Arnold Kling  

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A reader emails,

what is a sustainable level of US debt % to GDP?

I usually think of our debt as government debt. But adding up total private and public debt, we have something like 350 percent for a debt-GDP ratio, more than double the level of 1980. Most of the increase in the past 20 years or so has been in household debt and financial sector debt. See this post from a blog called the Elephant Bar.

Suppose that I borrow $100 K to buy a house. A lender sticks it into a security. A bank buys the security and issues debt to buy the security. I send the household sector debt up by $100,000. When the lender sells the security, does my mortgage increase the lender's debt by $100,000? I don't know exactly how the Fed does its flow of funds calculations, but I imagine that the lender's debt goes up, at least in gross terms (maybe not on net, because they have an asset as well as a liability). Similarly, in gross terms the bank has more debt, and I'm guessing that this shows up in the flow of funds. So in some sense, the same debt could be double- or triple-counted. Still, even taking that into account, the leverage in the household and financial sectors certainly has gone up.

In some sense, the Bernanke-Paulson plan is to substitute government debt for financial-sector debt. (The Bair plan is to substitute government debt and/or financial sector debt for household debt, by bailing out mortgage borrowers.)

Suppose that these plans succeed in dramatically boosting the ratio of government debt to GDP. Whether or not this is sustainable is in the eye of the debtholders. If enough of them get scared, they'll start a stampede out of Treasuries. At that point, our options will be (a) raise taxes, (b) cut spending, (c) formally default, or (d) print money. We could "borrow from the IMF," but in our case I think that just boils down to (d) by another name.

I'd be surprised if we chose a formal default. Doing so would effectively kill financial markets for generations. My guess is that we would mostly raise taxes and print money.

A fiscal stimulus would increase the risk of the this sort of "sudden stop" in which creditors panic about U.S. government debt. We might instead want to err on the side of risking a steeper recession, taking Tyler Cowen's advice:

Spend less, save more, be poorer for a while.

Nobody who wants to be elected could campaign on that platform.

Comments and Sharing

COMMENTS (12 to date)
TA writes:

You're right, both about the double counting in the funds flow report, and increased debt all around. If I have a securitized mortgage, both my mortgage debt and the ABS or GSE pool debt behind it are added into the Feds gross number for credit outstanding. And so on. Having said that, all of the following have grown faster than GDP since 2000: household debt, government debt, non-financial business debt, and the gross debt of financial institutions (much faster). This says something about increasing complexity of the financial sector, I'm pretty sure, but I don't know just how to characterize it. Credit default swaps aren't in these numbers

Philippe writes:

Why would a default in the case of federal debt "kill financial markets for generations"?

Another issue may be the nominal interest rate associated with the debt. The question is not only what level of debt (or ratio, relative to GDP) is sustainable but also what interest rates are. After all, I wonder to what extent financial crises are bound to happen because sufficiently large rates will create a huge amount of outstanding debt, which the economy (in the absence of excessive money printing) will not be able to repay (and at some point not even interest on this debt).

winterspeak writes:


You need to come to grips with fiat. Why print money AND raise taxes? Will the US want to increase the money supply OR decrease it? Printing money creates money. Taxes destroy money. Never any reason to do both.

Joe Marier writes:

Well, I can think of one politician that said, in essence, "spend less, save more". And she lost.

Sarah Palin, in the 2008 vice presidential debate...

"Let's do what our parents told us before we probably even got that first credit card. Don't live outside of our means. We need to make sure that as individuals we're taking personal responsibility through all of this. It's not the American peoples fault that the economy is hurting like it is, but we have an opportunity to learn a heck of a lot of good lessons through this and say never again will we be taken advantage of."

Marcus writes:

"Spend less, save more, be poorer for a while."

Doesn't all that debt represent somebody's savings?

Gary Rogers writes:

At first glance it appears that government debt is underestimated and personal debt is too large. Are IRAs and 401Ks included in personal savings? Are off budget government expenses included? At what point do unfunded government promises become debt? Irregardless of the answer to these questions, I agree with the conclusion. Save more and spend less. So why are we talking about a trillion dollar stimulus package?

The first step is recognizing our situation, and I believe more and more people are beginning to recognize the unpleasant truth.

The second step is bringing consumers and businesses into line. Markets will deal with this through the cost of credit as long as the government stays out of the way. Bailouts have a way of allowing people to keep spending when they really need to stop.

The third step is bringing government spending into line. This cannot happen as long as the government thinks they are doing us a favor by trying to stimulate the economy. We need good economists to tell them this is not so. If we cannot get control of governmetn spending before lenders lose confidence in the dollar, then our cost of carrying debt will shoot up rapidly and sharply. This is where we become a true Banana Rupublic economy and zero interest rates will be only a dream.

Lord writes:

Shouldn't that be 'get richer for a while' ?

The Snob writes:
Doesn't all that debt represent somebody's savings?

Yes, China's and Japan's if I recall correctly.

fundamentalist writes:

The answer to the reader's question is the amount of debt we can continue to make interest payments on. Accountants have financial ratios they use to determine if companies have too much debt, but I don't know of any for nations. You know you have reached the barrier when other nations quit buying your debt.

But long before we reach the default level we will have become much poorer. Additional federal debt requires greater taxation to pay for it. Federal debt hurts economic growth in two ways. The first is obvious--greater taxation to pay the interest. The second is not so obvious and as a result more dangerous. Every dollar invested in state debt is a dollar not invested in business. Business can grow only if they can invest the savings of others. If the state takes all of that savings, then business has to go elswhere to borrow, such as to China.

But borrowing from China has its own problems. For one, it increases the trade deficit.

TM writes:

I wrote the initial question to Arnold, and here is my fear...

Excessive and imprudent consumer and corporate borrowing has hit a wall, and govt debt is now partially bailing out forced consumer and corporate deleveraging. This has not yet accomplished private balance sheet stability. Further, global GDP is plummeting due to the income, net worth and spending inpacts.

Enter massive govt spending to replace consumer/corporate spending, and massive govt debt to finance it. In the very short term, no problem, as global financial panic subsidizes lower govt interest rates.

But for how long? Where will the future buyers of govt debt be? Will they not require much higher interest rates? And will this not force government deleveraging, an end to deficit financing, lower spending, higher taxes, and fewer bailouts?

And in the meantime, what happens to GDP? What level of total debt to GDP is sustainable, and what does this imply for how deep and long the Great Recession will be?

It seems to me we are in the hands of our lenders, the buyers of govt debt. Do they not have limits also?

Steve Roth writes:

To answer the question more directly:

In WWII U.S. government debt went from 50% to 120% of GDP. This was followed by the greatest period of prosperity growth in American history. (I am not saying that spending caused the subsequent growth (sufficient condition). But I will assert that it's what finally broke the recession's back, so it was a necessary condition at the time.)

That prosperity allowed us to pay down the debt over the next 35 years, to 35% of GDP.

Then...1980. It's been down (up) hill since then. We're close to 70% now.

Clinton/Rubin managed to pull up the nose, briefly, a bit, but...

Those thirty years of malfeasance put us in a tough spot, now. And many other conditions are different than they were in the 30s/40s. But we're still nowhere near where we were in 1945 on government debt.

Despite living overseas through decades of subtle and tumultuous change...

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