What impact does the out-of-control US debt have on Bitcoin?

On the surface, the US debt-to-GDP ratio doesn’t seem that bad in the global context. It is below the G7 average of 123% in 2023 and less than about half the debt of the world’s most indebted country, Japan, which has a debt of 255% of GDP in 2023.

Looking at the numbers alone, it’s easy to think this isn’t a problem. After all, Japan has handled its growing debt burden relatively well over the years. Its economy has remained stable, with the Nikkei 225 up about 31% over the past year (as of May 10), outperforming the S&P 500. But in reality, the two countries’ economic conditions are very different, which means that what works for Japan is unlikely to work for the United States.

The significant difference between the two is the composition of their debt ownership. In Japan, nearly 90% of its debt is owned domestically by its citizens and institutions. In contrast, about a quarter of U.S. debt is managed by international debt buyers. As a result, it needs to ensure that its debt remains attractive to them by paying a sufficiently high yield relative to global competitors - especially as debt as a share of GDP grows, which means that lending to the government becomes riskier.

In fact, last year Fitch Ratings already downgraded the U.S. government debt from AAA to AA+. At the time, this news was denied by U.S. officials as "arbitrary and based on outdated data." Later this year, Moody's downgraded the U.S. debt outlook to negative, which was also largely ignored by the market.

But investors should be more concerned because the U.S. won’t sit idly by and watch its debt soar to Japan’s levels. For one thing, Japan’s net debt is much lower than its total debt-to-GDP ratio, meaning it holds more foreign assets than it owes to other countries — the opposite of the U.S. This makes it easier for Japan to manage its growing debt.

Map of global debt-to-GDP ratios as of 2022. (Dark green indicates higher ratios, and orange indicates ratios below 25%.) Source: International Monetary Fund

Japan also isn’t plagued by inflation like the U.S. It’s currently at 2.7% after peaking at 4.3% in January 2023. That’s a far cry from the 9.1% U.S. inflation rate, which was reached in June 2022. The Fed is still struggling to keep a lid on sticky inflation, which makes soaring debt levels particularly dangerous because it could add fuel to the fire.

It’s no secret that the answer to inflation is restrictive monetary policy. But higher interest rates mean higher debt payments, unhappy consumers, and, ultimately, a slower economy. In fact, the Fed already faces all of these problems. Consumer confidence is starting to falter, debt payments topped $1 trillion last year, and growth in the first quarter of this year was far less than anyone expected.

So much so that we are now hearing talk of stagflation – a particularly undesirable economic situation in which inflation continues to rise while economic growth stagnates. Here, too, higher debt creates a problem because it limits the government’s ability to use fiscal power to mitigate an economic slowdown. As a result, the Fed finds itself in a sort of Catch-22 situation, especially given that it has all but promised to cut rates next.

Keeping interest rates high for too long in an election year could also lead to voter dissatisfaction. So far, however, both Democratic and Republican candidates seem to have completely ignored one issue that cannot be ignored: the growing U.S. debt. Neither party has proposed any meaningful policies to address the problem. But with the debt-to-GDP ratio now exceeding 100% and expected to continue to rise rapidly in the coming decades, sooner or later the government will have to face reality.

So what does this mean for cryptocurrencies? Paradoxically, all this could be a net benefit for assets like Bitcoin, which could become a safe haven as concerns grow about soaring U.S. debt. Typically, rising debt levels also lead to currency depreciation. While the U.S., like Japan, may be able to avoid this due to global reliance on the dollar, the high proportion of foreign debt also makes the dollar particularly vulnerable.

Combined with expectations of rate cuts later this year, it’s unlikely that the dollar will maintain its current strength. Of course, this is a boon for Bitcoin, which is widely seen as a hedge against dollar weakness.

Therefore, the trouble the U.S. finds itself in is not necessarily bad news for the cryptocurrency market, depending on how far things get out of control. For example, if the U.S. defaults on its debt — which, of course, it won’t. This would be catastrophic for all markets, including digital assets. However, a weaker dollar and some loss of confidence in the U.S. may be exactly what is needed for the next cryptocurrency rally.