Is Debt-to-GDP a Good Measure?

In a previous post, reader Sergei asks

Hello, I appreciate your article, however, I still wondering what is the meaning of the National Debt over GDP ratio? My numbers based on the US debt clock me that this ratio currently around 98%. Could you briefly explain what is the meaning behind this number?

Others might find the answer useful, so I’m making a post out of my response.

The “national debt” is the total money borrowed by the national government. It is the sum total of all the bonds and T-bills that have been issued and still outstanding by the U.S. government regardless of who owns (the lender or creditor) the bonds.  In some cases, one unit of the government such as Social Security owns the bonds which means in effect that one part of the government owes money to another part of the government.  In other cases, the central bank, The Federal Reserve, owns the bonds.  For details on the breakdown on the U.S. debt see here.

For centuries, nations have borrowed money and for centuries, there have been national governments that have found themselves unable to pay back the money or at times to even pay the interest on the money they borrowed.  These events are called “sovereign defaults”.   Economists are interested then in the is How much debt is too much?  Can the government bear the interest costs of the debt?  It is much the same kind of question that a bank asks about an individual when making a loan to an individual.  But there are important differences.

In doing this we are trying to compare the amount of debt to some measure of the government’s ability to make the payments.  The debt-to-GDP measure is simply a percentage number using total debt outstanding as the numerator and the size of GDP as the denominator.  We use GDP as a measure of the government’s ability to pay since a government’s income is taxes.  The taxes that can be collected depend on the total of all economic activity. After all, you can’t collect taxes of $1 trillion from an economy of only $500 billion, but it’s easily plausible to collect $1 trillion in taxes from an economy of $15 trillion. The higher GDP is, the more it is assumed the government has an ability to collect taxes and pay the interest.  Thus when the ratio is higher, it indicates that a lot of debt is outstanding and that implies (but only implies, not requires) a lot in interest payments.  So, it is assumed by many that a higher debt-to-GDP ratio means interest payments are likely a  greater burden and thus the chance of eventual default higher.

Using a debt-to-GDP ratio carries two major advantages over just using amounts of debt.  First, it allows us to compare two different countries regardless of their size.  For example, we can compare a small, little country like Greece which has a debt-to-GDP ratio that’s around 153% to a very large economy like say Germany which is around 84%.  Even though Greece has much, much less actual debt outstanding, it’s debt is a bigger burden on it than Germany’s debt is for Germany because Germany has a bigger economy and more ability to pay. Second, using the ratio allows us to compare debt levels of a country from different years.  Debt may be growing in dollar terms but becoming less of a burden because the country’s GDP is growing faster.  This was the experience of the U.S. since World War II.  In WWII debt-to-GDP reached 112%.  Ever since then, the U.S. has had an increasing debt because it almost always ran a budget deficit.  But the debt-to-GDP ratio declined from 1948-1981 because the economy grew so fast.

Why There’s So Much Attention to the Ratio In Recent Years

I’ll let noted economist Robert Shiller explain in his article in Japan Times (btw, this is an excellent, easy to read article – I recommend reading it):

A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90 percent of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.

One might be misled into thinking that, because 90 percent sounds awfully close to 100 percent, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90 percent figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30 percent, 30 to 60 percent, 60 to 90 percent, and over 90 percent.

And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The Problems With the Ratio

One major problem with the ratio is that people misunderstand it, as Shiller explains.  Many people think that a ratio of over 100% means the country is insolvent or bankrupt.  That’s false and a fallacy.  Many mainstream economists claim to be uncomfortable with ratios of over 90%, but that’s purely an arbitrary pick that reflects ideology more than economic experience.  Japan, for example, has been running a ratio of well over 200% for a decade with no signs of default.  In fact, investors think the Japanese government and economy are solid enough that the Japanese government borrows money at the lowest interest rates in the world.

Another very serious problem with the ratio is that when the ratio goes up, people assume it is because of deficit spending and borrowing.  In reality, most times when ratios go up it is because a recession or austerity program has shrunken the size of the economy and GDP.  For example, since 2007 the U.S ratio has gone up a lot.  But most of the increase has been because of the decline in GDP, not because of the stimulus spending program.

Finally, the last problem with measure is the very idea that it measures likelihood of default.  The empirical data on the relationship is weak.  Most importantly, default really happens when the debt-to-GDP ratio goes up AND the country borrows in somebody else’s currency (like small developing nations) AND the country has either fixed exchange rates or a gold standard.  These conditions apply to those nations that are part of the Eurozone – the countries that use the Euro as their currency.  These conditions also apply to many smaller developing nations.  These conditions absolutely DO NOT APPLY to large developed nations with their own currencies such as the U.S., U.K., Canada, Japan, Australia, Switzerland, and many others.

So, overall, the ratio is actually a pretty poor measure.  It’s useful in some esoteric technical econometric studies, but as a guide to whether the nation should cutting spending or not, it’s a horrible measure.

For the reader who is curious, data comparing different countries debt-to-GDP ratios can be had from the CIA Factbook here. offers some graphics comparing these concepts for the U.S. historically:

There are different ways of measuring US National debt.

Firstly, there is the actual value of debt. This shows that (even adjusted for inflation) the value of debt has increased significantly over the years

  • In 1900, US debt was $43.6bn (2005 prices)
  • In 1945, US debt was $2347.41 bn (2005 prices)
  • In 2010, US debt was $12032.28 bn (2005 prices)

Though there were a few periods in the 1920s, 1950s and 1960s when the real value of debt was actually being reduced.

gross debt / public debt

from: wikipedia US Debt

The Public debt is the US debt held by private sector.
Gross debt includes debt that the government holds itself.


We Have A Debt-Ceiling Deal. The Economy Loses.

Earlier this week the absurd and totally unnecessary debate in Washington over raising the national debt-ceiling came to an agreement, both houses of Congress passed it, and the President signed it.  Earlier this week I gave this metaphor for the deal, wondering why we need enemies with “friends” like our representatives in Washington.  Now that I’ve had a little more time to reflect, read some more on the details, comment on radio & TV about it, I think I was too easy on it.  It’s worse than it first appears.

This deal doesn’t “guarantee” that the U.S. government will reduce it’s deficit and maintain “solvency” (a non-concept for a sovereign country with a central bank).  Instead, this deal is more likely to guarantee that our economic non-recovery does, indeed, become at least a lost decade, if not a depression.  Right now I want to look at the economic impact of the deal.  In another post I’ll look at another casualty of the deal and the probably political-economy impact.

So what does the deal do specifically?  Well the details are fairly complex, even by Washington standards.  Right now the debt ceiling rises by $400 billion – enough to last for probably 3-4 months.  No real cuts will happen for maybe 60 more days.  Then starting in October 2011, which is the start of the government’s fiscal year 2012 budget (see here for definition of fiscal year), the action begins. Caps on spending start.  There are no tax or revenue changes in the deal.  It starts modestly with only $21 billion in spending cuts in 2012, although many of those cuts will be felt painfully by many citizens.  Students in graduate school in particular will feel the pinch in their pocket. Then in the remaining 9 years of the deal, there will be at least another $896 billion in reduced spending, amounting to about $100 billion less spending per year than currently planned.

This total of $917 billion in reduced spending is only the start though.  Congress is going to appoint a “special joint committee” of 12 members to recommend and additional $1.2-1.5 trillion in either spending cuts or tax revenue increases over the next 10 years.  (if you believe that committee with half Republicans will allow any revenue increases, I have a bridge in Brooklyn for sale).  If Congress doesn’t adopt those cuts, then Medicare payments, defense spending, and other discretionary spending would automatically by cut across the board. Either way spending gets cut another $1.2 trillion for the years 2013-2022.

This deal is supposed to raise the debt ceiling enough to get us through the end  of 2012 and the presidential election before the debt ceiling has to be raised again, sparing us this debate.  Don’t bet the your house on that though because House Republicans are betting they can keep this debate alive through then.  Basically Congress has created an elaborate mechanism in this law that increases the debt ceiling in several steps between now and the end of 2012.  But the way it’s done is that the debt ceiling keeps going up unless Congress votes to stop it (which the President would then veto).  It’s  a way for Republicans to keep talking about the debt and deficit, to keep recording “votes” against it, but all the time knowing that the debt ceiling will rise because it has to.  Pure politics at the expense of the country.

Right now the economy has over 9% unemployment.  Inflation is so low that deflation is actually the threat. The economy has effectively stalled or at least reached “stall speed”, threatening another double-dip recession.  This is not the time to be cutting spending.  To the degree spending cuts are necessary, they should happen when the economy is at or nearing full employment, not now.  At this time the economy needs all the spending it can find whether it’s from consumers, firms, or government.  And right now, firms and consumers are pulling back and keeping their wallets closed.  The government needs to step up and fill the gap.

So bottom-line, what should we expect?  I’ve seen several estimates from folks with more sophisticated econometric models than I can access.  My own back-of-the-envelope calculations and intuition say the drag on the economy is significant.  In 2012, this deal is probably going to take up to another 0.4 percentage points off of GDP growth.  The real damage starts in 2013 with a reduction closer to 1%.  Remember we’ve only grown at 0.8% rate so far in the first half of 2011, so 2012 will be close to zero growth and 2013 will likely be negative unless some other source of growth and spending can be found.  Looking around, it’s hard to imagine where that could be.  Instead I see nothing but possible negative risks: Europe imploding in a currency and austerity crisis, China having to pull back to slow their inflation, the housing mess in the U.S. is still bad, U.S. banks aren’t as healthy as they claim.

The estimates I’ve seen are similar.  Economic Policy Institute says the debt ceiling deal with cost us 1.8 million jobs in 2012 alone. The same article reports:

Top economists and CEO’s have also weighed in against the deal and said that GOP concessions to the Tea Party will cost our economy dearly. Pimco CEO Mohamed El-Erian warned that the deal will lead to less growth, more unemployment, and more inequality. Nobel Prize-winning economist Paul Krugman called the plan “a disaster” and “an abject surrender” that will “depress the economy even further.”

The Center for American Progress’s Michael Ettlinger and Michael Linden argue that while the deal “goes straight in the wrong direction,” Congress can redeem itself by using the so-called “super committee” mandated by the bill to focus on job creation. The committee, made up of six Republicans and six Democrats, is tasked with finding an additional $1.5 trillion of deficit reduction over the next 10 years, and must report a plan by Thanksgiving.

It’s noteworthy that J.P.Morgan Chase Bank’s research department, as representative of Wall Street as any, says that overall with this deal, government budget policy in 2012 subtract at least 1.5% points from GDP growth rate in 2012.  Since  it takes at least 2% growth in GDP to keep unemployment stable and we haven’t even had a single quarter of growth at more than a 4% rate since the end of 2006, things look grim for employment.

The cutters and austerians have won.  They will make a wasteland of the economy in the name of fighting the deficit.

There Is An Efffective Way to Reduce Government Deficit: Employment. But They Won’t Take That Route.

In the whole crazy, unnecessary debate over raising the debt-ceiling law, politicians, reporters, and commentators all spoke as if there were only two ways to reduce the government deficits.  Nearly everyone took it as an article of “serious thinking” that to reduce a deficit requires either reducing spending or increasing taxes.  But rather than being evidence of “serious thinking”, such talk is evidence of sloppy, imprecise, and ignorant thinking.  Such talk totally ignores the role of economic growth in determining government budgets and it ignores the role of the government in the economy.  It’s evidence of the government-as-household fallacy, the idea that government is just like a big household and subject to the same constraints as you and I.

There is a way to balance the budget that doesn’t require cutting major spending programs.  And it doesn’t require big tax increases.  It’s called economic growth and putting people back to work.  The major cause of the deficit is because we have very high unemployment.  We have over 9% reported unemployment.  That number rises to approximately 16% if we count all the people working part-time jobs but that desperately want full-time work and more hours.  And finally, both numbers totally ignore the fact that since we fell into this depression in 2007 well over 5% of adult Americans have chosen to drop out of the labor force altogether for now.  If we put those people back to work, they pay taxes. Government revenues will increase even without a tax rate increase.  If we put those people back to work, then government spending on unemployment compensation, Medicaid, welfare, and a host of other safety net programs goes down.  Automatically. Without cutting any programs or harming anyone.

This idea that economic growth and full employment will reduce deficits isn’t some theoretical possibility that only exists in the models of some economists.  We’ve done it before.  Other countries have done it.  In fact, everytime the U.S. has reduced it’s deficit it’s been by increasing employment.  The route to a small deficit or even a balanced budget lies in achieving full employment first, not in contrived artificial balanced budget amendments.

It wasn’t until the debt-ceiling debate was practically finished (for now – it will be back like zombie or vampire) that any in the media took notice that growth and employment is the key.  Last Sunday, July 31, as the President and the Republican Speaker announced their deal to cut spending and raise the debt ceiling, the New York Times finally runs a decent article about how growth is the real answer (bold emphases are mine):

 We wouldn’t need any of that [reduce spending, raise taxes, inflation, or default] if we could restore economic growth. If that happened, Americans would become richer and pay more taxes. Et voilà! — we’d pay down the debt painlessly.

Crazy as that might sound, particularly given Friday’s figures, the possibility isn’t some economic equivalent of that nice big farm where your childhood dog Skip was sent to run free. There are precedents.

Before its economy crashed, Ireland was a star of this sort of debt reduction. In the 1980s, Ireland’s debt dwarfed its economy. Over the next two decades, though, that debt shrank to about a quarter of gross domestic product, largely because the economy went gangbusters.

“Ireland went from being, you know, the emerging market in a European context, to a very dynamic economy,” says Carmen Reinhart, a senior fellow at the Peterson Institute for International Economics and co-author of “This Time Is Different,” a history of debt crises.

The United States has done the same in the past, too. After World War II, gross federal debt reached 122 percent of G.D.P., the highest ratio on record. But over the next 40 years, it fell to about 33 percent. That wasn’t because some blue-ribbon panel prescribed austerity; it was because the American economy became much, much richer.

The same happened during the prosperous 1990s, which began with deficits and ended with surpluses. Former President Bill Clinton is often credited for that turnabout, as he engineered higher tax rates. But most economists attribute the surplus years primarily to extraordinarily rapid growth.

It would be lovely to repeat that experience today, and send our federal debt off to that farm with Skip…

Usually after a recession, growth snaps back quickly and the economy makes up for ground lost — and then some. That’s not the case this time, at least so far. In the 60 years before the Great Recession, the economy expanded at an average annual rate of 3.5 percent. In the second quarter of this year, it grew at less than half of that pace, putting us further and further behind where we would be if the economy were functioning normally.

Unfortunately the article still tries to give the reader the impression that growth/full employment is difficult or unlikely this time.  It tries to give the impression that the growth during the Clinton years was somehow extraordinarily fast.  It was only fast by comparison with either the Bush I, Bush II or the first Reagan terms.  In fact, the growth during the Clinton years was only average at best when compared to what was achieved routinely during 1950-1973 or even during the Carter years.  The article also falsely claims that our “aging population” will require unusually large demands on government resources.  In fact the demands of the aging baby boomers on either Social Security or Medicare aren’t any greater than the resources we devoted to educating those baby boomers in the 1950’s and 1960’s.

Nonetheless, the point of the article is right on:  growth and growth in employment is the way to go if you’re worried about the deficit & debt (which I’m not, but that’s another issue).  The deficit we have is a jobs deficit, not a fiscal or budget deficit.  That’s what we need to worry about.

Washington and the chattering political classes have it wrong.  Their “serious” talk is anything but.