Debt to GDP Ratios: Why Not Make the Numerologists Happy?

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Monday, 01 April 2013 04:36

Numerology is usually held in low regard in intellectual circles. Unfortunately it is front and center in the debate over national economic policy.

Many economists and political leaders tell the public that we have to keep the DEBT to GDP ratio (capitalized to show reverence) below some magical level. Greg Mankiw professes his adherence to the faith in the NYT on Sunday. The reason that either a specific number or a strict focus on debt to GDP ratios is viewed as silly by people who are not numerologists is that the DEBT to GDP ratio is a completely arbitrary number that tells us almost nothing about the financial health of the government or the country.

First, the debt to GDP ratio is not even telling us anything about the burden of the debt on the government's finances. While the current debt to GDP ratio is relatively high, the ratio of interest payments to GDP is near a post-war low at 1 percent of GDP. (It's roughly 0.5 percent of GDP if we net out the money refunded to the Treasury by the Federal Reserve Board.) By contrast, the interest to GDP ratio was six times as large in the early 90s, at 3.0 percent of GDP.

If we revere debt to GDP ratios, we will have the opportunity to buy back large amounts of long-term debt at steep discounts if interest rates rise later in the decade, as projected by the Congressional Budget Office and others. This exercise would be pointless, since it leaves the interest burden unchanged, but it should make the numerologists who dominate economic policy debates happy. (This debt buyback story is discussed here.)  

The other reason why an obsession with government debt is absurd is that it ignores all the ways in which the government may increase national wealth or impose burdens that are not captured by the debt figures. Suppose that the government were to increase debt through a massive public investment program in clean technologies, publicly funded research (with results in the public domain), and free education.

The debt to GDP ratio would surely increase, but (let's imagine success) the country would be far more productive in the future. Suppose we could get wind or solar energy to meet most of our needs at virtually no cost on an ongoing basis. (This is hypothetical, so don't give me an argument here.) Suppose all our prescription drugs and medical supplies were available as low cost generics, saving us more than 2 percent annually ($320 billion a year in today's economy) in health care expenses, and suppose that we had a much more educated and productive workforce with no student loan debt. 

If this accurately describes our future in the big public investment scenario, should we be upset if our debt to GDP ratio were 30 percentage points higher? Suppose this actually translated into a higher burden of interest payments to GDP. Imagine that it increased by 2 percentage points of GDP, an amount almost as large as our annual savings on payments for prescription drugs and medical equipment.

Of course economists would have no basis for saying that we are worse off in this high debt to GDP ratio scenario. But the numerologists who control public policy would not like it. So look forward to high unemployment and slow growth in the hope of appeasing the god of DEBT to GDP ratios.