A note on sustainable debt ratios

Indicators that compare the outstanding balance of debt to a measure of repayment capacity are frequently used to estimate debt sustainability. There are many cases in which such ratios elevate the conversation, but it is helpful to highlight the pathological, indeed obvious, cases where they do not.

If the US suspended all tax collection for 3 years, the debt-GDP ratio may roughly double from 100% to 200%. Other things equal, I would guess rates would not move much. At least not without a presumption that individuals will use their rebate to dig holes. Even if we tried this over 30 years, instead of 3 years, future uncertainty in US earning potential might increase rate volatility and risk premia, but it isn’t obvious interest rates would increase much. This seems pretty clear at large magnitudes, but is equally valid for small changes in the ratio governing daily commentary on debt commentary and credit risk. Notably things about distribution over time is not necessarily important. A huge tax cut today means more cash provided in inheritance to future generations. (This doesn’t apply to spending because it doesn’t always in a form that can be sold and saved).

The level of debt-to-GDP is on the first order not much more than a choice about where we store future income, with some distributional effects thrown in at large magnitudes. And while countries are not perpetual entities, large debt-GDP ratios do not obviously change interest rates for credible institutions, even over large periods of time. Sometimes conversations such as these evolve into discussions on the properties of money, which I do not know much about. That said while it is true a large increase in US debt would be associated with certain “money-like” features, this observation is not necessarily limited to rich countries.

Obviously too much debt will increase interest rates and decrease expectation of repayment. Many times “too much debt” is associated with high debt-GDP ratios. But the underlying mechanism emerges from something else entirely. It may be that the increase in the ratio reflected large spending programs that were not expected to generate economic value. Or maybe it reflected the decline in expected future productive capacity of a country. (This isn’t a reflection of only stock and flow concerns as it would apply to flow/flow or stock/stock ratios as well.)

But without that information, understanding what debt ratios mean is hard. For example, it is sometimes claimed that we may not consider a large emerging market deficit to be problematic since we expect repayment from a growing economy. This is true in the same sense that we may not consider a deficit doubly big, other things equal, to be a problem outside of the way it modifies quality of projects funded. Since this ratio is a choice within reasonable bounds, understanding the motivation for this choice, the underlying economic truth it modifies, and the way it will affect and be affected by another country’s choice in the future are important to know.