5 Things You Must Know About Our National Debt
Business + Economy

5 Things You Must Know About Our National Debt


House Republicans are certain that the national debt has grown large enough to crush the U.S. economy, so they passed a budget that slices away much of what they see as a bloated Federal budget.

President Obama and many Democrats disagree with the GOP view. They claim that the debt needs to be stabilized at its current level, so that it doesn’t consume an ever-larger share of Gross Domestic Product. That belief is expected to be reinforced by the White House budget that will be unveiled on April 10.

This simple philosophical difference will be a source of gridlock on the budget for much of the year. But when it comes to hard data on who is right and wrong, our policymakers are flying blind. Several theories abound, but there is no consensus on the exact point at which a government’s debt suffocates a private economy. All we do know is that the greater the debt, the closer we are to some danger. And because budgets are submitted with ten-year horizons, what happens through 2023 might test just how dangerous the United States is willing to be. 

Federal Reserve Chairman Ben Bernanke favors putting in a long-term plan to mop up the government’s red ink, yet even he acknowledged during a 2010 speech that it’s not clear when a country goes from treading through red ink to drowning in it.

“Neither experience nor economic theory clearly indicates the threshold at which government debt begins to endanger prosperity and economic stability,” Bernanke said.

With that in mind, here is what you need to know when thinking about the upcoming political slugfest:

• Our National Debt Is High Relative to the Past – Not a surprise. The government racked up huge annual deficits in recent years to stop the 2008 financial crisis from becoming the sequel to the Great Depression. The amount of debt held by the public is equal to about 76 percent of GDP, according to the Congressional Budget Office. This is almost double the historic ratio of 39 percent. House Budget Chairman Paul Ryan (R-Wisc.) claims his proposal would reduce the current debt-to-GDP ratio to 54.8 percent in 2023.

• Why 80 Percent Isn’t the Tipping Point – Morgan Stanley’s David Greenlaw and two other economists issued a study in February indicating that a debt-to-GDP ratio of 80 percent puts the country on the path of a downward spiral.

Not necessarily. The case study holds true for Greece, but that country couldn’t inflate its way out of the problem by printing its own money. The United States can in theory run the printing presses at full speed, so it might have a safety valve that the Greeks did not with the euro. Inflation is generally regarded as a negative—except when governments use it to manage out-of-control debt.  Like everything in economics, there are tradeoffs to this strategy—prices for food and gasoline surge, ostensibly making much of the country that is already struggling even worse off.

Then there is the question about interest rates. If the markets are really efficient, they should start selling off bonds the second that 80 percent threshold is crossed, causing interest rates to skyrocket in a way that slows down growth. But, of course, markets don’t always behave as predicted.
• Why 90 Percent Might Not Be the Tipping Point, Either – The economists Carmen Reinhart and Ken Rogoff recently examined eight centuries’ worth of countries going bankrupt. Their research suggests that a debt-to-GDP ratio of 90 percent is when the panic button should be hit. Paul Ryan has cited this finding in previous budget plans.

Decent rule of thumb. Maybe it’s accurate. Laura D’Andrea Tyson, an economist who has advised both Bill Clinton and President Obama, has a bone to pick with their research. It confuses “correlation and causality,” she said at the annual conference of the National Association of Business Economics last month.

In other words, the research doesn’t show whether the debt caused the slow economy, or whether the slow economy caused the debt. This is a key nuance. In a normal economy, high government debt can crowd out private investment in a normal economy. But when an economy is in free fall—think about the start of 2009—tax revenues plummet as government spending increases, causing the government to cope with a financial shortfall.

Trying to lower the debt-to-GDP ratio without thinking about broader economic growth can be a disaster, as seen in the United Kingdom where austerity has not sutured the annual deficits as promised.  In that case, what is needed is actually more economic growth to ultimately tame the debt. And this is the haunting part of this possibility—if the United States cannot restore a stronger level of growth, a day of reckoning with our bondholders might be inevitable.

• Who Holds the Debt Matters – The identity of your bondholders often determines how much debt is acceptable. Are they cautious savers? Are they huge investment funds looking for a quick buck? Their background dictates their expectations.

Japan tends to spoil most theories about dangerous debt loads. It has a debt-to-GDP ratio of more than 220 percent, yet the interest rate on its 10-year bond is slightly more than half of a percent point.

So what gives? Much of Japan’s debt is held domestically, explained Stanford University economist John Taylor, who has advised House Speaker John Boehner. Because the Japanese people own the huge debt, they’re more tolerant of maintaining a ratio that defies most economic theories.

In this case, the United States is different. Half of our debt is controlled by central banks, sovereign wealth funds, and foreigners. This is a much more volatile mix, so it’s unlikely that our national debt can ever climb to Japan-like extremes. “When governments are making decisions, it’s harder to predict what they will do,” Taylor said after appearing on an NABE conference panel.

• Your Elected Leaders Matter – Debt isn’t just a numbers game. Bondholders also need to have some confidence in the politicians. If their distrust of the president and Congress becomes too deep, they will sell the bonds and interest rates will rise.

D’Andrea Tyson noted that in Italy, a relatively “stable” debt-to-GDP ratio became unstable because of “who the leaders are.” For all their sniping, Obama and Boehner have yet to inspire this level of pessimism.

But they may want to take a lesson from former Italian Prime Minister Silvio Berlusconi – and refrain from any “bunga bunga” parties.