Does the National Debt Matter?

by James Frazier

This article first appeared in the October 2009 edition of the Natural Investing newsletter

JF debtor Uncle Sam

Much of the controversy over the health care proposals in front of Congress has swirled around their cost.  Reform opponents claim that expensive overhauls, bailouts, and the resulting massive federal budget deficits will weaken our country.  This column will attempt to answer the question: Is this hype or reality?

First of all, it is crucial to note that the current debate over health care reform and budget deficits has become extremely polarized.  When almost everyone involved, including many “experts,” has an obvious political agenda or bias, it becomes extremely difficult to get reliable information.  Add in the obscure nature of government finances, and how is one to muck through the debate to get a sense of the reality beyond the headlines?

When confronted by important issues and confounding mass psychology, my best guide has always been history.  By taking a look at what our ancestors experienced, and how things worked out for them, I often find that our current predicaments, however immense they may seem, are nothing more than a new twist on a very old theme.  For example, in 1855, Lord Thomas Macaulay wrote in his book, The History of England, “At every stage in the growth of that [national] debt the nation has set up the same cry of anguish and despair. At every stage in the growth of that debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand.  Yet still the debt went on growing; and still bankruptcy and ruin were as remote as ever.”  Over 150 years later, England and its debt still seem to be getting by reasonably well.

Looking at the recent history of the USA, there is only one extreme point to compare with: the national debt that was incurred during the Great Depression and World War II.  How does the current situation measure up against that grave time in our nation’s history?

The size of the national debt, when taken as an absolute number (staggeringly huge as it may seem), means very little.  Only when it is compared to something else, such as the total output of the nation’s economy in a given year (a.k.a. Gross Domestic Product or GDP), can we get a sense of how substantial the national debt really is.  At the end of World War II, the USA had a debt-to-GDP ratio of around 120%.  Currently, we have a ratio of around 70%.  At first glance, this tells us that we still have room to take on more debt and survive.  Looking deeper, it seems that some kind of catalyst, like the end of a major war and/or a robust economic recovery, may ultimately be needed to turn this rising trend around.

Not all borrowing is equal, nor is all debt bad.  From a financial perspective, it makes sense to borrow and invest in future productivity, which eventually enables the debt to be paid back, and then some.  Thus, borrowing in order to invest in strong banks, a healthy and well-educated population, renewable energy, public infrastructure like highways, energy efficiency upgrades, and poverty reduction, can be very shrewd if it leads to a sustainable economic recovery that makes the national debt smaller by comparison.

It remains to be seen if we will experience that crucial catalyst we need to slow or reverse the growth of our national debt.  If skeptics are right, and financial disaster becomes imminent, how would we recognize it?  We might see it in the financial marketplace for U.S. government debt, otherwise known as the Treasury market, where we would see rising Treasury interest rates, which could in turn raise borrowing costs throughout our economy.  We also might see the value of the U.S. dollar decline, with corresponding rising prices of foreign currencies, commodities such as food and gasoline, and consumer goods.  Clearly, this important issue can affect us all.

In the Treasury market, as of this writing, the massive auctions of new U.S. government debt over the past year have been digested relatively well by the global financial markets.  Interest rates are still relatively low, which tells us that there is still solid demand for U.S. debt.  Even after the recent financial crisis, lending to the U.S. government is still considered the safest investment in the world.  If that changes, financial markets will tell us very clearly.

At Natural Investments, we continue to keep a sharp eye on these issues.  All of our model portfolios contain international bonds which serve to protect against a continued decline in the value of the U.S. dollar.  We have also recently made the strategic decision to reduce interest rate exposure in our model portfolios, which means that the negative impact of rising interest rates should be muted.

As history has shown, we are most likely to survive this situation as a country.  While the weight of the evidence on the national debt seems to be “So far, so good,” an ounce of precaution is warranted.  Therefore, we seek to protect our clients’ portfolios while expecting a positive and prosperous future in the long run.

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James Frazier

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