What is a Debt to GDP Ratio and why does it matter?

How many of you know what the term “Debt to GDP ratio” means? That’s OK if you don’t because it is rarely discussed by politicians and the media. It’s simply the amount of financial debt or liabilities a country has divided by the sum total of all its economic activity, or Gross Domestic Product (GDP). A simple definition is the total of all U.S. Treasury securities the federal government has issued and outstanding, divided by all the income American individuals and corporations earn each year. This ratio is an important measure for determining the ability of a country to pay back what it borrows, and the higher it climbs, the higher the risk of default becomes. According to the World Bank, countries whose Debt to GDP ratio is greater than 77% for an extended time, experience stagnant economic growth as government borrowing crowds out private activities in the economy. At of the end of 2018, the official Debt ($22 trillion) to GDP ($20.9 trillion) ratio was about 105%, as reported by our Federal Reserve.  

But like alien spacecraft in Area 51, our government hides the truth from us because, as Jack Nicholson’s character said in the movie A Few Good Men, “You can’t handle the truth.” The truth is the real government Debt to GDP ratio is several multiples higher than the “official” 105%. That’s because our fearless leaders do not include liabilities for all kinds of real commitments it has made. Let’s start with the debt incurred by government sponsored entities (GSE) like Fannie Mae and Freddie Mac that guarantee 90 percent of all home mortgages and the $1.6 trillion of student loans (92% of the of the market) and nearly all private pension plans through the Pension Benefit Guaranty Corporation. Together these GSE’s represented another $8.87 trillion in federal government liabilities in 2018 that are not included in our Debt to GDP ratio.

But wait, there’s more. We have two other levels of government in our three-tier structure that all issue their own debt. Unlike the Feds, state and local cannot print their own money so they actually have to pay back loans, and for a growing number of states, this is becoming a harder task. At the local level, we have seen some actual bankruptcies with medium size cities like Detroit and Stockton, CA going into federal receivership.  However, I seriously doubt the Feds would allow a state or major city to declare bankruptcy.  I mean look what the Federal Reserve did during the 2008 financial crisis. They were bailing out everyone. It seems likely that a serious crisis would force the Federal Reserve to expand its famous quantitative easing to include purchasing municipal debt. That means paying off, muni-bond holders, with newly printed money.  After all, think of the bad chain of events that would be triggered if a state were allowed to go belly-up?  So let’s add another $3.85 trillion in outstanding state and local debt to our numerator. So far, our Debt-GDP ratio is about 150%.

We are not done yet.  Government at all levels - federal, state, and local – have made massive promises through social promises that must be met. That means government is compelled by law to pay the ever rising costs of these commitments unless politicians decide to change the law. These future obligations are referred to as “unfunded liabilities” and are mostly comprised of pensions for teachers, police and firemen, and other government workers.  States and local governments are supposed to be contributing money each year to ensure there is enough to pay these retirees. But many have not done so and rely on making riskier investment bets with the pension funds rather than try to enact the massive tax increases that would be required to fund these retirement plans. According to the Stanford  Institute for Economic Research, the total amount of these state and local unfunded liabilities is about $5.2 trillion. Adding this our government Debt-GDP ratio now puts us at about 174%, right behind Greece at the second highest in the world.

Still not done.  We have massive unfunded liabilities at the federal level that dwarf state and local. Good luck reducing, Social Security, Medicare/Medicaid. These are the third rail of politics and any politicians trying to do the right thing to make these programs sustainable, would never be re-elected.  With 10,000 baby boomers retiring each day, and debt interest payments mounting, we collectively have some $126 trillion in mandatory unfunded obligations and growing fast. Adding this to our debt pile now makes the Debt-GDP ratio a mind-boggling 1068%.

But what’s the big deal you ask? After all, our economy is doing well even with high levels of debt. Then there is a new branch of economics called Modern Monetary Theory, which claims debt levels don’t matter for countries that can print their own money like the United States.  In addition, since the end of WWII, the U.S. has the “exorbitant privilege” of being the world’s reserve currency meaning that about 65% of global trade is conducted in US dollars (down from over 95% after WWII) which creates robust demand for our money. However, countries like China that lend us lots of money ($1.2 trillion as of 2017), are steadily decreasing their holdings of US debt because they are fearful of their dollars becoming worthless as we continue to print money to finance our ever-growing budgets. In fact, the Chinese are in the process of trying to replace the US dollar with the Yuan as the global reserve currency. Any serious reduction in our “exorbitant privilege” will trigger serious economic pain in America.

Considering that the federal government collects only $3.6 trillion in tax revenue (as of 2018), it’s tough to see how our current government debt load is sustainable. Something needs to be done, and I’ve written a little book with some big ideas about how to address this challenge. However, it seems clear that the strategy of our political leaders is to continue kicking the can down that road until the crisis arrives at our doorstep. At that time, there will be massive tax increase on everyone, not the just rich; more money printing and a reduction in social services. The average Joe will be looking for someone to blame for the crisis.  The usual suspects will point the finger at their usual bogeymen, but the real culprits can be found in only one place. By looking in the mirror.