Sovereign debt, the lifeblood of nations throughout history, must not exceed the country’s ability to service and repay it. Often in the form of bonds, investors and nations provide currency to the government in exchange for bond certificates ensuring repayment plus interest. During times of crisis or need, bonds can be crucial for ensuring the government and economy maintains sufficient liquidity.
Countries that rely on these bonds – who act less so as creditors – are often called “debtor nations”. A debtor nation means the debt of the nation to other countries exceeds the level of foreign investment.
It is famously said the United States tipped to a “debtor nation” territory in 1985.
U.S. TURNS INTO A DEBTOR NATION
-New York Times, September 17, 1985
Historically, the consequence of too much sovereign debt has been outright default, hyperinflation, or significant currency devaluations.
This, of course, is not the first time the United States has been a “debtor nation”. In the 19th century, the states were rife with discussions of default. The early 1840s saw a severe depression, plunging state debt to fifty cents on the dollar, with state governors banding together in favor of default. In a short period, five states defaulted on their interest payments. At the time, the economy was primitive and weak. The powerful creditor nation was England. Over the decades, the United States economy evolved into the most powerful economy in the world. The rise of J.P. Morgan and key watershed moments like WWI and II propelled the United States to creditor nation status and the world’s economic powerhouse.
Hyperinflations like that of Germany in the early 1920s and the lesser-known 1931 UK default were due to too much sovereign debt relative to what they could bear. The proportion of the debt load relative to GDP dictates whether the debt load is too great. A simple formula can measure it, debt divided by GDP, giving us the debt-to-GDP ratio.
History Shows High Levels of Debt Lead to Default
In a review of sovereign debt to GDP level of nations since 1800, when it crosses the 130% threshold, meaning $1.30 (or the applicable currency) of debt for every $1.00 in an annual gross domestic product, default is almost inevitable (98% of the time). Fifty-one of 52 nations.
Of course, the question is, who was the 2%? The US is no typical nation. Was it WW II America? Negative ( reached a height of 113%). The country in question, with a record of 266%, is Japan. Many say this situation is still unfolding, and expect a default is inescapable.
US Reaches 130% Debt-to-GDP Ratio
In response to the effects of the pandemic, in 2020, the Federal Reserve launched the largest QE campaign yet, with the ratio reaching 137%.
Currently, it resides at around 127%, just below the threshold. Does that mean the United States is in the clear?
Importantly, it is not necessarily this ratio that matters, but rather the interest payments being made on the debt, that indicates the time of default. Meaning, when interest rates are kept low enough, astronomical ratios are possible, as seen in Japan. Thus, when predicting when a country will default, or the currency will devalue, etc. one must determine when it will enter an environment where interest rates will rise sufficiently enough.
Hence, the crucial metric is interest on the national debt as a percentage of GDP.
By 1931-32, the UK had defaulted on its “inter-Ally debt”.