Debunking Krugman's Debt-GDP Defense

by: Adam Sharp

Paul Krugman just did a piece defending deficit spending. He argues that while $9 Trillion seems like a big number, it’s very manageable as a percent of GDP. In his words:

Right now, federal debt is about 50% of GDP. So even if we do run these deficits, federal debt as a share of GDP will be substantially less than it was at the end of World War II.

A chart like this seems to support his case at first:

public-debt-gdp

There are two glaring flaws with Mr. Krugman’s argument, however. The first is that total US debt has increased dramatically, and is far higher than any other time in history. At the end of WWII, consumers didn’t have $50k credit card balances and underwater mortgages worth 20x their annual salary. Companies weren’t nearly as highly leveraged as they remain today.

total-debt-gdp

Is GDP Indicative of a Country’s Ability to Pay off Debt?

The second flaw in this argument is GDP itself. How much does a debtor country’s GDP really say about their financial health? Fifty years ago, GDP included our strong manufacturing base. Today it includes massive government spending and financial products that provide zero real value to the economy. In 2007 financial services represented 40% of corporate profits in America. Will medicare, social-security, CDS, CMBS, increase productivity and pay the bills? No.

Examine this chart showing Government Spending as a % of GDP:

debt-percent-gdp

The trend is clear. QE and bailouts have really only just begun. The picture will worsen considerably as baby-boomers retire, putting pressure on Medicare, Social Security, pensions, etc.

Inflation seems inevitable with this much debt, and much more in the pipeline. We’re reflating the bubble temporarily, and if it works, the Fed’s job is to reign in all the money that “saved” us. They won’t, can’t. Those who think we’re going to get out of this mess by cutting spending and raising taxes will be proven wrong, I think. See Flaws in the Deflation Case for more on that.