Gaining perspective on the consequences of high government debt levels.
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.
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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.