• What is the relationship between a nation’s public debt and the value of the fiat currency issued by that nation? Historical evidence would suggest that high levels of government debt can trigger a sudden collapse in the value of fiat money. However, government debt levels have risen rapidly in many developed nations over the past twenty years with seemingly little impact on the value of those currencies.

• So, what is the relationship between the national debt of the United States and the value of the US Dollar and how much debt is “too much”?

• The view of The Money Enigma is that national debt plays a critical, but complex, role in determining the value of the dollar. More specifically, it is not “national debt” per se, but rather the market’s perception of the nation’s overall “fiscal sustainability” that directly impacts the market value of the fiat currency issued by that nation.

• Why does “fiscal sustainability” matter to the value of fiat money? In simple terms, the government has only two choices when it decides how to fund its deficits: it can issue debt or it can expand the monetary base.

• At the point that the market decides that the fiscal path of the nation is unsustainable and that the ability of the government to issue more debt will become increasingly restricted, the market will begin to discount the likely eventuality that both (a) real output growth will slow as taxes are raised and spending is cut, and (b) monetary base growth will accelerate as deficits need to be financed, at least partially, by more money creation.

• This combined shift in expectations, lower output growth plus higher monetary base growth, puts downward pressure on the value of the dollar and upward pressure on the price level.

• Why does the value of money depend upon expectations regarding the long-term future of real output and the monetary base? The value of money is sensitive to these expectations because fiat money is a financial instrument that derives it value from an implied social contract. More specifically, fiat money represents a proportional claim on the future output of society.

How Much Debt is “Too Much”?

The question “how much government debt is too much?” is an important one both for economists and policy makers. Not surprisingly, many attempts have been made to quantify the threshold at which government debt becomes dangerous.

However, attempting to provide this type of quantitative assessment is much more difficult than it first may appear. For example, Carmen Reinhart and Kenneth Rogoff in their book “This Time is Different” (2009) conducted an expansive empirical analysis of this issue covering sixty-six countries over nearly eight centuries. Their results were unable to uncover any “magic number” that can be used a threshold. Rather, the results of their work suggest that the threshold is highly variable and depends on a number of factors including the nature of the debt, the stage of the nation’s economic development and the nation’s history of default.

The issue is further complicated by the fact that, over the past twenty years, most major Western nations have accumulated levels of national debt that are exceedingly high by historical standards. Indeed, any attempt to have a sensible discussion regarding national debt is inevitability high-jacked by those that point to Japan’s record debt to GDP ratio (Japan’s national debt represents roughly 300% of its GDP) as evidence that there is no limit as to how much national debt and advanced economy can carry.

The view of The Money Enigma is that rather than focusing on quantitative thresholds, a more productive approach may involve taking a step back to think about national debt in the broad context of “fiscal sustainability” and the impact of perceived fiscal sustainability on expectations regarding the long-term economic prospects of society.

In this regard, it is helpful to put aside the specific issue of “how much government debt is too much?” and attempt to answer the more general question “how much debt is too much?”

Clearly, there is no simple answer to this question. From a corporate perspective, a sustainable level of debt will depend upon many factors including variability of cash flows, earnings growth expectations and, ultimately, some type of qualitative assessment regarding the strength of the business franchise itself.

The key point is that it is not the level of debt per se that matters, but rather perceptions regarding the sustainability of that debt. If the market suddenly decides that a given level of debt is no longer sustainable, then that is the point that the cost of both debt and equity capital can rise dramatically.

It is worth noting that, in practice, this tipping point in expectations is seldom triggered by a new issuance of debt. Rather, this tipping point most commonly occurs because of sudden change in perceptions reading the economic future of the issuing corporation.

Similarly, at a national level, the question is one of market perception regarding whether projected levels of national debt are sustainable. As the results of Reinhart and Rogoff’s work suggests, every country will differ in this regard. A national debt load that is dangerous for a commodity-focused developing nation with a history of default could represent a perfectly sustainable burden for a developed nation with a diverse and stable economy.

Moreover, as corporate experience would suggest, it is unlikely that any increase in national debt from say 100% to 120% of GDP is, in and of itself, likely to tip the balance of expectations from “sustainable” to “unsustainable”. Rather, it is more likely that a sudden loss in confidence regarding the sustainability of the US fiscal path will be triggered by other economic events such as the outbreak of war or a sudden and severe recession.

Whatever the cause of this sudden shift in perceptions, a loss of confidence in the fiscal sustainability of a nation should have dire consequences for the ability of that nation to finance its deficits. All else remaining equal, the cost of debt financing, i.e. the interest rate on government debt, will rise significantly.

Frankly, this much should be obvious. What is less obvious is how this sudden shift in perceptions impacts the value of fiat money.

The view of The Money Enigma is that fiat money is, in essence, the equity of society. Fiat money is a form of equity finance for a nation just as shares of common stock are a form of equity finance for a corporation.

If there is a sudden loss in confidence regarding the fiscal sustainability of a nation, then this impacts both the cost of debt, i.e. the interest rate on government debt, and the cost of equity, i.e. the value at which new money can be issued.

More specifically, if the market suddenly decides that the fiscal path of a nation is no longer sustainable, then the value of the fiat currency issued by that nation will decline. Moreover, this decline in the value of fiat money will be reflected in both foreign exchange rates and the domestic price level.

What Determines the Value of the Dollar?

In order to understand why the market’s assessment of fiscal sustainability matters to the value of money, we need to step back and think about what factors determine the value of fiat money and, more fundamentally, why fiat money has any value at all.

The question “why does fiat money have value?” is one that we have discussed in several recent posts including “Why Does Money Exist? Why Does Money Have Value?” and “The Evolution of Money: Why Does Fiat Money Have Value?”

At the most basic level, the view of The Money Enigma is that assets can only derive their value in two ways. Every asset is either a real asset or a financial instrument. Real assets derive their value from the physical properties. In contrast, financial instruments derive their value from the contractual properties. Moreover, a financial instrument is only an asset to one party because it represents a liability to another party.

Fiat money is a financial instrument. More specifically, fiat money derives its value from an implied contract, or “social contract”, that exists between the holders of money and the issuer of money. In essence, fiat money only has value to us because we recognize that, from an economic perspective, it is a liability of society.

The Money Enigma takes this concept further by thinking about the exact nature of the liability that fiat money represents (see “Theory of Money” section).

The view of The Money Enigma is that fiat money represents a claim on the future output of society. More specifically, fiat money represents a variable entitlement or “proportional claim” on the future output of society, much as a share of common stock represents a proportional claim on the future cash flows of a business.

The key practical implication of this theory of money is that the value of fiat money is positively correlated to expectations regarding the rate of long-term real output growth, and negatively correlated to expectations regarding the rate of long-term growth in the monetary base.

In simple terms, we can think of each dollar in our pocket as representing a slice of a cake made of “future output”. There are two reasons for why each slice of cake might shrink.

First, the cake itself could shrink, i.e. the market might suddenly decide that future output growth will not be as strong as previously expected. If this happens, then the value of a proportional claim on future output will be worth less and the value of fiat money falls.

Second, the cake may be cut up into more slices, i.e. people might suddenly decide that the monetary base will be a lot higher in the future. If this happens, then there are more claims against future output, hence every claim is worth less and the value of fiat money falls.

If both of these expectations move sharply in the wrong direction (i.e. less output, more money), then the value of fiat money can collapse quite suddenly. In an extreme scenario, a sudden collapse in the value of money can result in hyperinflation, i.e. the point at which the value of money has fallen so sharply that you almost can’t give the stuff away.

Why Do Perceptions of Fiscal Sustainability Matter to the Value of Money?

Let’s return to our original question and think about the relationship between fiscal sustainability and the value of fiat money. More specifically, what happens to the key set of expectations that determine the value of money in the event that the market suddenly decides that the current fiscal path is unsustainable?

If it suddenly becomes clear that the nation is on an unsustainable fiscal path, then one of the first things that will happen is that the market will begin to put pressure on policy makers to reduce future fiscal deficits. In other words, people will begin to expect that the government will have to cut spending and/or raise taxes.

In this event, what will happen to expectations regarding the long-term rate of economic growth? Most economists would argue that, in this event, people would expect economic growth to slow, particularly if government spending on key infrastructure projects was constrained.

As discussed, expectations regarding the long-term growth rate of real output are a key factor in determining the value of money. If money is a proportional claim on future output, then any event that reduces expectations for future output growth should have a negative impact on the current value of money.

Now, let’s consider to what happen to the other key input factor. How would a fiscal crisis impact expectations regarding the outlook for the monetary base?

Ultimately, every government has only two choices when it decides how to fund its deficits: it can issue debt or it can expand the monetary base.

In modern times, it is rare for governments, particularly those in developed nations, to engage in outright monetization of deficits, i.e. printing money to pay the bills. However, it is very common for central banks to “assist” fiscal policy makers in difficult times, even if such assistance is not explicitly acknowledged as such, by expanding the monetary base and using this newly created money to buy government bonds, thereby lowering the interest rate on government debt and artificially creating a more favourable capital raising environment for the government of the day.

Therefore, while the market may not expect a fiscal crisis to result in outright monetization of deficits, it certainly could impact the market’s expectations regarding the willingness and likelihood of central banks to engage in the aggressive expansion of the monetary base.

Moreover, in an environment, such as the one that exists today, where central banks have already engaged in aggressive monetary base expansion, a fiscal crisis could have a significant impact on the market’s expectations regarding whether the recent expansion in the monetary base is “temporary” or more “permanent” in nature.

If the fiscal crisis tips expectations such that the market believes that the monetary base ten or twenty years from now will be a lot a higher than previously expected, then this should have an immediate and negative impact on the value of money today.

In summary, the view of The Money Enigma is that fiat money is only as good as the society that issues it. A fiscal crisis can severely damage long-term confidence in the future economic prospects of society and, thereby, have a profoundly negative impact of the value of the fiat money issued by that society.