Is Sovereign Debt a Big Deal?

The European Central Bank (ECB) just announced a huge stimulus program that will pump over $1 trillion euros into the European economy over the next 18 months. The majority of these euros will buy up government bonds, artificially suppressing interest rates. This, in turn, will devalue the euro and empower European national governments to take on even more debt.

Photo by AgnosticPreachersKid / CC BY-SA

The United States (U.S.) Federal Reserve (Fed) just finished a third round of stimulus in the wake of the Global Financial Collapse of 2008.

In the last six years, the Fed has increased the U.S. dollar supply by nearly $4 trillion, with virtually all of that going to purchase U.S. Treasury Bonds, massively expanding U.S. sovereign debt.

I could go on and on, giving examples of ridiculous amounts of money printed for bond purchases in Japan, England, China and virtually every other nation in the world.

This does not even take into account the interest rate reductions of central banks. In case you didn’t realise, central banks can’t just declare what the interest rates will be. They must either expand or contract the supply of money through bond purchases or sales to achieve the market cash rate they desire. A brief lesson on that topic can be found here.

Why Nations Need to Borrow

National governments essentially have only three ways of financing government operations. They can tax their residents, they can print money or they can borrow by issuing sovereign bonds. Sovereign debt is a result of the latter. It is debt owed by a national government.

Many governments find it relatively easy to borrow money. In fact, many investors consider sovereign debt to be risk free. Imagine for a moment that you could force people to give you a percentage of their earnings by imposing taxes, or create money out of thin air by being your own central bank. Do you think you’d have any problem financing that next positive cash-flow property?

Federal governments resort to borrowing money for three basic reasons:

1. Unusual Events

An unusual event, like a war or other disaster, which the government must finance. Raising taxes by a large amount would be inefficient, so the nation borrows with an expectation of tightening up in other areas, once the event has passed.

2. To Smooth Short-Term Cash-Flow Fluctuations

Just like a business that might borrow short-term to smooth fluctuations in cash-flow, governments sell bonds to boost the government cash flow through troughs in the business cycle. In times of recession, government tax revenues fall as people lose jobs.

Government expenditures tend to rise as more people are applying for unemployment benefits. Then when the economy recovers, tax revenues increase again and government expenditures decrease.

3. To “Stimulate” the Economy

The third and final reason for government debt is a little more controversial, and is a result of the influence of Keynesian economists. They argue that a pure free market economy will always lead to inefficiencies, and therefore governments must intervene to smooth out the peaks and troughs of the business cycle.

What You Need To Know About Stimulus Programs

The idea is that during a recession, a nation should decrease taxes and increase spending in order to stimulate the economy. This creates a budget deficit, which requires the nation to borrow more.

Then after things turn around and inflation heats up, the goal is to reverse course by raising taxes and decreasing spending, then paying down debt. Nearly all developed nations today subscribe to this school of economic thought.

The problem is that raising taxes and decreasing expenses to reverse course is not politically expedient. Once citizens get used to free government handouts, they don’t like giving them up.

The easy fix of turning on the printing press to kick the can farther down the road is just too tempting for bankers and politicians. Rather than increasing revenue to pay down debt, many governments tend to borrow more just to roll their debts over.

So why are central banks printing money? When the open market will not buy government bonds at the rate required to finance expenditures, the government then turns to their central bank as the lender of last resort. Where does the central bank get money? They create it out of thin air. As a result, over the past 40 years, we have seen an exponential increase in both money supplies and sovereign debt levels around the world.

What Shifted In The 1970’s

Up until the 1970’s, central banks couldn’t just print money indiscriminately, like they seem to do today.

Most nations and central banks held gold reserves as the standard for their currency. In other words, they could only print as much currency as there was gold or silver to back it up.

While this created a solid basis to the currency by preventing governments from over-borrowing and over-printing, it also began to be seen as a limiting factor for economic growth.

Out of this desire for growth, economic philosophies began to shift. Governments wanted an amount of money that more appropriately reflected their ability to produce wealth and also provide room for greater government debt. The idea was that a nation’s true wealth was not a function of how much precious metal it possessed, but rather the total sum of all the economy could produce. So, in the early 1970’s, world governments adopted a fiat money system.

The Impact Of The Fiat Money System

Let’s look at my motherland, the United States, for an example of what’s possible under a fiat money system.

The U.S. government was officially formed in 1776 and began borrowing in 1791. Over the next 125 years leading up to 1916, they racked up $1 billion in debt. By the end of World War I in 1920, the national debt level had grown to $24 billion. That’s a 24 fold increase in just four years.

Thanks to World War II, by 1946, the U.S. government owed a whopping $270 billion. The borrowing slowed somewhat, as it took another 24 years to add another $100 billion, for a total of $370 billion by 1970. Then the U.S. dropped the gold standard.

The debt level nearly tripled over the following decade, crossing the trillion-dollar mark in October 1981. It only took four and half years to double to $2 trillion by mid-1986. Another $1 trillion was added in the next four years, bringing the national debt to $3 trillion by 1990. Within three more years, by 1993, the U.S. surpassed $4 trillion, and there seems to be no end in sight.

Thanks to the fiscal and monetary policies of the last two Presidents, U.S. government debt now stands at over $18 trillion.

U.S. Government interest payments in 2014 were $431 billion, which equates to about 15 percent of tax revenue.

Even at historically low interest rates, this figure is expected to more than double to $1 trillion in the next five years. Just imagine what repayments will be if or when interest rates do rise.

As I mentioned at the beginning of the article, the U.S. is not the only culprit. Since the financial crisis of 2008, central banks have been pulling out all the stops and massively expanding their balance sheets, as this article details.

While a commodity-based currency may restrict the pace at which an economy grows, it also seems to provide an objective standard that has reigned for centuries over humanity’s greed and government’s lust for power.

What to Expect Next

As we learned in 2008, our economy here in Australia is interconnected with the rest of the world.

While we haven’t quite plunged down the rabbit hole of monetary stimulus to the same degree as other nations have, we’re still sticking our heads in to have a look. Australia’s sovereign debt is approaching $400 billion and growing.

What will all of this mean for us?

Some say it’s no big deal, because here in Australia we must consider debt in the light of the GDP. In other countries, many are looking the other way because of the mindset that debt is something they owe to themselves, so it doesn’t really matter.

Logically speaking, I can only see four options that a government can leverage in order to deal with a debt situation.

1. Hope To Grow Out Of It. This is what most political leaders are holding out for these days. In this scenario, if a nation’s economy grows at a fast enough rate, they can use the resulting increased tax revenues to pay down debt. For many countries, this would require a growth rate that’s nearly double what they’ve averaged over the past decade.

2. Raise Taxes To Increase Revenues. Raising taxes while decreasing government entitlements creates a significant budget surplus to throw at the debt. We’ve already established that this is not politically expedient, because increased taxes and decreased government handouts create pain for voters. For the last 40 years, government leaders have proven that this is practically impossible.

3. Inflate The Debt Away. As the laws of supply and demand teach us, the more there is of something, the less it’s worth.
   As a central bank continues to print money,
   the money supply of that currency grows, and in turn that currency becomes worth less, which makes their debt “worthless” in the hands of the debtor.
   
   In other words, central banks can print the money to pay the debt. The down side to this strategy is that it equates to massive inflation and people end up needing a wheelbarrow to transport their cash to the bakery.

4. Default. This is when the government essentially says, “Sorry, we thought we could pay you back for all that money we borrowed, but it’s just not there, so tough luck.” Like option three, this scenario has some significant down sides. A default would most certainly lead to a banking and currency crisis as banks write down loans to the state, and foreign investors avoid the country like the plague.

In summary, unless the world gets lucky and can pull off option one, it’s hard to imagine any scenario for the future other than a painful one. Of course, governments have a remarkable ability to borrow way more money than anyone ever thought possible as they keep kicking the can farther down the road. So, it’s anyone’s guess when any of these sovereign debt issues will get sorted out.

What Do You Think?

I’d love to hear your thoughts.

Is sovereign debt really that big of a deal? What does the future hold for our world economy in light of growing government debt levels? How does your opinion play into your property investing strategy?

By Jason Staggers

Jason was a personal mentor working with Steve McKnight's Property Apprentices. He helped hundreds of investors apply Steve's teachings in the real world and achieve greater results on their journey to financial freedom. Jason now lives in Perth, WA where he leads Neuma Church.