Thanks to their high or rapidly rising public debt ratios, the United Kingdom, Japan, and the United States have been placed on the list of countries with worrisome sovereign debt. However, the structure and terms of these countries’ public debt and the circumstances of the debt growth do not support those concerns. Neither does history—even if public debt ratios rise to levels considered alarming today...
The United States, like the United Kingdom, has been successfully meeting its public debt obligations throughout its history. During 234 years of existence, the United States has been through many traumatic vicissitudes—depressions, the Civil War, two World Wars, and several smaller wars. Its public debt ratio has risen to well over 100% and then dropped back to a fraction of that.. Through it all, it has never rescheduled a debt repayment, missed an interest payment, or defaulted in any other way on its public debt.
Just as some analysts count the British suspensions of gold convertibility as defaults, some argue that the abrogation of the gold clause by the U.S. government in 1933—which voided gold clauses in private and government contracts—constituted default. However, the public debt burden was neither unmanageably large by historical standards nor the main cause of the abrogation. Rather, the motivation for the legislation reflected the inherent vulnerability of a gold-convertibility- based monetary system to abrupt swings in global gold demand, supply, and hoarding behavior. In any case, regardless of how one views the discontinuation of the gold convertibility of the dollar, U.S. public debt today no longer carries any promise of convertibility into gold, so, like the United Kingdom, the United States cannot default by violating such a promise...
Many investors, policymakers, and economists take it as fact that soaring government debt inevitably leads to inflation. This fear comes in several versions. Sometimes the emphasis is on the prospect of a stealth default by the government as inflation shrinks real debt service payments; sometimes it is on the consequences of serious future inflation for the economy as a whole. Many analysts assert that spiraling public debt growth will force central banks to monetize the government debt and that this action will assure worsening inflation. Others argue that central banks will choose to pursue policies of high inflation in order to chip away at the debt burden.
In fact, deflation, not inflation, is the danger during the next several years in the United States and most of the world’s advanced economies. Moreover, the fears of inflation are based on flawed logic and contrary to the historical record...
During this period of contained depression, it will be all but impossible for inflation to strengthen.10 Any short-term progress creating jobs notwithstanding, in all likelihood unemployment will stay troublingly high, pay raises will continue to fade, private credit quality will remain impaired, and overcapacity will continue to plague much of the business sector. In essence, the strong fiscal and monetary medicine will not overheat the economy and create inflation because the normal profit sources of the private sector are severely depressed...
Hiking interest rates aggressively can halt credit creation, bring recession and rising unemployment, and thereby depress inflation. On the other hand, lowering interest rates will not spark credit creation unless the private sector is willing and able to take on more debt and banks are willing and able to expand their loan portfolios...
In particular, in the presence of asset price deflation, goods and services price deflation (actual or feared), chronic overcapacity, widespread private sector debt service problems, and impaired bank balance sheets, lowering interest rates alone will do little to encourage credit creation to finance demand. These conditions apply to the current situations in the United States and the United Kingdom and have applied for many years in Japan. In the United States, the Federal Reserve has been pushing on a string. A near-zero federal funds rate and colossal excess reserves failed to encourage private credit growth over the past year. In the United Kingdom, the Bank of England cut rates to 0.5% and has undertaken extensive purchases of long-term government debt. As for the Bank of Japan, it has been pushing on a string for long enough to accumulate miles of slack, and as much as the Japanese would love a little inflation, the Bank of Japan has been unable to achieve it...
If the connection between monetary policy and inflation is weak during a period of severely underutilized resources and deflation, the relationship between public debt and inflation is even more tenuous. David Hendry, who has conducted extensive econometric research using long time series in the United Kingdom, concludes that, “Essentially there is almost no relationship I can find, having tried over many years, between [public] debt/GNP and growth, unemployment, or inflation over 1860-2000.” 12 Even a casual perusal of the data bears out the lack of relationship between the public debt ratio and inflation (charts 6, 7). The U.S. postwar experience also debunks the notion that high levels of public debt cause inflation. The peak U.S. public debt ratio of 109% in 1946 was followed by a decade of 2.8% average annual inflation (based on the GDP deflator). The inflation of the late 1960s and 1970s occurred well after the public debt ratio had already fallen steeply and was near its lowest levels in the postwar period. Now, the public debt ratio is at its highest level since shortly after World War II, and inflation has been melting away with deflation threatening.
As fast as the federal government has been jacking up the supply of Treasury securities over the past year, the supply of private debt has been shrinking even faster—total net debt issuance in the United States has been negative for five quarters in a row (chart 8). Although this pattern may be broken occasionally, the trend is likely to continue for a long time as households and firms continue to reduce their debt and see their asset holdings decline.
---David Levy, Srinivas Thiruvadanthai,"Uncle Sam Won’t Go Broke", at link to pdf. More salient commentary in pdf
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