The ratio of outstanding government debt to annual gross domestic product has become the primary measure of a country’s indebtedness. With debt-to-GDP levels surging to historic highs in the United States and other large economies, many economists and policymakers fear the situation could be unsustainable, foreshadowing slower growth and even defaults.
But in a recent paper titled “Why Care About Debt-to-GDP?”, Berk, a professor of finance at Stanford Graduate School of Business, and Jules van Binsbergen, a professor of finance at the Wharton School and co-host of their All Else Equalpodcast, argue that there is no solid economic justification for focusing on debt-to-GDP. On the contrary: They argue that the measure is flawed and distorts the conversation about the sustainability of rising debt levels at home and abroad. And they introduce a couple of alternative measures adapted from the realm of corporate finance — namely, debt-to-equity and interest-to-GDP — that paint a very different picture of what’s going on.
Here, Berk talks about what’s wrong with debt-to-GDP, what we should really care about when we talk about federal borrowing, and why it all matters.
Q: You credit the economists Carmen Reinhart and Kenneth Rogoff with popularizing the debt-to-GDP ratio in their 2010 paper “Growth in a Time of Debt,” which warned of the negative effects of high debt-to-GDP levels on economic growth. How did debt-to-GDP come to be the definitive measure of government indebtedness?
A: I’m not sure. I don’t know whether Reinhart and Rogoff really thought it was the definitive measure, but it took on a life of its own. But as we say in our paper, there’s really no reason for that measure. And there are a lot of reasons why it’s not a measure we generally use in the corporate context.
Q: Yet high levels of debt-to-GDP are now seen as a harbinger of economic decline and government default. Economists and policymakers have been ringing alarm bells over the debt-to-GDP ratio for the U.S., which has tripled from 40% to 120% over the past several decades.
A: It’s now at an all-time high, which you would think should be alarming. Yet we’re borrowing at low interest rates and the stock market is up, not down. So you have to ask the question: Wait a minute, why is it that the government, with such a crazy level of debt-to-GDP, can still borrow at relatively low interest rates? That tells you the market doesn’t seem as concerned. If the market thought we were going to default on our debt, then the market value of equity wouldn’t be high and interest rates wouldn’t be low.
Q: You point to the example of Japan versus Argentina: Japan has a debt-to-GDP ratio of 250%, but no one worries about it defaulting. Meanwhile, Argentina has a history of defaulting at much lower levels.
A: Yes, at a level of 40% debt-to-GDP. So there’s something fundamental about the debt-to-GDP ratio that is not getting things right.
Q: You say that one of the problems with debt-to-GDP is that it compares a “stock” variable — debt — to a “flow” variable — GDP. What does that mean?
A: Stock is usually the capitalized value of some flow. So if you have a house, the price of the house is the stock. The money that you get when you rent the house out is the flow.
Jules and I were in the middle of a podcast, and he said, “You know, it’s a bit odd. We don’t usually put stocks over flows.” And I said, “Yeah, that is a bit odd.” So we started thinking about it, and we realized that there really is no theory that says this is the correct measure. There’s no major theory that says, “Derive the debt-to-GDP ratio as the definitive measure of government indebtedness.”
Q: You suggest a pair of alternative measures that avoid this problem: debt-to-equity, a stock-to-stock ratio that compares outstanding government debt to total wealth as represented by the stock market; and interest-to-GDP, a flow-to-flow ratio that compares annual interest expense to GDP. Why those two?
A: The main measure we use in the corporate context is debt-to-equity, which in the government context is debt to something like total wealth. Total wealth is very difficult to measure, so we just said debt-to-market equity. The other measure is debt service: interest-to-revenue or interest-to-earnings. And in the government context, that’s interest-to-GDP.
Q: When you compared these two alternative measures with debt-to-GDP levels in the U.S. and 19 other large economies over the past 125 years, you saw very different — and much less dramatic — trajectories.
A: There’s nothing alarmist in those other measures. Debt-to-GDP has gone straight up since about 1980, whereas the others haven’t. They’re flat compared to debt-to-GDP.
Now, it would have been nice if the other measures had been more predictive about crises, but they aren’t. Debt-to-GDP isn’t a particularly good predictor of default, and neither are the other measures. They don’t do any better than debt-to-GDP. There isn’t anything that really predicts these things, which tells you that there’s a lot going on.
Q: So debt-to-GDP is technically problematic, and these alternative measures, though no better at predicting economic crises, paint a much less dire picture of government indebtedness. Does that mean we can ignore debt-to-GDP completely?
A: I don’t think we should just ignore it. But I don’t think it is necessarily the doomsday scenario that people paint. There is a level of debt that is unsustainable, and we would like to know what that is. I just think the current measure needs some work. If you want to use debt-to-GDP as the definitive measure of indebtedness, the profession needs to do a better job of justifying it theoretically.
Q: If debt levels aren’t really the bugbear some people think they are, is there a different economic indicator we should be focused on instead? What’s the flashing red light we should actually be worried about?
A: Really, if you want to focus on one thing, I think the focus should be on the budget deficit. Are we collecting more than we are spending? We are not: Even without interest, we spend more than we collect. And we can’t run a primary deficit forever. Eventually, that has to turn; eventually, we have to go to a primary surplus. [Like a primary deficit, a primary surplus excludes interest payments on government debt.]
And so that should be the question: What are we going to do about budget deficits? How are we going to turn from deficit to surplus? In the current political environment, those tough decisions look hard to make. But you never know.
