The recent downgrade of America’s national debt by US credit ratings agency Fitch has sparked concerns about a potential “debt bomb.” This theoretical scenario involves a vicious cycle of borrowing to service debt, leading to higher interest rates, more borrowing, and ultimately a deep recession.
There is also the argument that the US debt-to-GDP ratio is higher than that of Britain, reaching 118.6% in the first quarter of 2023. With trillion-dollar deficits and increasing government spending, Fitch suggests that US debt is becoming unmanageable. Political acrimony is also cited as a factor contributing to the downgrade.
However, these fears may be misguided. Both the UK and US debts are actually quite manageable. Looking at the debt-to-GDP ratio, America’s 118.6% is historically high but has decreased significantly since Q2 2020’s 134.8%. It’s important to note that this figure includes debt owned by the government itself, which cancels out as both an asset and a liability. Excluding this debt, the ratio falls to 93.2%, which is comparable to the UK’s 100.1%.
Debt-to-GDP comparisons can be misleading as they represent a balance sheet versus cash flow mismatch. Debt accumulates over time, while GDP measures a year’s economic activity. A more accurate but less commonly used metric is the comparison of annual tax revenue to yearly interest payments.
In the UK, inflation may raise debt costs, but it also increases government revenue. VAT revenue, for example, rises alongside prices, and higher inflation-driven wages expand the income tax base due to the British government’s freezing of tax bands during inflation. Higher interest rates have a similar effect.
All of this means that debt is more affordable than debt-to-GDP comparisons may suggest. A growing economy, even if it’s slow, boosts tax revenue and makes debt more manageable. It’s worth noting that the share of US interest payments in tax receipts is lower today than in the 1980s and 1990s. While UK interest payments have fluctuated recently, they remain below the levels seen in the 1980s.
Looking at history, both the US and UK stock markets performed well during those eras, which challenges the notion that debt will impede economic growth.
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