Debt in the US

I think the US debt picture deserves a bit more discussion because it can be a bit confusing but it is incredibly important to understand to avoid macro-policy mistakes (mistakes that we and many other developed countries have been making for the past several years).

First, it’s important to understand all of the different measures of debt:

The debt to GDP ratio measures a country’s absolute gross debt (for the US, that would be the total number of dollars the US owes its creditors; both domestic and foreign) as a percentage of that country’s GDP. Because the debt-to-GDP measure is a ratio, the final value of debt-to-GDP depends on both the numerator (total level of debt) and the denominator (GDP).

Debt-to-GDP is the primary US debt figure cited by the media–right now, debt-to-GDP in the US is roughly 100%; meaning that the gross debt held by US creditors is roughly equal to US GDP. I am not quite sure why debt-to-GDP is such a popular statistic, but it probably has to do with the fact that two prominent economists (Reinhart and Rogoff) came out with a study in 2010 demonstrating an empirical correlation between debt-to-GDP ratios over 90% and slower growth.

Of course, this factoid was jumped on by proponents of austerity, arguing that because the US debt-to-GDP has now exceeded 90%, the US needs to cut spending now Now NOW or else our growth will slow! However, the old saying “correlation isn’t causation” applies to the Reinhart and Rogoff study. Think about a recession–even if a country’s debt level remains unchanged, in a recession a country’s GDP shrinks, meaning, by definition, that same country’s debt-to-GDP ratio grows. For a concrete example, liquidity problems in the US banking sector (sparked by a decline in housing prices) led to a global financial crisis and a severe recession in the US. As a result, the US debt-to-GDP ratio grew rapidly from 2008 on because the US GDP declined and US budget deficits rose as tax revenue collapsed and automatic stabilizer spending (Medicaid and unemployment) rose. However, to argue that a high US debt-to-GDP ratio caused the 2008 recession would be absurd; it completely reverses the causality!

Presumably, the mechanism by which high debt-to-GDP levels would slow growth would involve a rise in interest rates–because of the higher interest rates, government borrowing would crowd out private sector borrowing that could be used more productively (for investment, say, rather than paying interest on debt to foreign creditors), leading to slower growth over time. However, if you look at interest rates on countries with their own currencies, it turns out that they have no relationship with debt-to-GDP levels.

So if debt-to-GDP doesn’t actually mean anything for interest rates or GDP growth, why is it important? Well, for one, it is a useful way of comparing the relative debt levels of countries. Beyond that, however, I’m not sure why it gets so much attention in the media (beyond the flawed Reinhart-Rogoff argument).

I think a better indicator of a country’s fiscal health might be net interest payments as a percent of GDP. This measure takes into account both the overall level of debt for a country (which will increase interest payments) as well as interest rates, which are a very important (really, the only) indicator of how financial markets view the safety of a country’s sovereign debt. As you can see in the link, net US interest payments as a % of GDP are at their lowest level in decades, in spite of a high debt-to-GDP ratio, primarily because interest rates in the US are extremely low (real interest rates on Treasury Inflation Protected Securities are negative).

Ok, so why are interest rates in the US so low? Many people seem to have jumped to the conclusion that this is because the Federal Reserve is artificially lowering US interest rates. However, that argument is completely flawed for multiple reasons (Krugman does the intellectual garbage cleanup): first, long-term interest rates have moved very similarly (to low levels) across a wide range of countries with varied monetary policy. The US, Germany, England, and Japan all have extremely low interest rates, but not all of them have had central banks pursuing quantitative easing as aggressively as the US Federal Reserve. Second, if the Fed is artificially holding rates down, interest rates should have spiked when the Fed ended QE2 in June of 2011; they didn’t, and many investors (cough Bill Gross cough) lost a fair bit of money. Last, economic theory predicts that if Central Banks keep interest rates below the ‘natural rate’ of interest, the economy overheats and inflation rises. Seeing as how inflation projections have been on the low side of 2% recently, this is clearly not the case.

If interest rates aren’t low because of artificial interventions from the Federal Reserve, what is keeping them so low? Basically, interest rates are low because of weak expectations for growth in the US and financial instability in key areas like the Eurozone (which causes investors to seek safe financial assets; namely US Treasuries). (I’ll follow up with another post explaining in more detail why low growth expectations lead to low interest rates). However, this has key implications for fiscal policy–basically, interest rates are low enough that our net interest as a % of GDP is at its lowest level in decades, and weak growth expectations imply that interest rates won’t rise anytime soon. So, rather than be wary of (nonexistent) inflation or (nonexistent) threats to growth from an elevated debt-to-GDP level, the US should be taking advantage of its historically low interest burden to finance infrastructure investment (negative interest rates=FREE MONEY). We know we will need to finance the investment at some point, why not lock in free money while we can, invest in our infrastructure, and raise growth expectations (by avoiding harmful fiscal policy like sequestration) so that savers can earn a little more money on interest in the bank!


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