I found the graph below from a recent article by economists Carmen Reinhart and Ken Rogoff to be very interesting. My interest was not so much in the main point of their article, which is that public debt to GDP ratios above 90% are dangerous for future growth prospects, based on historical evidence across a wide array of countries.
While I do find that result to be interesting, I would note that the sample size for countries with public debt above 90% is relatively small, and in most cases the debt was denominated in non domestic currencies, or if looking at ancent history type cases, in gold, which is functionally the same thing as a non-domestic currency.
In neither case does the country own a printing press that can “solve” a debt problem. When a country is mostly incurring debt in its own currency, the risk of an out right default is very low, although the probablity of a “stealth default” through inflation rises.
While I agree that is would be a mistake to go overboard in American Exceptionalism — which could be simply a case of “this time its different” — the sample of high debt-years for the U.S. is very small. Essentially, they come down to the immediate post-WWII period when the country was demobilizing from the war, and as such need to be treated with an asterisk.
I would also note that the definition of public debt in the graph is not the same one that they used in their overall analysis; the graph includes State and Local Debt, while the overall study just used Federal (or Central Government debt for other counties). Thus don’t get alarmed by the first quarter of 2010 level of 117.4% of GDP number, and conclude that we are already past the critical threshold they pick of 90%.
What I find so interesting about this graph is what it says about just how leveraged we allowed the overall economy to get, and just how rare it is for the overall level of debt (both private non-financial and public) to actually decline. The fastest growth in the ratio of overall debt to GDP actually came in the early (Hoover) part of the Great Depression. It came not from large increases in the amount of debt, but from a shrinkage of GDP.
A Little History
Starting in 1933, when FDR took the US off the gold standard and when the New Deal kick-started a very rapid growth in GDP (from a very low level) the ratio of debt-to-GDP plunged. The other thing to note is how little the overall ratio of debt-to-GDP rose during WWII. The government was taking on massive amounts of debt at the time, but there was very little for consumers to buy. Even if they had the money, they also needed ration coupons to buy most goods.
So instead they bought war bonds and saved their money. Private debt as a share of GDP hit is all-time low in 1946. The overall leveraging up of the economy during the war was minimal. That debt was quickly brought down to size through solid (although very volatile) economic growth in the immediate post-war period. By the early 1950’s, the overall leverage in the economy was at an all-time low, and then started a steady rise, year after year, decade after decade.
Two Times Debt Growth Accelerated
There are two periods when the growth rate in the debt of the economy as a whole really accelerated. The first started in 1981 when President Reagan took office. The rate of increase in the ratio moderates starting when the first President Bush takes over and roughly maintains that pace through the end of the Clinton adminstration, but the slope of the line is still steeper than it was from Ike through Carter. The second acceleration happened starting in 2001.
That brings us to our current situation. Even though the federal government is running very high budget deficits, the overall ratio fo debt-to-GDP is actually declining now for the first time since the country was sending Rosie the Riveter back to the kitchen.
The ratio of private debt-to-GDP has plunged from an all-time high of 282.9% in 2008 to “just 234.8%” in the first quarter. While the level of private debt-to-GDP is still very high, far exeeding where it was even in the depths of the Great Depression after GDP had evaporated — and well above where it was in 1929 — it is also deleveraging extremely rapidly.
Effectively what the country has been doing as a whole is paying down private debt and adding to public debt. The former is outpacing the later. Money spent paying down debt is money that is not being used to buy current production, which helps explain why consumer spending has been so weak.
The decline in the overall debt level is a good thing in the long term, but in the short term it is very painful. Constantly increasing the ratio of overall debt to income is essentially a case of living large on the credit card. We have been doing that since everyone liked Ike, but it really picked up steam starting with the Reagan Revolution.
While the credit card is not totally maxed out — after all, the government can still borrow at historically low rates — we have decided that it is time to pay more than the minimum on the balance. Over time that is the prudent thing to do, but it does not make sense to pay so much paying down the Visa (V) that you cannot afford bus fare to get to work.
It is not at all clear that if the Federal Government had cut spending and raised taxes by enough to keep the overall budget deficit at, say, 2007 levels that the overall level of debt-to-GDP would have fallen faster. Indeed, it seems likely that it would have soared, just as it did in the early 1930’s. Given the highly leveraged state the economy was in at the start of the crisis, that would have been a disaster.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
