Gross distortions. Did that introduction get your attention? Now a few numbers to keep you interested. One, US debt was $13.4 trillion (R92.4 trillion) last year. Two, that was equal to roughly 92 percent of its annual gross domestic product (GDP). Three, the US is drowning in debt. Four, an economic truism: left unchecked, this debt threatens long-term growth.
My lead paragraph is formulaic. It resembles thousands of articles during the recent US debt drama. Change the country name and the exact figures and you’ve got a piece on Ireland, Portugal, Greece, Spain or Italy. We all read these articles, but very few of us think critically about them.
US gross debt was $13.4 trillion in 2010. If you subtract financial assets from this number, net debt shrinks by nearly 30 percent to $9.5 trillion. That’s 65 percent of GDP, psychologically more palatable. Is the US drowning in debt or swimming in it?
Gross debt was equal to 92 percent of GDP in 2010. Economists arrive at GDP by annualising quarterly GDP data, multiplying quarterly GDP data by four. As Yale University economist Robert Shiller points out, economists could just as easily decadalise GDP, multiplying quarterly GDP numbers by 40 instead of four. Do this, and gross debt was merely 9 percent of GDP. Net debt was 6 percent of GDP, hardly frightening. Do we expect the US to pay off its debt in a year? No, so why use an annual denominator to report a debt to GDP ratio?
High long-term debt threatens to slow economic growth, probably true. A widely cited study by the Peterson Institute’s Carmen Reinhart and Harvard economist Kenneth Rogoff found that when gross debt exceeded 90 percent of GDP in the 44 countries they studied, median growth rates fell by 1 percentage point annually.
A tax increase equivalent to 1 percent of a nation’s economic output can also reduce GDP by 1 percentage point after about 18 months. A reduction in spending of the same magnitude can reduce GDP by 1.5 percentage points.
Raising taxes and cutting spending is what leaders are doing to reduce debt, and it’s our fault. Governments are draining money from the economy at the wrong moment because we are demanding it. Investors are overreacting to debt ratios.
The same credit rating agencies that missed the boat on the subprime meltdown and other “experts” tell us that sovereign debt levels are too high. We believe them, we panic and put pressure on politicians. The politicians “fix” the problem. Debt is reduced, but they make a mess of it.
Take the US as an example. Legislators became focused on debt reduction and lost sight of the alarmingly high unemployment, anaemic consumer spending and awful manufacturing data. As Harvard economist Martin Feldstein says, the US economy is still “balanced on the edge”. Hope of further fiscal stimulus from the US is off the table. Was capping expenditures and pledging $2.4 trillion in cuts over 10 years a good idea? I’ll let you be the judge.
In 1929 the American economy fell off a cliff. In 1932 it hit rock bottom. GDP fell by a staggering 13 percent. The following year, things began to improve and growth continued through 1936. Concerned about record deficits, the government cut spending and raised taxes. The result: by 1938 the US was back in recession. Sound familiar?
Circumstances are not exactly the same, but similar. As we get bombarded with economic news, take a deep breath. Think about what it means and not overreact the way we have with sovereign debt.
Matt Quigley is a former divisional director at the US Treasury’s Office of the Comptroller of the Currency and a fiscal policy analyst at the Federal Reserve Bank of Boston. He now runs an import and distribution business in Cape Town
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