Question:
How high can our national debt get (as a % of GDP) before it will be a threat to our financial stability? ie: dollar loses its status as the reserve currency.Answer:
The national debt of the US is the amount owed by the US federal government and is the value of the Treasury securities that have been issued primarily by the Treasury and which are outstanding at that point of time. By far, the largest component of US public debt is debt held by the public, investors outside the federal government, including that held by individuals, corporations, the Fed, and foreign, state and local governments. Current total public debt is bit over 100% GDP. 47% of the debt held by the public is currently owned by foreign investors, primarily China and Japan.
Central banks all over the world hold financial reserves, in bonds or money market instruments denominated in a currency other than their own, called foreign reserves. Currently, the US$ is considered the world’s reserve currency with roughly 60% of international currency reserves being held in US$, a good chunk of it in dollar-denominated US Treasury securities. This generates a strong demand for US Treasury bonds and keeps interest rates low reducing private sector borrowing expenses. In this sense, having the status of reserve currency is a huge privilege the US enjoys.
One reason for this privilege is that the US offers a large selection of easily tradable, dollar-denominated US Treasury securities. This means countries needing liquidity can sell their holdings of these securities fast and in huge quantities without affecting prices too much. One other reason the US$ is considered a reserve currency is that the dollar, when compared to other currencies, is generally not expected to lose a lot of value.
However, if the US defaults on its debt or receives serious credit downgrades, the US$ may lose its status as reserve currency. If US debt levels rise and the US government cannot raise enough revenue from taxation (and other sources) to service the debt, it can default; it is technically possible for that to happen. (Unlike many developing countries, the central bank in the US, the Fed, is independent of the Treasury and cannot be asked to print dollars to help pay off Treasury debt.) Even though economists generally believe a Greece-style debt crises is highly unlikely in the US, there is a lot of consensus that current US debt levels are fairly high and that the burden of debt will ultimately hamper future economic growth due to “inevitable fiscal adjustment”. Ken Rogoff in a 2010 piece in the Financial Times has argued that “an apparently benign market environment can darken quite suddenly as a country approaches its debt ceiling. Even the US is likely to face a relatively sudden fiscal adjustment at some point if it does not put its fiscal house in order.”
The current political climate in Washington does not seem conducive to getting the US fiscal house in order. This realization has eroded some of the confidence the world has in the US, but all said and done, the world still has more faith in the US and in the US dollar than it has in any other country or currency. There is really no “magic threshold”, a debt level that once crossed will necessarily cause the world to prefer to hold their reserves in some other asset. It will depend on what other options countries have at that time. Right now, the competition (the euro or the renminbi) is not doing much better, but that can always change.
