With markets and news headlines reacting daily to the drama that is the European sovereign debt crisis, economic observers are emboldened in their claim that high government debt levels ultimately lead to disastrous outcomes (at least if you are a European Monetary Union member country without your own printing press). As investors, should we be concerned? What specifically makes high government debt-to-GDP bad? How much is “too much”? Does it matter who owns the debt? In this issue, we will review the basic economics of government debt financing to gain perspective on the consequences of high government debt levels.
Government Debt Levels
In 2010, economists Carmen Reinhart and Kenneth Rogoff found that growth rates for countries display a strong negative relationship once their government debt-to-GDP ratios exceed 90%; below 90%, there seems to be little relationship between government debt and future growth.1 As Table 1 shows, many countries are near or at the “danger threshold” now. Unsurprisingly, Greece, Ireland, Italy, and Portugal are in that category. But Germany and France, which anchor the European Monetary Union, are dangerously close to the threshold and, in fact, exhibit higher debt-to-GDP ratios than Spain. Japan, which has been the poster child for government deficit spending, has a 233% debt-to-GDP ratio. The United States and the United Kingdom, where government debt has dominated the political discussion, are at 100% and 81% respectively. We will not address issues related to the crowding out of the private sector by the government sector in this issue of Fundamentals.
Government debt is what a country’s government owes to domestic and foreign creditors.2 The net foreign debt is the amount of debt the country owes to foreigners, netting out foreign assets, such as foreign securities held by its central bank, public and corporate pension schemes, and mutual funds.3 Net foreign debt is often ignored in sovereign debt discussions, which is unfortunate as who owns the debt is an important factor in understanding the costs of indebtedness.
Let’s examine how countries stack up along these two debt dimensions. Within GIIPS, Italy appears to have a significantly less onerous net foreign debt (at 24% of GDP) than might be suggested by its 121% government debt-to-GDP ratio. This fact suggests that the Italian private sector has been far more financially prudent and, as a result, has accumulated net foreign assets totaling nearly 100% of GDP. Similarly, the private sector holdings of foreign assets in the United Kingdom, France, Canada, and the United States very significantly offset the government indebtedness. Surprisingly, despite the frightful U.S. debt clock’s constant reminder that each U.S. citizen is on the hook for more than $48,000 of government debt, much of that is actually money that one household owes to another.
The much touted Japanese household frugality combined with the country’s decades of trade surpluses has resulted in a net foreign investment of 56%; in effect, the Japanese private sector owns 233% of GDP in Japanese government bonds plus 56% of GDP in foreign assets. Similarly, the German private sector savings absorbs the equivalent of its government debt while owning 37% of GDP in foreign assets. Other examples include Singapore and Belgium, both of which register government debt-to-GDP ratios near 100% with net foreign investment of 224% and 45%, respectively.
Digging into the Numbers: American Domestic Debt
On the surface, U.S. government debt equal to 100% of GDP is a cause for concern. Looking closer, we see the U.S. government owes 83% of its debt to Americans and 17% to foreigners (see Table 1). Stated this way, the government debt is somewhat less intimidating. What do these numbers really mean? Let’s dig a bit deeper.
Ultimately, U.S. government debt must be paid for by future tax revenues (and thus by future American taxpayers). For simplicity, let’s ignore the foreign debt for the time being. Using a naïve extrapolation, the current debt amounts to $114,000 owed by each future taxpayer to the American savers (domestic holders of U.S. Treasury bonds). This means future American “taxpayers” will consume less of future American GDP than they help produce. This translates into a “transfer” of about $12.5 trillion in consumption from future taxpayers to savers (future debt owners).
Loosely speaking, three parties split the American pie: (1) taxpayers, who convert after-tax labor income into consumption, (2) savers, who convert assets [i.e., withdraw bank deposits] into consumption, and (3) the government [and its service and welfare recipients]. For the government to consume more of today’s goods and services, either the taxpayers or the savers must consume less. Any government spending gap must be filled by raising taxes or issuing debt. When debt issuance is the funding source, savers must save more and consume less. When taxes are the funding source, taxpayers receive less after-tax income and consume less.
Let’s acknowledge that a key function of the U.S. government is to ensure that a certain amount of wealth transfer occurs to maintain an orderly society. Given that government expenditures must be funded, debt-financed spending is a “wealth transfer” from savers to taxpayers. In the future, as that debt is paid back through future tax revenues, the repayment becomes a “wealth transfer” from taxpayers back to savers. The substantial impact of the U.S. government debt today is in the reshuffling of the sharing in American production (GDP) between savers and taxpayers. If, on average, taxpayers are also savers, the net effect is zilch—that is, raising taxes and issuing more debt are largely equivalent! Under this equivalence, if you are opposed to issuing more government debt, you should also be opposed to more taxes and vice versa.
Many have lamented the inter-generational transfer effect of government debt. This effect is more nuanced than intuition might suggest, and the real impact is ultimately small.4 It is true that future generations of taxpayers lack the political power to impose strict debt ceilings on the government (because they do not yet have the right to vote). As a result, government deficit spending has been on a precipitous rise while tax rates have actually declined. Interestingly, this financing scheme leads to an increase in the wealth of the savers and a simultaneous increase in the consumption of the current taxpayers, while allowing the state to provide amply for the “have nots.” One can hardly argue that this is a calamitous outcome. However, the analysis changes substantially, once we consider foreign debt and the possibility for domestic debt to be exchanged for imported goods and to become foreign debt.
Digging into the Numbers: American Foreign Debt
Over the past 30 years, the United States has swung from net foreign investment of +13% to a net debt of 17%, as can be seen in Figure 1. This dramatic shift means the United States has borrowed from foreigners to boost consumption by nearly 1% per annum. While U.S. GDP grew at nearly 4% per annum during this period, U.S. consumption increased by 5% per annum. The additional consumption was made possible by borrowing consumption from the young Asian working middle class.
This situation, however, is likely not sustainable. As Asia’s asset-rich middle class begins to retire, they will begin to convert their savings in order to consume global goods, in effect, demanding the reversal of the trade surplus with the United States. The result could be a 1% headwind in consumption growth for Americans relative to GDP growth. U.S. GDP is already projected to slow from 4% to 3% due to aging demographics.5 The combined effect of a reversal of the trade surplus and retirement of the Baby Boomers could mean a decline in consumption growth from 5% to 2% annually over a nearly 20-year span, which would be traumatic. The 17% in net foreign debt, while not quite as breathtakingly bad as Greece’s 83%, is, nonetheless, no small matter. By comparison, Japan, with a net foreign investment of +56% can offset very significantly its unenviable demographics headwind.
Ultimately, it is the net foreign debt, built up from years of trade deficits, which actually ties future generations to the sins of our current excess consumption. We must understand the danger of high domestic debt in that context as well. American savers may decide to liquidate their savings to buffer their retirement consumption. Clearly, non-savers are in no position to be buyers of trillions of dollars in Treasury bonds or to give up the equivalent amount in consumption. Foreign buyers must come in to clear the trade (exporting more consumer goods to Americans in exchange for more U.S. debt), resulting in an increase in the U.S. net foreign debt. Even a partial conversion of the American investment portfolio into retirement consumption could easily take U.S. net foreign debt to well above 50% of GDP over the next 10 years.6 Future generations of Americans will have to share a much more significant portion of the GDP they produce with the Asians, resulting in an even more terrifying decline in future American consumption.
So, what are we to make of the government debt level, which stands at nearly 100% of GDP? The part that corresponds to foreign debt tells us how much of our future GDP we must share with foreigners. The larger our net foreign debt level is, the less of the fruit-of-their-own-labor our children will consume. Insofar that we have added 30% to our net foreign debt in the past 30 years, the Boomers and their government have indeed robbed future generations. There are reasons to believe that as Boomers retire, the trade deficit will accelerate and cause a continual deterioration of the U.S. net foreign debt.
The domestic component, which accounts for 83% of the government debt, carries a far more ambiguous interpretation. In the worst of situations, a substantial part of the domestic debt converts into foreign debt, which further erodes the future standard of living for Americans. In the best of situations, it forecasts how much future political and social bickering will result as savers and non-savers, taxpayers and non-taxpayers, and bankers and Occupy Wall-Streeters fight over their interpretation of the equitable sharing of the American pie—but then again, that’s almost always true regardless of the level of government debt.