Government Debt – How Much Is Too Much?
January 23, 2012
Economists and policy makers like simple nostrums. Popularised by Economists Carmen Reinhart and Kenneth Rogoff, the unsustainability of a sovereign debt level above 60-90% of a country’s Gross Domestic Product (“GDP”) has become accepted wisdom.
But government or corporate debt rarely ever gets repaid. The real question is whether that debt can be serviced and investor confidence maintained to allow it to be refinanced.
The level of tolerable sovereign debt depends on a multitude of factors.
One factor is the currency of that debt. Where it borrows in its own currency, a sovereign’s capacity to borrow is only constrained by the willingness of investors to purchase its securities and the cost of that borrowing.
Where the borrowing currency is also a major reserve currency, used in global trade or favoured as an investment by central banks, the scope for borrowing is commensurately higher. The combination of these factors has enabled the USA to continue to borrow large amounts to finance its budget and trade deficits.
The inability to print money to service debt has been a significant issue in shaping the European debt crisis.
Where a country has a large domestic saving pool, like Japan, the ability of the government to finance its expenditure is significantly enhanced. A country reliant on foreign investors for its funding is far more restricted, limiting its debt levels.
A significant portion of government debt of weaker European states is held by foreign investors –Greece (91%), Ireland (61%), Portugal (53%) and Italy (51%). For some stronger nations, the level of foreign ownership is also high – Belgium (58%), France (50%) and Germany (41%). In contrast, only 28% of Spanish debt is held by foreign investors. Most of this debt is held within the Euro-Zone as the average holding of government debt outside the area is 25%.
The portion of government debt of other large economies held by foreign investors is lower – US (30%), UK (19%) and Japan (15%).
Significantly, when the net external liabilities of the economy (external liabilities adjustment for foreign assets) is considered, only Japan, Germany and Belgium are owed more by foreigners than they owe externally. All others have a net external liability. Interestingly, Spain’s relatively low level of foreign ownership of government debt is replaced by net external liabilities equivalent to 88% of GDP reflecting high levels of overseas borrowing by Spanish financial institutions and businesses.
The level of interest rates also determines the level of acceptable debt. Higher interest rates and the resultant larger claims on public revenues to service the borrowing limit the level of debt. Extremely low interest rates, such as those in Japan and more recently in the USA and Europe, enable higher level of borrowing.
A further consideration is the maturity structure of the debt. Short term debt increases vulnerability to market disruptions, limiting the level of borrowing. Conversely, longer maturities and low concentration of maturing debt in an individual period can increase debt capacity. The inability to re-finance maturing debts was a crucial catalyst in the European debt problems.
Sustainable debt levels also depend on the size and economic structure of the country. A large, varied economy with a substantial potential tax base can sustain far more debt than a narrowly based and tax revenue poor country. Peripheral European economies, such as Greece, Portugal and Ireland, are heavily dependent on few industries and also a limited tax base.
But perhaps the most important determinant is the level of current and expected economic growth. A dynamic economy capable of high levels of growth, with the attendant ability to generate additional tax revenues and attractive investment, can maintain a higher level of debt than one with lower growth prospects.
While not exact, the sustainable level of debt can be approximated by another formulation, which links the existing level of public debt (% of Gross Domestic Product (“GDP”)), the current budget position (% of Gross Domestic Product (“GDP”)), interest rates and growth rates:
Changes In Government Debt = Budget Deficit + [(Interest Rate – GDP Growth) times Debt]
Italy illustrates the relationship between debt levels and GDP growth. Assuming borrowing costs of 4% and a debt to GDP ratio of 120%, Italy needs to grow at 4.8% just to avoid increasing its debt burden where it budget is balanced. At current market borrowing costs of 6%, Italy has to grow at an unlikely 7.2% just to avoid increases in its debt levels.
Like most of Europe, Italy is projected to have anaemic growth of 1-2 %. Its current borrowing costs are elevated (around 6%) although its overall borrowing costs are lower as the bulk of its debt is at lower rates. This means that Italy must reduce its debt levels significantly to avoid the risk of insolvency.
Assuming interest costs of 4% and growth of 2%, Italy would have to run a budget surplus of 5% per annum for 10 years to reduce its debt to 90% of GDP. Alternatively, it must sell state assets to reduce its debt. Such sharp contraction in net government spending would reduce growth significantly in the absence of other helpful circumstances.
The relationship illustrates the problem facing many governments currently. A toxic cocktail of high levels of existing debt, large and seemingly irreversible structural budget deficits, low growth rates and high borrowing costs makes the position of many countries unsustainable. Europe’s beleaguered economies have to run a budget surplus (through spending cuts and tax increases), grow at very high rates, decrease its borrowing costs or combination of these to merely stabilise its debt.
The US is not immune from these problems. Assuming average borrowing costs of 3% and a debt to GDP ratio of around 100%, America needs to grow at 3.0% just to avoid increasing its debt burden where its budget is balanced. To the extent that growth levels are lower than the interest cost, it needs to offset the difference by running equivalent budget surpluses in order to keep its debt from increasing further.
The status of the US dollar as reserve and major trade currency, the ability of the Fed to print dollars and the flight to quality has allowed the US to avoid too much scrutiny of its own debt problems, at least for the moment. But the relationship highlights the vulnerability of heavily indebted economies. A combination of intractable, corrosive budget deficits, low growth rates and increased pressure on borrowing costs, as a result of investor concern of its creditworthiness, can result in a rapid slide into a debt crisis.
Following the global financial crisis, governments expanded their borrowing, replacing the private sector, especially consumer, debt, in a heroic bet to engineer a recovery. The increase in government debt will prove unsustainable if growth does not return quickly to high levels, driving a new phase of the global financial crisis.
Note: A shorter version was published in the FT previously.
© 2012 Satyajit Das All Rights Reserved.
Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (2011)