Dollars and debts
How long is forever?
“If something cannot go on forever, it must stop,” Herbert Stein said. Stein had been chairman of the Council of Economic Advisers under Richard Nixon and Gerald Ford; he made his remark, which became known as Stein’s Law, during the presidency of Ronald Reagan, when the mounting federal debt broke new records every year. The debt markets wouldn’t allow this to continue forever, Stein predicted. At some point lenders would decide the dollar wasn’t a good investment.
Human life cannot go on forever; in 1999 Stein died. He had cause to think events were proving him right. After peaking in 1996 at 66 percent, the debt-to-GDP ratio (the best measure of a country’s ability to service its debt) fell to 60 percent in 1999, on its way to 55 percent in 2001.
But the reversal was pause, not a hard stop. The debt began growing again, and kept growing. It hit 100 percent of GDP in 2015 and topped 130 percent in 2020. That high was related to the covid pandemic, which depressed GDP while increasing government spending. As the pandemic eased, the ratio declined somewhat. It currently sits around 120 percent.
Truisms like Stein’s are irrefutable but often unhelpful. He thought the 1980s debt-to-GDP ratio of 50 percent was approaching unsustainability, but we’re chugging along at more than twice that. Every time the Treasury holds an auction of debt, investors line up to bid. To be sure, their bids are lower than they used to be (which means the Treasury has to pay higher interest rates), but they still prefer Treasuries to many other assets.
Will they continue to do so forever? Of course not. Nothing lasts forever. But that’s not the operative question. Will they continue to do so for ten years? Twenty? Thirty?
And what will cause them to change their minds? Will the reign of the dollar end with a bang or a whimper? Will American have its counterpart of Britain’s Suez moment? In that 1956 fiasco, an ill-conceived British decision to launch a war against Egypt caused debt markets to flee the British pound sterling and threatened the British economy with collapse. The British government fell, and the British people recognized that their country’s great-power days were over.
America won’t encounter anything like that soon. What made the flight from the pound possible was a currency for investors to flee to, namely the dollar. Nervous investors today have nowhere to go. It’s not inconceivable that the euro might develop into a credible alternative to the dollar, but it’s not there yet. China would have to revamp its entire approach to finance, and maintain the new policy for a decade or two until foreign investors learned to trust it, before the yuan could challenge the dominance of the dollar.
A slow fade is a more likely for the dollar. The greenback was established as the world's currency in 1945, when the American economy bestrode the world. America's economy has grown but the world's economy has grown faster. Investors have been diversifying their holdings and will continue to do so. The digitization of finance makes moving money around the globe and from one currency to another more efficient than before. The employment by the United States government of economic sanctions has encouraged targeted countries to shun the dollar and American financial institutions. Increasingly since the start of the Ukraine war, Russia and China trade directly with each other, using rubles and yuan. Iran conducts its foreign trade in rials wherever possible.
How long will the transition from the dollar take? Will it accelerate, slow or even reverse?
You won’t find the answer here. If I had it, I’d make my own investment decisions before I shared it. In fact, nobody knows. The markets can’t decide: the dollar goes up, then the dollar goes down. The decline of Britain became apparent overnight, but the eclipse of Spain, Britain’s predecessor as imperial hegemon, took a century.
Will the dollar survive a debt-to-GDP ratio of 150 percent? 200 percent? Herbert Stein didn’t think it could. But he didn’t think the markets would let the ratio reach 100 percent. And here we are, a fifth above that.
If something cannot go on forever, it might still go on for a long time.
Excellent point regarding the comparison to investors fleeing the British pound to the dollar in 1956. Yes, the dollar is still the most attractive currency in the world; you don't hear of Argentines keeping hard euros in their homes.
Japan's debt/GDP ratio is currently 260%. And they're not even a global reserve currency. Portugal and Singapore (small countries but very nice places to live) are in the 130's.
Considering these data points, it is likely the US could go considerably further into debt before facing any serious blowback. That doesn't mean it would be a good idea, and I have several foreign currency denominated bank accounts just in case I'm wrong, but predicting imminent collapse (either economic or political) for the United States seems foolish at this point. As Adam Smith said, "there's a lot of ruin in a nation", an axiom doubly applicable to the world's only superpower. As a side note, Smith would likely be amazed at his country's claiming of that position and appalled at what we've done with it.