The Debt Debate

A debate is raging about government debt. On one side, economists like Paul Krugman argue that large deficits and debt levels above 100% of GDP are nothing to be too alarmed about. This camp cites historical examples of nations successfully clawing themselves back from massive national debt burdens by combinations of tax increases and spending reductions. Of course, for every example of success, an example of failure can also be found. A new book entitled 'This Time is Different,' by Reinhart and Rogoff, chronicles the surprisingly long historical record of debt defaults and introduces its chapter on Sovereign Default on External Debt with the following note:

Policy makers should not have been overly cheered by the absence of major external sovereign defaults from 2003 to 2009 after the wave of defaults in the preceding two decades. Serial default remains the norm, with international waves of defaults typically separated by many years, if not decades.

Reinhart and Rogoff also point out that defaults frequently occur at ratios of external debt to GDP much lower than 100% - indeed, developing countries typically default long before debt reaches 70% of GDP.

What emerges from this debate is that the focus on debt to GDP ratios as a measure of a country's likelihood to repay is misguided because the record is very mixed. A variety of other factors need to be considered: The household savings rate, ease of cutting government spending, demographics, ability to inflate, liabilities not counted in national debt figures (ie. Fannie Mae and social security), state debts, and municipal debts seem like good places to start.

Readers should therefore find little comfort when they encounter claims that if Japan, the United Kingdom and Belgium have historically been able to handle massive debt burdens, so can Greece or the United States. Likewise, they should not conclude a massive default wave is approaching just because current debt ratios exceed those of countries just before they defaulted. Each country is unique and the focus on debt to GDP ratios is woefully narrow-minded.

Consider the United States, for instance: Our debt hole is really much bigger than the 60% debt to GDP ratio often cited. Medicare, social security, municipal pension obligations, and low household savings rates all make the true debt burden much heavier. On the other hand, we have been able to print over a trillion new dollars without causing significant inflation (so far), a long record of political and financial stability, a history of entrepreneurship, and the strongest military on Earth. The question of how much debt a country can handle is extremely complex. Economists and policy makers need to conduct a much fuller analysis as soon as possible so that we can develop a wiser fiscal policy.