Jim de Bree | We’ve Failed to Manage Debt

Jim de Bree
Jim de Bree

Over the past year, I intended to write a column about the uncomfortable levels of outstanding debt. In good times this is downplayed, but when the economy weakens, excessive debt becomes an unmanageable burden. It merits current attention.

Governments around the world face a serious crisis trying to balance health concerns with the economic consequences of addressing those concerns. This is not a problem that will abate soon.

We won’t really put the COVID-19 pandemic behind us until we either achieve herd immunity or develop a vaccine and vaccinate a sufficient portion of the population, creating synthetic herd immunity. Neither of these is likely to occur for 12-18 months. During the interim, all we can do is buy time by “flattening the curve.”

Unfortunately, the economic collateral damage of curve flattening is severe and may dwarf the Great Recession. The dilemma is, if we take our foot off the curve-flattening pedal to help the economy, the pandemic’s severity is likely to increase. 

A strong balance sheet, evidenced by reasonable debt levels, helps endure an economic downturn. Conversely, weak balance sheets have debt levels that consume earning capacity. 

We measure a government’s economic fortitude by comparing its outstanding debt with the size of its economy (gross domestic product). In 1929, the ratio of debt to GDP was only 16%. During the next four years, our GDP shrank, in large measure due to tariffs, and in 1933 that ratio increased to 33%. The ensuing 12 years saw that ratio exceed 100% because the government utilized its borrowing capacity to fight the Great Depression and World War II. 

Once debt exceeds GDP, the cost of servicing that debt becomes an unacceptably large portion of governmental expenditures. According to Treasury Department figures, our national debt is about $23.7 trillion. Our GDP before the shutdown was about $21.7 trillion according to the Federal Reserve Bank of St. Louis.

State and local governments have incurred another $2 trillion of debt, not counting unfunded pension obligations. 

Furthermore, the private sector is burdened with debt. Student loans amount to $1.4 trillion. Sub-prime auto loans total $1.3 trillion. Overall consumer debt exceeds $14 trillion — which is higher than before the Great Recession. A substantial portion of this debt is likely held by people who have lost their jobs and their ability to repay those debts.

Corporate debt is estimated to be $10 trillion, or 47% of the nation’s economic output. 

Before the COVID-19 outbreak, Treasury Secretary Steven Mnuchin stated that trillion-dollar deficits were planned for at least the next two years. If the government intends to bail out everyone who asks for assistance, the national debt will possibly balloon to $30-$35 trillion while GDP drops below $20 trillion. 

Debt at these levels means the government will have to cut future discretionary spending and probably raise taxes to prevent further discretionary cuts. Moreover, interest rates are at historically low levels; if interest rates return to the average levels of the 20th century, the cost of carrying debt is going to increase significantly, further constraining debtors’ ability to function.

The outstanding national debt at the end of World War II was about $270 billion. We never paid it off. Instead we kept refinancing it, and by growing the economy, the debt became inconsequential. Our economy was about $225 billion back then and the debt was 119% of GDP. Today, that portion of our national debt is a mere 1% of our GDP. 

We exited the Great Recession through massive government spending. We added $6 trillion to the national debt between 2008 and 2014 in response to that crisis. After 2014 our economy stabilized, but somehow we have managed to add another $6 trillion without commensurate economic growth.

We now face an even greater economic challenge that promises to destroy a significant amount of wealth. Those who carry too much debt cannot pay their bills, which unleashes a series of severe economic consequences.

Consider the retailer who cannot pay his rent because he has too much debt. The landlord needs the rent payment to fund his mortgage payment. The retailer eventually goes out of business. If the landlord can re-rent the property, it is probably at a reduced rate. If he cannot rent the property, it is foreclosed upon. The lender sells the property for less than the mortgage, incurring an economic loss. The property is now worth less, so fewer property taxes are collected. During this period the government does not collect income taxes or sales taxes that it previously collected. 

In this example, wealth was destroyed as the retailer and landlord lost their investment. The lender suffered a partial loss of equity. The government lost out on tax revenue and cut services. 

This occurred because debt was not responsibly managed. 

Jim de Bree is a CPA residing in Valencia.

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