By Karl Smith
In his post-debate post, Joe Scarborough posted a chart of federal debt held by the public as a percentage of GDP similar to the one below.
Ironically, such charts are commonly presented by economists and economic policy makers. Ironic because the economics world still seems a bit uncomfortable with the idea that nominal shocks/contracts have real effects. Yet, the debt-to-GDP ratio is a nominal figure and indeed refers specifically to the nominal stock of bond contracts the Federal Government has entered into.
It feels as if you are a creating a real figure because you divided through by GDP. However, as finance undergraduates know, its not just the current price level but the growth rate of the price level that matters.
Bond prices and inflation inversely related. Lower inflation expectations raise the nominal value of a stock bonds. This holds not only for the bond investor, but for the bond issuer as well. Said another way, debt-to-income of 100% may be a heavy burden in a world where inflation is 1%, but quite manageable in a world where inflation is 7%. In the later world inflation will erode the principle balance in half each decade. In the former, the same erosion would take a lifetime.
Similarly, a debt is easier to manage if the terms are more lenient. For a given rate of inflation, a loan at 12% interest is a lot heavier than a loan at 2%. What matters, in large part, is the difference between the interest rate the borrower is paying and the inflation rate in general.
With that in mind, I've started playing around with some alternative measures. The first and easy cut is simply Federal Interest Outlays as a Fraction of GDP divided by the GDP deflator. Low interest rates make this estimate of the "real debt burden" larger. Low inflation rates make it larger.
One of the things that stands out immediately is how high this ratio was in the mid-1990s. That shows -- in part -- the surprising rationality of Treasury policy. In the mid-1990s, the U.S. Treasury was in a huff about getting the Federal Debt Burden down, and indeed succeeded with a combination of tax increases and military spending cuts.
By this metric that made sense. The real debt burden was 10 times as high as it had been in the mid-1970s. The data only go back to 1955, but I am betting the real burden in 1990s was on par with the burden right after World War II, when the U.S. government also ran a surplus on the back of high taxes and declining military expenditure.