Is There a Debt Limit?

The national debt is one of the cornerstones of conservative fretting about the future of the nation. We shouldn't dismiss this outright, since the debt is really high. There's a lot of economic research into this topic, and it's worth reviewing.

Reinhart and Rogoff are the go-to economists on this. In general, government debt above 90 percent starts to cause problems for most countries. Unfortunately, there's technical issues with this cut off. We only have a few cases that we have to measure it, and it's hard to apply the average of these small instances to all countries in general.

The key to this is the concept of debt tolerance, which Reinhart and Rogoff talk about a lot in their book. For a lot of "fundamental" reasons, like governance, economic vitality, their relative position versus other countries and general investor sentiment, some countries can manage high levels of debt. For the same reasons, there are many countries that can't. For example, no investor would ever loan money to a country like Zaire if it had debt levels similar to what the US has right now. At the same time, there are extreme instances where high debt has been paid down. The UK, for example, had a debt to GDP ratio of 240 percent after WWII and did not default. The US hit 120 percent at about the same time and got that down without any issue at all.

On the other hand, less debt-tolerant countries have slipped into crisis much sooner. Spain, for example, is a complete basket case as far as its debt goes, but its GDP to debt ratio is only 69 percent. The interest rates on its 10-year bonds regularly jumping over 7 percent, although it's at 6.8 right now (yay Euro summit).

The current US GDP to debt ratio is about 103 percent (but only about 80 percent is actually owed to people; the rest is held by the Fed). The 10-year US Treasury interest rate 1.64 percent (which is actually a negative interest rate once you account for inflation). If you trust markets, and you should, then it's pretty clear that the US is capable of tolerating debt levels much higher than Spain. There's a good question about how much further we can go, but it should be obvious to everyone that we're definitely not in terrible trouble yet.

This doesn't mean that the current level of debt and the rate at which it's growing isn't a problem. The argument among serious economists is not whether or not the debt to GDP ratio needs to be reduced, the argument is about when it needs to be reduced and how it needs to be reduced. There's a few issues here.

As the Euro-crisis proves, you cannot reduce public debt during a depression. Cutting government spending reduces economic activity, reduces the tax base and reduces the government's ability to pay off its debt. Ireland, Greece and the UK have all tried to immediately reduce their deficits, only to fail in the process. Not only has their economic situation become worse, but debt has increased.

At the same time, a country doesn't need to actually pay back any debt to reduce its debt burden. The only important issue is to reduce the rate of deficits (i.e. debt growth) below the rate of GDP growth. The dirty secret about that massive post WWII debt was that it was never paid back. Technically speaking, the nominal value of that debt is still on the books. But once the US economy took off in the 1950s, doubling per capita income over the next twenty years, the burden of that debt was dramatically reduced.

So those are the things you need to keep in mind. When does a candidate plan on reducing deficits? What mix of spending cuts and tax hikes will they use to get them? What is the size of the deficits vs the assumed GDP growth rate at that time?

Neither party differs much in their underlying goals. Obama targets 4 trillion dollars in deficit reductions; Paul Ryan targets 4.4.

The real difference is in the mix of policies and the number of flights of fancy. The Republican plan passes large tax cuts and then reduces spending to levels not seen since World War I. It also involves a big asterisk, in that it promises to eliminate tax loopholes, without specifying which ones. It would likely live the big ones alone, since everyone likes deductions for capital gains and mortgages. That would make it damn hard to raise the taxes to meet the budget's targets.

In other words, Ryan has lots of promises, but not too many actual ideas. It's nice politics, let's just leave it at that.

While far more realistic, the Obama budget looks to mostly stabilize the level of debt at its current levels. This might not be enough to actually solve the problem, but it's very hard to say what the world will be like 12 years from now (10 years ago we had budget surpluses). The biggest problem for the President is that he keeps most of the Bush tax cuts, and only looks to raise taxes on the rich. Even though Obama is in the running for the lowest rate of spending since the Korean War, this probably won't cut it in the end either.