Smart Investor: the great American debt

All eyes are on Greece and its debt crisis. We should not forget that the US has a huge and growing debt problem too.

Deficit denial

The US has survived colonial rule, civil war and global conflicts, but it appears in denial over its current public debt.

Since the mid-19th century the US has provided some of the finest achievements and prosperity the world has ever seen. It has also experienced a wide range of challenges: civil war, debilitating economic depression, Pearl Harbour, and the Cuban missile crisis.

But it now faces a test that it appears to be finding difficult to overcome, and one which US President Barack Obama appears to hinder rather than help. The US is in denial about the extent of its debt problem.

I consider myself to be pro-American and would like nothing more than the US to return to economic growth while paying down its debt. But as the chart below shows, this could prove to be a monumental task.

Source: usgovernmentdebt.us (figures estimated for 2011 onwards)

The chart plots the percentage of US debt as a proportion of gross domestic product (GDP) since America’s inception in 1776. The first thing that may stand out is the peak during World War Two or perhaps the insatiable growth of debt since 1980.

But to put the sheer scale of the US’ problems into perspective we must go further back in time to a handful of significant world events, all of which have a common theme. The peaks in the chart coincide with the times when the US has been at war.

Debt as a proportion of GDP was about 35% in 1780, just after the US had fought off the Brits in the War of Independence. In the wake of that conflict debt fell, but in the 1860s debt rose again, the American Civil War was in full swing and the ratio of debt to GDP rose back to 35%.

Record debt

The pattern continues with the US’ involvement in the First World War. This caused debt to spike, rising from a pre-war level of about 10% to 35-40%, which is still moderate by today’s standards.

As the US began to mobilise for the Second World War, debt increased at an unprecedented rate – rising from less than 50% of GDP in 1939 to peak at more than 120% in the mid-1940s. This is the highest US debt level in history.

The fact that wars cost money is no surprise, but the key point revealed by the chart is that after each of these conflicts the debt to GDP ratio fell. These falls in public spending did not restrict growth: the US economy performed exceptionally well in the aftermath of the two world wars.

Exceptional item

The reason for this post conflict growth is that spending on war is an exceptional item; almost a discontinued operation in accountancy terms. What this means is that once the war is over, spending can be quickly cut back and the economy will not suffer because the economy was not the beneficiary of that spending.

In other words nothing is being taken away from the economy and after a reasonably short time, the economy will start to grow once those returning from war begin working towards wealth creation.

The economic challenges faced by the US government today are very different to those faced at any other time in the country's history: US debt stands in excess of 100% but its debt is not down to war. The US economy is currently reliant upon debt, and the deficits that are increasing it, in order to survive.

If the US government were to draw tight the public purse strings and run a budget surplus in order to pay down the debt, it would starve the economy of the spending to which it has become accustomed. In plain English it would be likely to cause a depression.

The chart sheds light on how the US has found itself in this situation. In 1980 debt was around 35-40%, but since then successive presidents, first Reagan, then Bush senior, Bush junior and now Obama, have all run budget deficits to satisfy the US' insatiable appetite for growth and prosperity. The odd one out was Clinton, under whose presidency the debt to GDP ratio fell.

Insatiable appetite

Advocates of the big spending four would argue that they delivered significant economic growth. However, it came at a cost and, as a past article stated, growth comes easily to any government that is willing to borrow to fund it.

So, what next? The problem appears to be that the US administration is not yet seriously contemplating how to tackle its debts, nor appears to realise the problems that failing to deal with the debt will cause.

The US appears to believe that as long as the economy grows, it will be fine. However, what it fails to realise is that this growth is being funded by yet more debt.

President Obama has spent two years in office pushing through healthcare bills and social programmes while avoiding the elephant in the room – a 100% and rising debt to GDP ratio.

Presidential election

Moreover, the real problem for the US currently is the fact that the majority of Americans are in denial about the extent of the problem. There appears to be an attitude of ‘we’re America; we’ll sort it out at some point’.

His recent visit to the UK may have given Obama inspiration. Discussions with UK prime minister David Cameron may have caused him to consider adopting the government's plan of reducing the budget deficit to zero within five years.

But the lack of growth in the UK, as well as a not too distant presidential election, may have made him think otherwise. He is unlikely to win an election if the US economy is in recession, so his number one priority is growth.

History tells us that no superpower lasts forever and that its demise is often caused by over-ambition and complacency. The US is guilty of them both. I hope it realises this sooner rather than later and begins the painful process of rebuilding its economy based on enterprise, hard-work and intellect, rather than adopting the attitude of ‘in debt we trust’.

However, with a presidential election just two years away, we may have to wait a little longer before the US faces up to its debt problem.