Why Total Debt/GDP Hides West's Sick Finances

♠ Posted by Emmanuel in at 9/02/2010 01:17:00 AM
Constantly travelling around, I meet all sorts. I've met folks who worked for Enron, the US military in Iraq, and a private military company operating there--and I'm talking about the same guy (bada-boom)! Today, however, one of my other contacts has delivered on something that has piqued my interest which (thankfully) doesn't involve violence like that in Iraq. Still it involves quite a bit of fraud like Enron and accounting for US expenditures in Mesopotamia.

In recent days, both FT Alphaville and the Becker-Posner blog commented on a recent Morgan Stanley report fetchingly titled "Ask Not Whether [Developed] Governments Will Default, But How." It is the first in a series of reports concerning "Sovereign Subjects." The main gist of the report is that it is not possible for major developed countries to meet their obligations given current demographic and economic trends. Now, this is plenty obvious to everyone but the most jaded mathlexics who are unfortunately all too common in the blogosphere--especially America#1-style cheerleaders who try to make up for their proud ignorance with ideological blinders. Being a more curious and open-minded sort, I asked a colleague to fetch me a copy of this Morgan Stanley report to see for myself.

Before getting to the juicy bits, I must mention that parts of it are available on the MS Global Economic Forum. Brad Setser used to link there a lot, but I guess the blogosphere kind of forgot about it despite GEF still having some interesting free content. What the author Arnaud Mares points out is that the ratio of total debt to GDP is a misleading indicator of just how fiscally shot developed countries are for a number of reasons. Essentially, it is a backward rather than forward-looking indicator. Those who actually bother to do the math will find little new here, but it bears repeating:

Four reasons why debt/GDP misses the point. The problem with these historical comparisons is not the reference: how governments dealt with their war debt burdens sheds useful light on what might be in store for coming years. Rather, the problem lies with the measurement tool: debt/GDP is the most widely used debt metric, but we believe that it is a very inadequate indicator of government solvency. There are four reasons for this:
  • Gross versus net debt: First, debt/GDP is a measure of gross indebtedness. It therefore overstates the size of the government's net financial liabilities, especially when - as has been the case through the crisis - debt is being raised for the purpose of on-lending or acquiring assets. Where measures of net debt exist, they provide an apparently less alarming picture of the government's balance sheet. The difference can be sizeable (in excess of 17% of GDP in the UK currently, for instance). Good news, however, stops here.
  • Missing liabilities: The second flaw of debt/GDP is that it only accounts for part of a government's contractual liabilities. There exists a broad range of liabilities that are debt, yet are not captured in national accounts. To take one example, in March 2008 the UK Government Actuary Department valued the government's unfunded civil service pension liabilities - that is, the contractual claims on government accumulated to date by civil servants - at £770 billion. That is 58% of GDP, not captured by the debt/GDP ratio. Debt/GDP does not capture contingent liabilities either.
  • It is not GDP but government revenues that matter: Whatever the size of a government's liabilities, what matters ultimately is how they compare to the resources available to service them. One benefit of sovereignty is that governments can unilaterally increase their income by raising taxes, but they will only ever be able to acquire in this way a fraction of GDP. Debt/GDP therefore provides a flattering image of government finances. A better approach is to scale debt against actual government revenues. An even better approach would be to scale debt against the maximum level of revenues that governments can realistically obtain from using their tax-raising power to the full. This is, inter alia, a function of the people's tolerance for taxation and government interference. Seen from this angle, the US federal debt no longer compares quite so favourably with that of European governments.
  • Debt/GDP looks at the past. The main problem is in the future: The fourth and largest flaw of debt/GDP is that it is an entirely backward-looking indicator. It only accounts for the accumulation of past deficits. This captured reasonably well the magnitude of the fiscal challenge at the end of World War II because at that time the challenge did indeed result entirely from the past: large wartime deficits had pushed debt ratios higher, but governments were no longer running deficits, nor were there expectations of them doing so in subsequent years.
By contrast, the accumulation of past deficits now represents only part of the problem for advanced economies' governments. The other part consists of coping with the large structural deficits opened up by the crisis and compounded by the fiscal consequences of ageing. What raises questions about debt sustainability is not so much current debt levels as the additional debt that will accumulate in coming years if policies do not radically change. Debt ratios do not capture this part of the problem.

It's me again. I suggest that you closely read the portion concerning how "It is not GDP but government revenues that matter" above. When you recompute these developed states' power to tax against their obligations, we come up with a familiar result. You might say primitive-mathlexic American politics exist in a reality-free zone where debate still surrounds whether to extend Bush 34's tax cuts despite the enormous harm they've done to America's long-term fiscal prospects. While US lawmakers are really quite bad at math, so too are the folks who elected them: Many say they're concerned about spiralling deficits, but they also say taxes shouldn't be increased. The end result of this brand of free lunch economics? Well, see for yourselves:

That's right, boys and girls. The US is in worse fiscal shape than Greece after adjusting for America's extreme aversion to tax increases and revenue generation. The tax haul there is so low and it's likely to stay that way. And don't even get me started on the finances of individual states. In the end, Americans get the government they deserve as it fully reflects their sheer ignorance of economic reality. See ya, and I definitely wouldn't wanna be ya.