How much is too much government debt?

WASHINGTON (Reuters) - When it comes to borrowing trillions of dollars, it helps to have a golden reputation, a steady income stream, and plenty of rich, trusting friends.

When it comes to borrowing trillions of dollars, it helps to have a golden reputation, a steady income stream, and plenty of rich, trusting friends. REUTERS/Graphics

As the world’s wealthiest nations pile on debt at a pace that in less developed countries would alarm investors they appear to have ample supplies of all three -- for now.

That helps explain why a $1.4 trillion U.S. budget deficit announced last week drew gasps from politicians but didn’t rattle investors who remain willing to loan money to the U.S. government at low interest rates.

It also explains why Japan and Italy can carry debt that exceeds their annual output, while emerging market economies such as Argentina in the past crumbled under such burdens.

Across all the Group of Seven rich nations, debt as a percentage of gross domestic product will rise in 2009, and probably stay elevated at least through 2012, according to International Monetary Fund data.

Some of that is a consequence of the global recession. Government spending soared to bail out banks and resuscitate economies, while tax revenues fell. Governments are trying to strike a delicate balance between doing enough to end the crisis without digging an inescapable debt hole.

“It is the central economic choice of our time,” U.S. Treasury Secretary Timothy Geithner told Reuters on Tuesday.

Geithner, speaking at the Reuters Washington Summit, said it was imperative to do whatever it takes to restore economic growth and stop a recession from becoming a depression.

“For that to work over time, people need to understand and be confident that you will have the will and the ability to get back to living within your means when you have growth established,” he said.

Confidence comes from decades of fiscal responsibility, but it can vanish almost overnight. While financial markets show little sign of losing faith in the United States right now, concerns about inflation are on the rise.

That suggests some degree of discomfort about whether Geithner, President Barack Obama, and Federal Reserve Chairman Ben Bernanke can safely navigate the economic and political obstacles to corralling rising deficits in the coming years.

“As long as there is confidence, things can be just rolling along,” said Kenneth Rogoff, a Harvard University economist and former chief economist for the International Monetary Fund. “If confidence evaporates, for whatever reason, you’re dead meat.”


If the rich world mismanages its debt position, the consequences will be severe and widespread. For the United States, the early signs of trouble would probably come in the form of a sharp decline of the U.S. dollar, a steep rise in inflation, and a spike in Treasury debt yields.

Investors appear willing to give the United States and other major economies the benefit of the doubt as long as the global economy remains weak and unemployment elevated.

With the exception of gold, which is considered an inflation safe haven and recently jumped to more than $1,000 per ounce, the traditional inflation gauges look tame.

The U.S. dollar, while weakening, has not suffered an unnervingly swift decline. Yields on 10-year U.S. Treasury notes are still well below 4.0 percent, suggesting investors see little risk of runaway inflation in the next decade. Polls such as the Reuters/University of Michigan survey of consumers show households expect modest price increases in the coming years.

The major credit ratings agencies have maintained their top-tier “AAA” sovereign debt rating on the United States.

Still, Moody’s lead U.S. analyst warned that the top-notch rating “is not guaranteed” and the government must reduce its budget gap in the next three to four years.

And Japan lost its last remaining “AAA” rating in May.

What causes investor confidence to evaporate is not fully understood. Economists have sought to establish early warning systems, but most studies have focused on emerging markets, which have been the primary source of sovereign debt crises.

Paolo Manasse, an economics professor at the University of Bologna who co-authored a paper with New York University’s Nouriel Roubini on rules of thumb for predicting debt crises, said reputation and confidence go hand in hand.

Italy has a debt-to-GDP ratio slightly above 100 percent, yet its borrowing costs are manageable, in part because the country hasn’t defaulted since the Benito Mussolini era. That history, plus the perceived protection that comes from being part of the euro zone, helps Italy sustain its debt burden.

Manasse said reputation was also working in the United States’ favor, although he stressed that Obama’s administration would soon need to detail how it plans to shore up finances.

“If the United States can announce credibly a plan for fiscal retrenchment and commit to it, then a temporary jump in the budget deficit and debt wouldn’t scare anybody off,” he said in a telephone interview.


Mario Blejer, who was governor of Argentina’s central bank in 2002, knows first-hand how difficult it is to restore investor confidence once it is blown. Argentina defaulted on its debt eight years ago, and is only now trying to return to global debt markets.

Blejer, who is now an economic consultant, said that at the height of the debt crisis, his central bank initially had to offer interest rates of 130 percent to entice investors to extend seven-day loans.

“We needed to do things that would create a situation where greed would exceed panic,” Blejer said in an interview.

Argentina’s experience shows that debt-to-GDP ratios alone don’t always provide an early warning signal of impending default -- something Manasse’s research shows as well.

The United States has the advantage of being the world’s safe haven in times of panic, and as long as it retains that reputation, its debt sustainability won’t be in doubt.

U.S. debt held by the public stood at $7.53 trillion as of October 19, amounting to 53 percent of total output and up by about $1.5 trillion from one year ago. Recent debt auctions have generally been well-received, and major foreign investors including China and Japan have maintained their purchases.

Those two countries together held $1.53 trillion in U.S. Treasury debt as of August, up from $1.13 trillion a year earlier, according to Treasury data.

Geithner has taken pains to ensure that China in particular understands the U.S. commitment to bringing down future deficits -- and is comfortable investing a large chunk of its $2 trillion in reserves in dollar-denominated assets.