Debt dynamics

Interest rates are at historical lows so some consider large government and personal debt balances to be, well, sustainable no problem.  Unfortunately, this misses a large part of the equation:

While interest rates have indeed declined, nominal GDP growth has fallen likewise.  I pointed out in a recent post that in the US “Compound nominal GDP growth averaged 5.5% p.a. in the 10 years to 1999, from 7.6% in the prior 10 years, to 2.5% since 2007.”   Higher nominal GDP growth translates into higher government revenues to fund debt interest payments, to fund expenditure and reduces the value of debt accumulated relative to GDP. 

In fact, in the US we have seen both a decline in GDP growth and a decline in current revenue as a % of GDP.

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So while interest costs of debt have indeed fallen, as a % of GDP, they have not in terms of their relationship with GDP growth and GDP growth is key to the ability to accommodate debt :

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Interest payments as a % of average annualised 5 year compound GDP growth shows that interest payments have actually spiked in terms of their relationship with nominal GDP growth. 

And, if we adjust interest payments as a % of GDP for lower current receipts we also see a higher debt servicing risk:

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The red line shows the adjusted figure: what I have done here is to use the average of current receipts/current GDP for the 1990s as the basis for adjusting current interest costs.  Where revenue is below the average 1990 level the difference in % terms is added to the interest cost as a % of GDP.  What we in fact see is that the overall relationship has deteriorated since the early 2000s, in other words the economic fundamentals underpinning sustainability are weak.

But, the budget deficit, has also increased at a time of slower growth and declining current receipts.  

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So while interest payments may have fallen and reduced the burden of higher debt levels, current debt dynamics are not sustainable.  Interest rates are lower because the returns on capital are lower and the risks to capital are higher and bond prices have been supported by central bank bond purchases. 

The same goes for the ability of consumers to support their own debt balances: for example the following shows UK household and non profit institutions, serving UK households, debt and debt as a % of GDP.

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But real personal disposable income growth has also fallen significantly:

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And we can also look at historical nominal GDP growth rates per capita:

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One point that has not been touched on is the valuation of debt relative to the present value of future economic growth.  If the PV of future GDP growth is below the present value of debt and equity/total assets, then asset values will become impaired to some degree.   Therefore it is not so much the interest cost of the debt but the productivity of the underlying assets.   If economic growth, post recession, in the US has only been supported by expansion of public sector debt and aggressive monetary policy, then we most likely have little clarity over the real present value of assets and little real guidance as to the sustainability of debt.      

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