Tuesday, June 8, 2010
Sound as a Pound
The BBC reported today that the British pound took a massive hit as a major ratings agency issued a warning about the scale of the United Kingdom’s debt crisis. Fitch’s warning echoes Britain’s new Prime Minister, David Cameron, by drawing attention to one of the highest debt ratios in the world. At the same time, the loss of confidence in the pound is a warning that no country is safe from the emerging worldwide debt crisis, not even the United States.
Of course, not all debts are bad. The United States is forced maintain a large amount of government debt as a consequence of our position as the world’s dominant reserve currency and the same is true for Britain, although to less of a degree. In order to hold dollars in reserve, a large portion of our debt will be continuously renewed by the same countries that are holding it now. Far more important than the amount of a nation’s debt is whether or not a nation is able to meet its obligations.
In this regard, a much more important measure than the size of the debt is the ratio of interest payments on the debt to GDP. For 2009, the interest on the U.S. debt totaled more than $383 billion, or about 2.7% of GDP, thanks to extremely low interest rates. Meanwhile, the Guardian reports that the interest on the debt for the United Kingdom is currently about £42 billion, which is about the same in terms of GDP.
That 2.7% may not sound like a lot, but when interest rates start to increase, the ballooning debts here and in the United Kingdom will take an ever larger proportion out of tax revenue. With no end to trillion-dollar deficits in sight, our national debt is well on its way to doubling as a percentage of GDP within a few years compared to the 69% debt-to-GDP ratio of 2008.
It is worth considering that defense spending and government health care each account for about 5-6% of GDP right now, but as the baby-boomer generation ages, government health care expenditures are going to skyrocket. If the ratio of interest on the debt to GDP approaches 5%, the United States will face massive societal upheaval and economic collapse. Britain is making painful choices now in order to avoid this bleak forecast. We postpone the same difficult choices at our peril.