What’s the critical debt-gdp ratio?

by on July 23, 2010 at 7:22 am in Economics, History | Permalink

Krugman (here), Rogoff, DeLong, and others all have recent writings on this topic.  My general view on these matters is the following:

1. There is nothing sacred about "90 percent" as a cut-off ratio and in any case such structural quantitative estimates are not stable over time.  The accompanying expectations matter too.

2. The United States today (and in many other times) can manage a ratio higher than that; how much higher we do not know and what is the correct "stopping rule" we do not know.  I suppose we will find out.

3. Major wars aside, if the United States approached or exceeded the 90 percent figure, it would be a sign of a dysfunctional politics and an irresponsible citizenry.  Do we have to borrow that much money?  Can't we just pay for the stuff?  Apparently not.

4. Even if the debt is not itself a problem, being skeptical about the debt is one way to enforce accountability on the expenditure side, namely by requiring transparency on expenditures and who is really footing the bill for what.

5. If the United States reaches or exceeds that ninety percent ratio, which is likely, it will be because of health care costs, spending too much on health care, and having dysfunctional health care institutions.

6. Under the scenario of #5, measured gdp might do OK.  Health care costs are part of gdp too.  But we will be misallocating resources on a massive scale and the high debt helped make it possible.

7. At some sufficiently high debt-gdp ratio, it becomes a foreign policy issue and a big one.  Postwar UK had a high debt to gdp ratio, and to this day it is a fine place, but that debt meant the end of England as a world power, for better or worse.  The U.S. for instance used financial issues to push England around and they basically had to give up on their overseas commitments.  A very high debt ratio here would mean the end of the U.S. as a global world power, again even if gdp does OK.  A global power needs the option of spending a lot more, quickly, without asking for anyone's permission.  Your mileage on a U.S. retreat from the global policeman role will vary, but it's the elephant in the room which hardly anyone is talking about.

8. I don't agree with Jim Buchanan on either a balanced budget amendment (I am against it, preferring deficits in recessions), or on the intergenerational incidence of domestic debt.  Nonetheless his writings are an undervalued resource in this debate.  Very often he focuses on what debt does to a country, drawing upon the Founding Fathers, the classical economists, and the Italian public finance theorists, among others.

Addendum: Ezra Klein comments.

Kerub July 23, 2010 at 8:01 am

point number 5: why are HC costs the exceeding ones? Only because they came later than, for example, significant intelligence/homeland-security infrastructure reforms costs?

point number 6: why is spending for HC a misallocation of resources?

My view is that the debt is a geopolitical issue. As long as the US keep their leadership among western countries a high debt will be tolerated.

Asher July 23, 2010 at 8:09 am

As Larry Kotlikoff constantly points out, the accounting concept of the “deficit” is irrelevant. What matters is the total extent of the intergenerational transfer. The Social Security debt is off-balance-sheet but it is huge. As Larry has also pointed out recently, the de facto bailout commitment is also huge. (That is also why a balanced budget amendment is irrelevant, so much is already off the balance sheet and so much more can be put there. The law of unintended consequences that economists love shows that such an amendment would harm transparency without aiding fiscal responsibility.)
To get to the point, I agree that nothing is sacred about 90% and the sky won’t fall if we get there, but I also worry that we probably passed the 90% mark long ago in terms of defacto statutory intergenerational transfers.

Andrew July 23, 2010 at 8:35 am

7. I know of a lot of people about it, one in particular. I assume you know about these people. So, how ’bout Niall Ferguson. He’s talked about it.

Here is the problem with the debt as I see it. We don’t owe it to ourselves. We owe it to the people that are financing the transfer of our industrial base to their countries. Free trade is fine. Capital flow is fine. Owing others for the privilege of exporting to them our productivity is not fine.

Just An Australian July 23, 2010 at 8:39 am

The big question is who the debt too. The $100,000 I owe my parents is not as big a problem as the $10,000 I owe the bank, but the one that can really bring the house of cards down is the $1000 I owe to the guy down the road who lent it to me late one night…

E. Barandiaran July 23, 2010 at 9:14 am

Asher, I agree with you. Larry K. is right –by studying in detail Social Security financing, Larry has been able to make clear that accounting practices in public finance are at best deceptive. In addition, as anyone that participated in Latin America’s debt crisis during the 1980s knows (especially those familiar with Argentina before, during and after the 1980s), to assess the prospect and consequences of a fiscal crisis you have to know well a lot of details about expenditures and revenues. Leaving aside deceptive accounting, it is not only the deficit and the debt that are relevant to that assessment: often the waste in public expenditure and the cost of raising revenue are the critical issues.
And economists that like to focus on the “optimal” (or “natural” or “critical” or whatever) amount of something, they should always make explicit the variables that determine it, in other words the model in which the amount is relevant –otherwise it’s much ado about nothing.

Andrew July 23, 2010 at 9:47 am

Ezra Klein: “As everyone knows by now, the threat is long-term, not short-term, debt.”

Okay, for the time being, let’s set aside JournolistGate and assume Ezra didn’t just get this talking point from the Paul Krugman Mafia.

It is not just a short-term debt problem. Our GDP is down because of the debt. Didn’t the banks just fail? Didn’t they just fail because people were buying houses, aka non-productive assets? The best argument against AD, consumer spending is that this is one of those instances where the Austrian critique is absolutely, 100% true.

Ed July 23, 2010 at 10:20 am

Ironically, the prevalence of the view that “the US can’t default, it is the superpower and has the world’s reserve currency” may make it less likely that the US can sustain a high debt to GDP ratio. First, this view probably encourage US policymakers to overestimate the amount of debt the economy can really tolerate, second you are looking at a pretty big adjustment if either of these conditions end. It would be like running up huge debts when you have a high paying job and suddenly getting fired.

neb July 23, 2010 at 10:43 am

Agree with much of what you’re saying, albeit that tax cuts on the rich and the economy, military spending and other items have caused the debt — not just “health care.”

But I particularly disagree with the statement that “A very high debt ratio here would mean the end of the U.S. as a global world power…” That is just not true. It might mean the end of the US as THE lone hegemon, but we’re moving into a multi-polar world, and the US would still, even with vast military cuts and a weakened economy, have one of the biggest military budgets and biggest economies in the world. Your post implies a false dichotomy of either the US is a global power or it isn’t.

LarryM July 23, 2010 at 11:45 am

#7 has changed my position on large and increasing deficits. Bring them on. :)

floccina July 23, 2010 at 12:07 pm

The potential problem that I see is that people have ways of avoiding taxes. I.e. wives of high earners might work at home rather than in taxed worked, people might dealing more in cash, or provide more of their own services, Use barter etc.
Take the example of private verses government provided health insurance, with private insurance a family with a low earner and high earner keep the low earner working to help pay for the insurance, but if Gov. provides the insurance the earner might quit a taxed job to provide services at home.

ottovbvs July 23, 2010 at 2:17 pm

Point 7. Britain’s postwar debt problems weren’t the cause of their demise as a great power but a symptom of the relative narrowness of their economic base relative to their global committments and warmaking capacity. From the first world war onwards maintenance of first rank power status was much more dependant on the size of your economy, Britain had used up the fat it had accumulated over two centuries by 1940 and simply wasn’t big enough to play in the big leagues any longer. The US accumulated huge deficits and debts during WW 2 but the size of its economy ensured rapid recovery.

Bernard Yomtov July 23, 2010 at 4:22 pm

Andrew,

Didn’t the banks just fail? Didn’t they just fail because people were buying houses, aka non-productive assets?

In what sense are houses non-productive assets? Mine provides me with shelter, a place to store food and prepare and eat meals, sanitary facilities, etc.

Al Brown July 24, 2010 at 2:22 am

Lets be democratic about this. Lets vote on whether to continue growing the debt. Then those that are for it can each take an equal share of the additional debt as personal debt. That should make us all happy.

mulp July 24, 2010 at 4:09 am

Reagan proved deficits don’t matter.

Bush tried to prove debt burden doesn’t matter, but to oppose Obama, every bit of ammunition is being used to bring him down, do debt matters a lot.

But if Obama is defected in 2012, then Bush proving debt burden doesn’t matter will allow the tax cutters to cut without any sacrifice.

After all, those who believe in tax cuts also believe in free lunches.

Reagan proved conservatives could deliver lunch for free, that tax cuts don’t need to be paid for, that smaller government never means cuts in your benefits, and budget austerity never means reductions in revenue to government contractors or health care corporations.

If you read the Paul Ryan et al program for fixing the entitlement problem, it lays out a set of tax reforms that cut taxes for everyone and then generate at least 19% of GDP in revenue based on the historical record post war of tax revenue, but not a single Republican administration ever reached that average.

Then, Social Security and Medicare would be replaced with new systems over a period of fifty years with the budget balancing after that. In the interim, the deficits would be large as the existing benefits would be deficit funded and the new generation paying into a separate system.

The people screaming the loudest about deficits and debt are exactly the same calling for both cutting taxes and defending Medicare from cuts.

After all, Reagan proved the US government can provide a free lunch to all those who vote Republican.

Jon July 24, 2010 at 8:05 am

Re: Has any country ever repaid or significantly paid down it’s debt once it reached a level similar to 90% of GDP?

Yes. The US after WWII.

Mr. E July 24, 2010 at 12:55 pm

The government can spend money without borrowing. Until this is recognized, we’re in for a long and meaningless discussion. We are no longer using a gold standard, but this discussion about debt is based on gold standard ideas. The government doesn’t need to borrow to spend.

In fact, with double entry accounting, for the public to hold net USD savings, some other entity must be running a deficit. That entity is the U.S. government.

Then the credibility issue: We have a good guide to what the market and world thinks about the credibility of the U.S. government. It is called the 10 year real yield. Until the 10 year real yield is somewhere north of 10%, the U.S. government should be considered credible. We know the 10 year real yield from the 10 TIPS yield. 1.25% or so right now.

Dan H. July 24, 2010 at 6:10 pm

In the recent Romer and Romer paper on the effect of tax increases, one of their findings was that, although exogenous tax increases in general cause up to 3% in GDP loss per 1% GDP tax increase, taxes that were specifically aimed at deficit reduction did not share this trait, and in fact could actually increase GDP growth.

Does this say something important about the cost of debt and deficits? Might this explain why deficit-financed Keynesian stimulus isn’t as effective as expected?

Andrew July 25, 2010 at 4:52 am

Inflation is a tax. It is especially a tax on people who have nominal incomes and real liabilities. Inflation is a debt transfer.

The U.S. is only credible in a relative sense.

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