What Makes Debt So…Sustainable?

Greece is just one of many countries in deep debt. 175% of gross domestic product, to be exact.

Think about all the goods and services that Greece – a nation of 11 million – produces. Think about how much those goods and services are worth. It is a major shipping power and it has the largest economy in the Balkans. And they owe 1.75 times what they make.

Imagine you have a decent job and you earn $60,000 a year. Not bad, right? Except every year you also owe $105,000. How long do you think you could keep that up?

That’s kind of like what it means for a country to have a large government debt.

Except governments are allowed to continue operating, and in positions of great debt to which a regular person would never be allowed.  Take Japan, for instance. In 2013, the Japanese public debt was more than 1 QUADRILLION yen (or $10.5 trillion), more than twice the yearly gross domestic product (GDP).

At 233%, Japan has the highest ratio of debt to GDP among the world’s advanced economies (developed nations). But while Greece is in a debt crisis, everything is calm on the Japanese front. Why is that?

We can intuitively understand when, as private individuals, our debt is getting out of hand. But what makes government debt sustainable? Or unsustainable?

Till Debt Do Us Part

Governments are often let off the hook when it comes to operating under huge amounts of debt. This really comes down to one thing: faith.

So long as people believe that Japan can pay its debtors, then Japan will continue unfettered.  A loss of faith would easily lead to a crisis. After all, as we are currently seeing with Greece, it can be hard for creditors to squeeze out money from nations. Nations might agree to receive payments from one another over longer time horizons than individuals might. In 2010, Germany finally paid off all its debt from World War I.

The sustainability of government debt is often assessed by looking at the size of the primary deficit and the gap between GDP growth and borrowing costs.

debt

The primary deficit is the difference between all the money the government spends on goods and services and the revenue that the government collects from all types of taxes. If the government spends more money than it collects from taxes, it would be called a primary deficit. If you are Japan or Greece, you have one of these bad boys. If you are Germany, you have what is known as a primary surplus, i.e. you collect more money in taxes than you spend.

GDP growth would be the difference in GDP from one year to the next. If it is growing, and growing faster than the cost to the government of borrowing money, it’s a good sign. It’s as if your annual salary of $60,000 were growing faster than the interest payments on your debt. Cool.

It can be hard to separate the need for an individual, like you or I, to balance their books from the rampant borrowing than governments indulge in.

Think back to the growth of borrowing costs. This is probably the most important factor when it comes to the market deciding whether or not a government’s debt is sustainable. If the market believes that a nation’s borrowing costs have gotten so burdensome, to the point that the country will start to default on its payments, then the markets will price that in.

You might also be thinking: “Can’t a government just print money and pay off their debts?”

That would be a good solution…if the government were unconcerned about rampant inflation. Simply printing more money devalues the money that is out there and can quickly cause national conditions to go crazy. After World War I, Germany was hit with incredibly harsh reparations. They were expected to pay annual installments of 2 billion gold marks PLUS a quarter of the value of Germany’s exports. Under this extreme pressure, Germany resorted to mass printing of bank notes to pay off their debt to the world. This led to massive hyperinflation, and the value of the mark imploded. Like, really imploded. It went from about 30 marks to the dollar in 1919 to 4 trillion German marks to the dollar by 1923.

debt

People were burning their money to keep warm because it was more useful as tinder than as a means of exchange. So…not the best strategy.

Is a Large Deficit Even a Bad Thing?

There’s not a lot of evidence that large debt slows down economic growth. It’s sort of the reverse. In our modern world, it is when economic conditions are dire that governments tend to increase spending via taking on increase debt. They do this so as to jumpstart the economy and boost economic growth.

So far, the markets have been pretty tolerant with countries that have large deficits. The U.S. and Japan have been able to go on for years with huge deficits and equally massive debt-to-GDP ratios. Belief in the continued strength of these countries combined with low interest rates that keep the cost of borrowing low have combined to keep trouble at bay. It’s a bit like having a credit card where you only make the minimum payments. The interest rate is such that you’re forever paying just enough such that you never make a dent in the overall debt. You’re making your payments but you’ll never pay off your debt in full.

That’s kind of like what a government debt scheme is like.

There’s just one thing to consider. If you are constantly treading the line of sustainability then what happens when unforeseen events occur?

Food for thought.

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