most prominent example. It has benefited from the fact that a large part of its debt is held by a somewhat captive domestic investor base that includes large banks, pension funds, the post office and other institutional investors.


 


1. Source: Congressional Budget Office as of 4 March 2021. Federal debt held by the public. Long term forecast excludes the impact of the American Rescue Plan Act of 2021 and assumes no meaningful changes to current laws affecting US government revenues and spending.


2. Sources: Bureau of Economic Analysis, Federal Reserve, Refinitiv Datastream. As of 31 March 2021. Chart displays the difference in percentage points between the year-over-year growth rate of nominal GDP and the nominal 10-year US Treasury yield on a quarterly basis since the first quarter of 1962.


 

Risk factors you should consider before investing:
  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.


Darrell R. Spence  is an economist at Capital Group. He has 28 years of investment industry experience, all with Capital Group. He holds a bachelor’s degree with honors in economics from Occidental College graduating cum laude. He also holds the Chartered Financial Analyst® designation and is a member of the National Association for Business Economics.

Greg Garrett is a fixed income investment director at Capital Group. He has 33 years of investment industry experience and has been with Capital Group for 19 years. He holds a bachelor’s degree in finance from the University of Arizona. Greg is based in New York.


 

Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.