How Much Debt Is Too Much Debt?

Just about everyone in Washington seems to agree that the U.S. deficit is large and unsustainable over the long term. But there are few signs that Congress has the discipline to reduce the deficit anytime soon. The Obama administration and many Congressman talk about deficit reduction. It remains unclear how they aim to achieve it. It will be especially difficult to cut the deficit if the economy does not recover as Washington is hoping; another downturn could make it tricky for politicians to cut popular - and expensive - stimulus programs. Keep your eye on how Congress handles the upcoming expiration of the $8,000 first-time homebuyer credit for early indications about how much willpower exists to reduce spending (there has been a lot of chatter about extending and/or expanding the program).

Policy makers have a difficult balancing act: cut spending too much and economic activity could plummet; spend too much and the United States could have a fiscal crisis replete with inflation, high interest rates, and a weakening of the dollar. Both scenarios could be disastrous to Americans' well being. But there has not been a thorough public discussion about how close we are to the latter outcome. How is Congress supposed to balance these monumentally important constraints when so little is understood about how much debt is too much debt?

Recent articles in the Economist and the New York Times have examined this question. The Economist suggests that the high amount of government debt may weigh on growth in the future, but will not cause a crisis. This thesis largely rests on a comparison of the United States with Japan. Japan's government debt to GDP ratio is actually much higher than America's ratio. The Times makes a similar comparison, but raises questions about how useful such a comparison will be in reality. The Times correctly points out a crucial difference between the United States and Japan that the Economist failed to mention:

One hugely important difference is that Japan is rich in personal savings and assets, and owes less than 10 percent of its debt to foreigners. By comparison, about 46 percent of America’s debt is held overseas by countries such as China and Japan.

In other words, Japan owes Japan money and the United States owes other countries (including Japan, incidentally) money. By some measures, America actually looks much worse than Japan. A useful statistic that receives insufficient attention in discussions about debt is the net international investment position. The NIIP of the United States measures the value of foreign investments held by Americans minus the value of investment in the United States owed to international holders. This accounts for all types of investment (stocks, bonds, and direct ownership) by all sorts of entities (government, businesses and consumers). Japan has a positive NIIP, meaning that other countries owe Japan more money than Japan owes the rest of the world. The NIIP of the United States, on the other hand, is negative.

Considered in this context, it appears incorrect to find comfort about America's debt levels by comparing them to Japan's debt levels. So how much debt is too much debt? I don't know. But the current plan of spend now, figure it out later, and don't worry because our government debt to GDP ratio is lower than Japan's seems dangerous and ill-informed. Economists and Congress should be scrambling to determine just how much debt the United States can sustain without triggering a new financial crisis. Armed with a better understanding of how much debt is sustainable, policy makers will make much smarter choices about spending.