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6 min read

Understanding national debts today and tomorrow

High national debt has many governments facing spending challenges. As investors, it’s important to understand debt and remain vigilant to invest prudently. In this market update, Malcolm Jones looks at why national debt exists, why it’s so high, whether it’s sustainable, and if not, how it will break.

As a Head of Fixed Income and Senior Portfolio Manager, Malcolm creates Fixed Income investment strategies that are secure and enduring, with the goal of increasing profits to make asset growth and protection possible.
  • What drives national debts?
  • Political dimensions to the debt story
  • Spending challenges on the near horizon

 

There are some parallels between personal finance and government debt, but also some key differences. With many big spending challenges facing governments, it’s important to understand debts and to remain vigilant from an investment perspective.

 

What drives national debts?

Levels of national debt are in the headlines lately. Figure 1 shows how debt to GDP has been rising in many countries.

 

Figure 1: Government debt/GDP level comparisons 

Chart showing the Government Debt as a percentage of GDP from 1990 to 2022

Sources: Bloomberg, IMF

 

Let’s look more closely at some underlying questions: Why does national debt exist, why is it so high, is it sustainable, and if not, how will it break?

 

We can see parallels in government debt with our own personal finance. When we were young, many of us took out a mortgage to buy a house. The government similarly can borrow money to buy a long-term asset, such as a bridge or an airport. We can see the merit in buying a durable good and paying for it over the life of that asset. There may be less merit in buying consumable goods on credit, such as buying groceries on a layaway plan. It may not be as prudent as buying a long-term asset, but the government certainly has the capacity for such borrowing to buy consumables.

 

We can also see the government borrow in an effort to “smooth the business cycle”. Keynesian economics argues in favour of the government net-spending in bad times, offset with net-saving in good times, all with the long term in mind. At first blush, there doesn’t seem to be a parallel here to our personal lives, but I direct your attention to retirement savings: save during your working years so you can continue to have an income after you stop working. One significant difference between people and governments is time. We may each get 80 or so years on this Earth. Governments (i.e., the machinery of government, not the political parties) can readily count their timelines in centuries.

 

We can also appreciate the concept of borrowing capacity. When we got our first mortgage, the bank agreed to lend us money for a starter home, but not for the multi-million-dollar mansion that we wished we could buy. Similarly for governments, there’s a level of borrowing that the government can sustain with tax revenue. Even those who chant “tax the rich” ultimately understand there’s a limit to how much tax can be raised. The question that arises is what that limit is.

 

There’s an issue with government debt in terms of incentives. If we individually overspend, then we will individually face the consequences and need to take corrective action. Government-purchased goods and services are disbursed among citizens, bought from revenues derived broadly from those same citizens. However, there’s no necessary correlation between beneficiary and payer. When a government overspends to provide benefits to citizen A, the cost of corrective action may well fall on citizen B.

 

Political dimensions to the debt story

Consider this situation through the lens of an elected official. A politician seeking re-election may find it beneficial to tailor policies such that benefits flow preferentially to a politically important group, while costs are distributed to either a wide group, or a politically unimportant group. Likewise, a politician today can help structure indebtedness such that more payments are delayed, and thus will fall on some future politician. This leaves the current politician basking in the glow of handing out goodies while burdening some unknown future politician with the task of collecting taxes. It's easy to see how short-term thinking can drive up government debt.

 

There is limited incentive for a government to engage in long-term thinking. When I started my career in investing, numerous articles suggested that if the U.S. didn’t do something soon, their Social Security fund would run out of funding within 40 years. I’m 30 years into my career, and I just read an article on how the U.S. Social Security fund is likely to run out of funding within 10 years. It was politically difficult to do anything, and nothing was done. To be fair, all government is not necessarily dysfunctional. When I started my career, the Canadian CPP was also on shaky ground. Difficult decisions were made, however, and today’s CPP is well funded.

 

Spending challenges on the near horizon

Governments of all levels face big problems, and many near-term big-ticket items will prove difficult to address. Military spending needs to address current hot spots and other potential conflagrations. Health spending (either directly as in Canada, or indirectly as in U.S.) faces the daunting challenge of an aging population. Education has seen an inflation rate much higher than in other goods and services. At the same time, a more technologically based world demands a more educated population. Finally, interest rates themselves have risen from many years of suppressed rates. The bond manager in me appreciates higher yields, yet the taxpayer in me knows that governments are having to roll over their outstanding bonds at higher rates.

 

A phrase often repeated is that if something cannot continue, it won’t. If government debt loads are too high, they will be fixed. Solutions can come either fast or slow. During the 90s, the IMF knocked on Canada’s door noting that we were on an unsustainable path. Our government implemented policies to provide slow, but steady improvement. Currently in Argentina, their new president successfully campaigned on taking a chainsaw to government services. Will he succeed in bringing down Argentine debt levels?

 

We recently held a series of investment roadshows for clients. One of the themes emerging from that was how many big market breaks are caused by something that no one saw coming. We know national debts levels are high and, at some point, will become unsustainable. What isn’t known is the timeline. The investment response is to remain vigilant. We know the causes of high government debt, and that there’s a limit to that debt, even if we don’t know the precise number. So, we watch. And invest prudently.

 

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