No, Really: How Much Debt Is OK?
There are two plausible ways of resolving the argument over the sustainability of government debt, neither of which is conclusive. The first is empirical economic research. Here, the world's appointed authority is the International Monetary Fund, which is especially interested in analyzing debt sustainability because it is the institution that will be called in when government debts risk becoming unsustainable. The IMF has concentrated most of its attention on emerging-market countries, because it has been assumed both that developed countries are less likely to default, and that even if they did there is little the IMF, with its limited resources, could do about it.
That said, the IMF has done extensive research on debt sustainability, including attempts to estimate the sustainable debt levels for specific countries. Abdul Abiad and Jonathan Ostry, two IMF economists, have a paper on "Primary Surpluses and Sustainable Debt Levels in Emerging Market Countries" (this is their research, not official IMF policy), which outlines two analytical approaches to estimating debt sustainability — one based on a country's past performance at paying off debt, the other based on a model of economic fundamentals. Applied to a sample of 15 emerging-market countries, both the historical approach and the model-driven approach put the median sustainable debt level at around 30 percent of GDP (although across the sample the estimates range from less than 10 percent to more than 100 percent).
It would be a mistake to apply this single number to a country like the U.S., though. For one thing, developed countries in general can sustain higher levels of debt than emerging markets, among other reasons because they have higher revenue-to-GDP ratios. The IMF's September 2003 World Economic Outlook has some charts comparing government debt levels in industrial and emerging-market countries. Industrial countries in aggregate had public debt levels above 70 percent of GDP for most of the 1990s; yet no industrial country has defaulted on its debt in the post-World War II period. Empirical studies have shown at most a weak correlation between the amount of U.S. government debt and the interest rate the Treasury Department has to pay to borrow money.
The other way to see how much debt is too much is to ask the market. If investors think there is a risk that they won't be paid back, they will demand a higher interest rate, for the same reason that subprime mortgages have higher rates than prime mortgages. Interest rates on U.S. Treasury bonds are at historic lows, because people looking for a safe place to put their money are falling over themselves trying to lend to the U.S. government. The U.S. is able to borrow money cheaply despite everything we know about the recession, the government deficit, the Obama stimulus package and the looming retirement savings problems.
So the short answer to the question of how much debt is sustainable is simple: We don't know. If we were close to the edge of some fiscal cliff, the market would warn us, under ordinary circumstances. But these are not ordinary times: Due to the upheaval in all markets, there is a level of demand for Treasuries that is . . . how shall we put this . . . probably not justified by economic fundamentals, and as a result market signals don't work as well as they should. Right now, the markets are saying that the U.S. government is as good a place to lend money as any and are implicitly giving us time to sort out our fiscal problems. At what point that will change, though, no one can predict.
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