Question

Compare and describe the U.S. federal debt with the level of GDP. How is it possible for a country to have a debt level this high? Compare and contrast the debt to GDP ratio of Japan, Italy, and Germany.

Answer 1

The United States had a government debt equivalent to 105.40 percent of the country's Gross Domestic Product in 2017. Government Debt to GDP in the United States was averaged at 61.70 percent from 1940 until 2017. The highest figure was recorded in 1946 at 118.90 percent and a record low of 31.70 percent in 1981.

The U.S. government finances its debt by issuing U.S. Treasurys, which are considered the safest bonds on the market. The countries with the 10 largest holdings of U.S. Treasurys are Taiwan at $182.3 billion, Hong Kong at $200.3 billion, Luxembourg at $221.3 billion, the United Kingdom at $227.6 billion, Switzerland at $230 billion, Brazil at $246.4 billion, Ireland at $264.30 billion, the Cayman Islands at $265 billion, Japan at $1.147 trillion and Mainland China at $1.244 trillion. Treasury issues bonds and sells them to the private sector; then the government spends the proceeds right back into the economy. The private sector gains financial assets (bonds); the government records more liabilities (bonds, reserves, and cash are all government liabilities). The Fed buys bonds in exchange for reserves it creates on the spot in the normal course of business. So the government is able to alter the makeup of their liabilities in the private sector, as all of those liabilities are interchangeable. In none of the above transactions does the government really borrow any private sector assets.

A high debt-to-GDP ratio isn't necessarily bad, as long as the country's economy is growing as in the case of US, since it's a way to use leverage to enhance long-term growth. When debt is used to fund economic expansion, current and future generations stand to reap the rewards. However, when debt is raised simply to fund public consumption the use of debt loses a significant amount of support.  A higher debt-to-GDP ratio is acceptable when the buyers of the debt are either domestic investors (citizens) or repeat buyers that have a reason for buying, like in case of US, U.S.'s buyer (China) purchases debt to keep a favorable trade balance with its largest consumer.

When debt is used appropriately, it can be used to foster the long-term growth and prosperity. But high levels of national debt for prolonged periods of time has a severe impact on the overall economy.

While we compare Debt to GDP Ratio of Japan, Italy and Germany, let us first understand the significance of Government debt as a percent of GDP. Government debt as a percent of GDP is usually used by investors to measure a country ability to make future payments on its debt, thus affecting the country borrowing costs and government bond yields.

Japan: Japan recorded a government debt equivalent to 253 percent of the country's Gross Domestic Product in 2017. Government Debt to GDP in Japan averaged 137.40 percent from 1980 until 2017, reaching an all time high of 253 percent in 2017 and a record low of 50.60 percent in 1980.  

Italy: Italy recorded a government debt equivalent to 131.80 percent of the country's Gross Domestic Product in 2017. Government Debt to GDP in Italy averaged 110.97 percent from 1988 until 2017, reaching an all time high of 132 percent in 2016 and a record low of 90.50 percent in 1988.

Germany: Germany recorded a government debt equivalent to 68.30 percent of the country's Gross Domestic Product in 2016. Government Debt to GDP in Germany averaged 66.40 percent from 1995 until 2016, reaching an all time high of 81 percent in 2010 and a record low of 54.70 percent in 1995.

Since 2007, the beginning of the Global Crisis, the governments of most advanced economies are drowning in debt.

Japan’s debt ratio has been rising sharply both before and since the crisis. Italy’s debt ratio was on a slowly declining path before the crisis but has been rising since 2007. Germany’s debt ratio rose after 2007 but has been declining since 2012. Judging from the trajectory of debt, and the fact that its current debt ratio exceeds 240% of GDP, one might have expected Japan’s debt to be considered risky. And yet, according to financial market indicators, Italy, with a debt ratio under 140 percent of GDP is considered to be the greater risk. Credit default swaps (CDS) spreads on government debt are indicative of market-based assessments. During the first four months of 2017, the five-year CDS spreads for Japan, Germany, and Italy averaged 25, 20, and 175 basis points, respectively. The low CDS spread on German debt is unsurprising. Comparing the CDS of Japan and Italy suggests a puzzle. Japanese government debt is considered to be nearly as safe as Germany’s. In contrast, Italy’s debt, is seen as considerably riskier and out of line with what would be expected of a major advanced economy.

A higher debt-to-GDP ratio is acceptable when the buyers of the debt are either domestic investors as in case of Japan where Japan's buyers are domestic mostly. Japan's stagnation after its rapid growth in the 1980s resulted in its elevated debt today. Japan isn’t burdened by interest payment as government creates money at no cost. Also they dont have the burden to pay principle because all government liabilities are interchangeable - the central bank can exchange bonds for yen (or vice versa) with a few keystrokes; no pre-existing money has to be amassed. It is just accounting.

For Japan, the dramatic rise of the debt ratio before the crisis reflects the lack of nominal growth. Since 2013 the Bank of Japan has embarked on a decisive QE programme which has simultaneously boosted nominal GDP growth and depressed long-term government bond yields. This monetary policy has stabilised Japan’s debt dynamics and has provided the Japanese government more time to implement structural reform measures and complete the fiscal adjustment needed to bring its primary deficit under control.

In contrast to Japan, where in the past few years decisive monetary policy actions have allayed fiscal concerns, in Italy monetary policy decisions appear to have contributed to debt sustainability concerns.

Italian nominal GDP growth has been consistently and significantly below Germany’s, while the long-term yield on Italian government debt has been consistently and significantly above Germany’s. While some of the difference can be attributed to non-monetary factors, discretionary ECB decisions have played a critical role.