A Primer For The Debt Crisis

markets-blog480By George Noga


In prior blog posts I may have overwhelmed readers with numbers pertaining to the debt crisis. Some therefore have suggested I write a primer; this is it.

We begin by distinguishing between the public debt and the total debt. The public debt now stands at $11.3 trillion. To this must be added the intra-government debt of $4.8 trillion which results in the total national debt of $16.1 trillion. This leads to the first two (out of eight) important primer points.

1. Only the public debt matters; the total debt is not germane.
2. The amount of debt is relevant only in relation to GDP.

Intra-government debt is strictly notional, i.e. nominal or theoretical. It is like writing an IOU to yourself. It consists mostly of Social Security debt of $2.8 trillion along with debts to FHA and other agencies. It is not real debt to real people with real interest and never will be repaid; it will be retired via future budgets.

For example, the Social Security debt will be repaid through future budgets between now and when the bonds putatively are repaid – estimated to be in 2030. Therefore, the intra-governmental portion of the national debt is an internal government accounting entry and shouldn’t enter into a discussion about the debt except as a claim on future budgets.

*Many people use total debt to GDP (currently 103%) because they don’t know better or because they wish to make the debt seem even worse than it is.

Just as a family’s debt must be viewed in connection with its income, a government’s debt is relevant only in relation to its nation’s economy, i.e. GDP. Currently GDP is $15.6 trillion; hence, the ratio of public debt to GDP is now 72% ($11.3T/$15.6T). This ratio is critical because we have 600 years of economic history that informs us how much debt governments can carry without experiencing serious problems nearly always culminating in default.

History teaches government debt above 90% of GDP usually is lethal. Also, we must consider the structural nature (built-in as opposed to transitory) of the deficit including its trend.

3. When debt exceeds 90% of GDP, default becomes all but inevitable.

4. The structural nature of the deficit and its trend are both important.

You may hear the US debt/GDP ratio was 110% after WWII – the only time in history (until Obama) it exceeded 50%. This is intended to beguile you and to assuage you of your concerns about the current deficit.

However, the WWII deficit was transitory and not structural. The US borrowed heavily to finance WWII. War expenses ceased and we were the only country with an intact industrial base. Social Security was generating a huge surplus; Medicare and Medicaid didn’t exist; and public employees were pari passu with private sector ones. There was a baby boom and our demographics were favorable; productivity boomed; and budget deficits were unacceptable; hence, the deficit plunged. To expect a repeat is delusional.

Today the structural deficit is well over $1 trillion per year; entitlements are growing at quadruple the rate of the economy; public employees earn twice that of their private sector counterparts; demographics are singularly unfavorable; we are benefiting from historically low interest rates; and deficits have become politically acceptable. The US public debt/GDP ratio will exceed 90% by 2015, 100% by 2017 and 120% by 2020.

In 2010 I projected the ratio at 75.8% by the end of 2012; that forecast will be accurate within mere tenths of a percent!

5. The US public debt/GDP ratio will exceed 90% by 2015.

6. Foreigners own only a moderate share of US debt.

There is widespread public perception that China owns much of our debt; this simply is not true. China owns $1.2 trillion, or about 10%, and that share is shrinking. Japan also owns 10%; after that the next highest country owns only $0.26 trillion, or about 2%. Total foreign holdings of US sovereign debt are between 30% and 40%; the exact number is unknowable due to much of the debt being held in nominee names by major international banks.

Most Americans own a piece of the debt. Anyone who owns money market funds or mutual funds owns a share of the debt. Insurance contracts, mortgages and bank CDs are impacted. But all this pales in relation to how a default will impact the lives of every American for what will become a lost generation. We all have a huge stake in the outcome.

7. Every American will be severely impacted by the debt crisis.

8. There is no realistic escape; we are facing a lost generation.

With just the information in this primer you will know more than all but a tiny percentage of your countrymen. The next time you hear someone bloviate about the total debt to GDP ratio, you can set them straight by explaining why only the public portion of the debt matters. When someone prattles about China owning the USA, you can counter with the facts.

I must conclude on a decidedly down note. Ultimately there is no realistic escape from the US crisis of spending, debt and deficits. Escape theoretically remains possible but politically it is impossible. No administration (even one with Paul Ryan as VP) could survive reelection if it took the painful steps that are necessary.

The best we can hope for is that a new administration does the maximum politically possible, buys a few extra years and a near miracle happens. Metaphorically however Uncle Sam is hanging over a bottomless abyss clinging desperately to life by holding a tiny sapling and the soil is beginning to give way around the roots.

The debt crisis is not some uncertain, abstract and distant horror affecting only the well-off; it is all but certain, real, imminent and affects us all. It will be the defining event in the lives of those who are fated to live through it. Alas, much of Europe, along with several major U.S. states and cities, also are going under. Bummer!

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