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What’s all the fuss about US debt & why does it matter to me as a property investor?

There’s been lot’s of fuss about the US fiscal cliff and the size of the US debt, but what is it all about and what does it mean for you and me as Australian property investors?

What actually is the US debt?

US government debt comes in to two parts. Firstly, there is the debt held by the public, through Treasury securities. Although this is known as public debt, a great deal of it is held by corporations as well as individuals. Secondly, there is intra-governmental debt.

By the middle of December 2012 the public debt was around $11.6 trillion and the intra-governmental debt around $4.8 trillion, giving a total US debt of very close to $16.4 trillion today.

As you may well know, this figure is rapidly approaching its agreed limit or debt ceiling.

Government debt has to be paid back at some point, and so in effect in represents deferred taxation from future years.

This in itself may not be seen as a great problem if the debt is incurred for the good of future generations – such as investment in education and schools – however, often the debts incurred are for costs relating to today’s generations.

In effect, governments are borrowing from future generations to cover today’s costs.

Why does the government have so much debt?

Historically, governments did not have to run huge deficits every year, but they sometimes were forced to do so during times of war and recession.

Today, however, a number of developed world governments including the US and the UK continue to run deficits year after year.

But why? There are a number of theories, but as I have touched on before, one of the major problems for developed world governments is the spiralling cost of medical and welfare payments as populations are tending to live for longer.

Over recent years we have seen a very sharp run-up in the US government’s debt levels due to a number of factors including a series of tax cuts from George W. Bush, wars in Afghanistan and Iraq, massive increases in the defence budget and a huge stimulus package after the sub-prime crisis in 2008.

Interestingly, the government chose not to include the obligations incurred on behalf of Freddie Mac and Fannie Mae in its accounts. Why? Because of the sheer size of the obligations being an estimated $5 trillion. The government also excludes a number of other obligations from its official figures.

And, of course, as the debt balance increased, so did the cumulative interest charges thereon…

History of US debt

The US has had government debt continually since 1836. Thus, whether or not a government has debt is not in itself a concern. Economists instead tend to express government debt as a percentage of the country’s Gross Domestic Product (GDP).

The US has had an interesting history with regards to its debt levels. A historical chart of government debt shows a number of clearly identifiable spikes such as one caused by the Civil War in the 1860s, two caused by the respective World Wars, and another great spike caused by the devastating effects of the Great Depression of the 1930s and beyond.

During the Clinton administration the government debt ran as high as almost 50% of GDP, but Clinton was able to turn this around and the level fell to around 35%of GDP during his time in power.

Unfortunately, since George W. Bush came into power the US debt levels have increased by a staggering sum from $3.3 trillion in 2001 to the $16.4 trillion seen today.

What happens next?

At some point, many economists and commentators believe that the US government needs to bring its debt levels relative to GDP down. The way things are headed it is forecast that debt as a percentage of GDP could run as high as 90% by 2020.

There has been much conjecture as to what would constitute a “danger” level of debt, with many believing that 90% of GDP for the US would represent a disastrously high figure.

At some stage therefore, the US will have to take some pain in the form of spending cutbacks and taxes.

Many believe that the endgame to the debt ceiling crisis could be a high rate of inflation as the government uses devaluation of the currency to reduce the real value of its debt. And indeed, high levels of government debt have historically had a tendency to weaken the currency of a country.

Debt levels could also hinder US economic growth, which would naturally have a knock-on effect to the rest of the world.

As the debt levels increase, investors may also begin to demand higher rates of interest as compensation for the perceived risk, which is potentially a genuine problem for the US.

Interest rates are currently at rock bottom in the US, with the Fed Funds rate sitting at just 0.25% as the country attempts to stimulate its anaemic levels of growth.

The debt ceiling

Normally, votes to increase the debt ceiling are treated as something of a formality, but in 2011, we saw that this was no longer the case as concerned politicians believe that more decisive action must be taken to reduce the national debt.

The debt ceiling was raised in January 2012, to $16.394 trillion, a figure which will be hit in the next couple of months as you can see by today’s national debt clock.

Incredibly, over the past 5 years, the US debt has continued to increase at around $3.8 billion per day!

Thus, expect more concerns and wobbling stock markets in February as politicians once again meet to hammer out a deal.

Ultimately, it seems that many developed world governments will continue to borrow more and more each year, unless something is done to stop them doing so.

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About

Pete Wargent is a Chartered Accountant, Chartered Secretary and has a Financial Planning Diploma. He’s achieved financial freedom at the age of 33 - as detailed in his book ‘Get a Financial Grip – A Simple Plan for Financial Freedom’. Pete now manages his investment portfolio, travels and works as a consultant in the finance industry from time to time. Visit his blog


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