Approaching the Debt Tipping Point

01/08/2010 3:09 pm EST


Jim Jubak

Founder and Editor,

So, exactly when does a lot of debt for a country such as the United States, Japan, the United Kingdom, Greece, or Italy become too much debt?

The threshold is when government debt rises above 90% of national gross domestic product (GDP), economists Carmen Reinhart and Kenneth Rogoff argue in a paper headed for publication in the American Economic Review. (You can read a draft of the paper here.)

After looking at data from 44 countries spanning 200 years, they’ve concluded that at ratios of debt to GDP up to 90%, there’s not much correlation between government debt and economic growth.

Above 90%, however, median economic growth rates fall by one percentage point and average economic growth rates fall by about four percentage points.

That makes the 90% level a kind of make-or-break point for countries that are hoping to grow their way out of debt. If the government debt load climbs above 90% of GDP, economic growth slows so much that growth is no longer a viable solution to reducing that debt.

Above the 90% level, governments serious about reducing their debt load have to increasingly rely on “solutions” such as reducing wages and depreciating their currencies, which might over time increase global economic competitiveness enough to give a boost to national economic growth. In the short to medium term, however, these “solutions” inflict real pain on the citizens of the countries since they reduce standards of living.

The scary thing about Reinhart and Rogoff’s conclusion is how close the United States and other major developed world economies are to the 90% cutoff thanks to the global financial and economic crisis.

The United States finished 2009 with a debt-to-GDP ratio of 85%, according to the International Monetary Fund (IMF). On current trend, the United States will finish 2010 at 94% and 2011 at 98%.

The United Kingdom was slightly further away from the cutoff when the International Monetary Fund last updated its numbers in October. At that point, current trends saw the country finishing 2009 at a 69% debt ratio and ending 2011 at 89%. The economic and financial condition of the UK has deteriorated since then, however. The most recent figures show the country finishing 2009 at a debt-to-GDP ratio of 72% and breaking the 90% barrier in 2011. (For more on the UK financial crisis, see today’s Jubak’s Journal article.)

The two biggest continental economies are in surprisingly similar shape, according to the IMF’s October calculations. France ended 2009 at a 77% debt-to-GDP ratio, according to the International Monetary Fund, and on current trend, will hit an 87% ratio in 2011. Germany ended 2009 at 79% and will end 2011 at 88%.

Italy, at 116% in 2009, and Japan, at 219% in 2009, are already well beyond the 90% cutoff where debt begins to depress national economic growth. The recent steps by the Democratic Party of Japan government to move to a weak yen policy would seem to mark recognition that there is no way to avoid “solutions” that reduce living standards in Japan. (For more on this shift, see this recent post.)

Sorry to be such a bundle of gloom today, but the clock is ticking on the debt problem. Loudly.

Full disclosure: I don’t own shares in any company mentioned in this post.

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