I'm back from vacation and I have some catching up to do on here, so two posts this weekend about the debt ceiling situation.
I wrote previously about the government debt ceiling, spending most of that post detailing the history of the (under-followed) debt/GDP ratio. That wasn’t the plan when I started the post. I wanted to do two things in that post, and I promise I’ll do them here. I kept this on the back burner until the debt ceiling finally started to appear in the news.
First, I wanted to detail the absurdity of using an arbitrary increase over the current level as a debt ceiling versus indexing the measure to growth, which the debt/GDP ratio does.
Think of it this way. $14 trillion in debt is perfectly acceptable if you have a GDP of $140T (debt/GDP = 10%), however that same $14T is a major problem if you have a GDP of $14T, like we have now (debt/GDP = 100%). Said another way, as long as GDP is much larger than debt, or GDP is growing faster than debt if they’re roughly equal, you’re in good shape.
I mentioned in my last post that 90% debt/GDP is the key level to stay under, and once you go above that, trouble can follow. That wasn’t just a random number. My source is a paper called "Growth in a Time of Debt" by Carmen Reinhart and Kenneth Rogoff. It can be found here. I share their view that wartime spikes in debt/GDP are acceptable because they often unwind quickly once the war ends (and because, many times, going to war is about survival, and if you lose, it doesn’t matter if your debt/GDP is 10% or 1,000% because you’re dead and/or conquered). I also agree that peacetime spikes in debt/GDP are more dangerous because they are harder to unwind and often accompany some sort of domestic angst.
At face value, this makes perfect sense. Debt brings with it servicing costs (aka interest). With debt, you’re taking money that could be spent on investment or consumption and you’re using it to service debt by paying interest costs. Too much debt will strangle a person, business, or a government. Investment spending is ideal. Here’s an example.
If you borrow at a 5% annual rate and make a 15% annual return on investment, your net ROI is 10% (15% AROI – 5% annual borrowing rate; assuming no inflation, taxes, or other costs – simple example here). That’s a reasonable investment case. However, if you borrow at 5% for consumption, you’re probably going to get an AROI of zero, so your net ROI is actually -5%. Obviously, we can’t invest everything because we need to consume to live.
This makes the perfect transition to the second thing I wanted to do, which is to spend more time talking about how government finance isn’t so different than personal or business finance (except for the fact that governments can print money and inflate their way out of debt, but that's a sad story for another time).
At its most basic, finance is very simple. If you bring in more money than you put out, you’re fine, and if you spend more than you earn, you’re going to have trouble eventually. Simply put, live within your means. Whether you’re a government or a business or an individual, just do that and you’re all set.
This line of thought could make someone say they never want debt, to which is I say, “Not so fast, my friend.” As I showed above, there is good debt and bad debt. I generally view good debt as something that either makes money (investment) or ensures survival (war debt or healthcare) for you and your family. Consumption is a little bit of a gray area. A reasonable level of consumption is necessary to ensure survival and happiness. Besides, you can’t take the money with you when you die. However, excess consumption is also dangerous. It’s a balancing act, but everyone’s got to live within their means and find what works for them while ensuring financial viability.
This is not always easy to do in a society that still places great emphasis on the appearance of wealth, whether it’s real or not. Progress is what counts, not the illusion of progress.
Let me leave you with this last bridge between government finance and personal/business finance. This will be a bit back-of-the-envelope, but instructive nevertheless.
$14T in debt with approximately 300 million Americans translates to over $45,000 per person. But, wait, there’s more. Just like a bad infomercial. That’s per person, not per labor force participant. The American workforce is roughly 150 million, so we half the number of people involved and subsequently double that debt to over $90,000 per labor force participant.
Labor force participants include employed and unemployed people. We’re at about 10% U3 unemployment, the official headline number (yes, I know it’s a bit lower, but I’m keeping the math simple, and yes, when I refer to unemployment, I usually use U6, which is currently around 17% and it includes those who want full-time work and can only find part-time work, but U3 is more appropriate here). So, we decrease the 150 million by 10%, taking it down to 135 million. So, $14T in debt divided by 135 million is just over $100,000.
Yes, this means that every working American today, in effect, has $100,000 of extra debt. Again, this excludes state and local level debt, so depending on what kind of shape your town and state are in, it could be a little higher or a lot higher. Ouch.
Links:
http://www.aeaweb.org/aea/conference/program/retrieve.php?pdfid=460
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