Debt Dynamics: Who is Most at Risk?

The debt dynamics equation was in the past of interest only to sovereign credit analysts (such as this blogger) and macro policy wonks.  Now, more people want to know about it.  You can generate such an equation that is elaborate or not, but the gist is the following:  The primary budget surplus, that is, government revenues minus expenditures — not including interest expenses and earnings, must be large enough to cover the excess of the interest cost on the national debt over GDP growth, or else the debt to GDP ratio will rise. 

Primary surplus/GDP > Debt/GDP x (r – g)

…where r is the interest rate on the government debt and g is the rate of growth in GDP; r and g are either both expressed in real (inflation-adjusted) or nominal terms.

Many countries today have primary budget deficits, which means, unless GDP growth is stupendous, that is, in excess of the interest rate, then their debt to GDP is going to rise.

The debt to GDP ratio is a comparative measure of a country’s debt burden.  Think of it this way — you have the amount of debt your government owes, and you divide it by GDP, which is a measure of the size of the economy.  GDP, you may recall, is defined as the sum of the transactions (buying and selling) taking place in an economy in a given year.  Debt is divided by GDP in order to measure the capacity of a country to handle its debt burden, because, after all, you could tax all those transactions in order to pay off the debt. 

What the debt to GDP ratio does not tell you is how high taxes are.  For example, in Sweden tax revenues (broadly defined) represent a whopping 52% of GDP; whereas in the US and Japan, they represent only 32% fo GDP.  If you believe that high taxes squelch growth — and you don’t have to be in the Tea Party to do so — then you would be more optimistic about growth prospects in the US and Japan than in Scandinavia.

Now, it just so happens that Sweden’s GDP growth rate has not been consistently lower than that of the US or Japan in recent years; but you might think that over time, if US and Japanese politicians would stop ruining investor confidence with their antics, then these countries could grow more rapidly than Sweden.  Furthermore, both the US and Japan, again if their politicians would behave better (and here you can blame the Tea Party), have greater scope to raise taxes to improve debt dynamics than does Sweden.  It has been estimated that Japan, if it had a VAT tax as high as Europe’s, would balance its budget overnight.

So, growth matters, taxes matter, the interest rate matters, and the budget deficit matters. So, how do some of the sovereigns we see flash across our computer screens fare on the debt dynamics equation?  

Even though Italy has a high debt to GDP ratio of 120%, analysts and euro-officials trumpet the country’s primary budget surplus as an argument for why the government is solvent.  Well, that surplus has been squeezed down to near zero; and, given rising interest rates resulting from the euro zone crisis, an abysmal GDP growth record and poor growth prospects, the primary surplus would need to be between 1.5% and over 4% of GDP in order to stabilize government debt.  Hence, the market’s concern about Italy.

Spain has a much lower debt to GDP ratio than Italy, at just over 60%; however, its primary balance is in deficit of about 4% of GDP.  Yet Spain only needs its primary balance to be in balance, not surplus, to stabilize its debt to GDP ratio.  But closing that 4% gap is still quite a feat.  The new right of center government, with its majority in the legislature, may just be able to do this.  But the market still has its doubts.

How about France, which the rating agencies still have at AAA but have placed on a negative outlook? Its primary balance is in deficit like Spain’s, but only to the tune of 2.5% of GDP.  Yet its debt burden is higher, at 85% of GDP.  France too needs a primary balance that is in balance, but has less distance to go than Spain.  Still worries about France’s growth prospects — especially its international competitiveness — plague the markets. 

And then there is Germany, which has a sizable government debt burden of close to 80% of GDP, worse than Spain’s. Those pesky German states (lander) love to borrow.  Germany too requires a primary balance to stabilize government debt, but AAA Germany’s primary balance is currently nearly in balance, and its GDP growth track record has been impressive of late.  We’ll see if that continues.

The problem here is growth, stupid!  With high tax burdens, an ideological vice grip on the ECB, poor political leadership at the European and national levels, a lack of structural reforms, and a currency in grave doubt, prospects for GDP growth in the euro zone that would support virtuous debt dynamics are dim.

The UK, which thumbed its nose at greater European oversight of its budget, has a primary deficit of 3.5%, debt to GDP like France’s, and requires balance in order to stabilize government debt.  Yet the UK has the flexibility of its exchange rate and monetary policy to support GDP growth, which euro zone countries lack; however, the UK sends 40% of its exports to the euro zone, so its “splendid isolation” is a mere pipe dream.

Leaving the shores of Europe, we find the US and Japan with woeful primary deficits of 6% and 8% of GDP respectively, suggesting explosive deterioration in sovereign debt dynamics.  US debt to GDP is approaching 95% this year, and Japan’s, get ready for this, is crossing 225% of GDP!  However, given very, very low interest rates in both countries — how long they can get away with this is another story, but most believe they have at least a few years — and possibly better growth prospects than in Europe, both the US and Japan can stabilize government debt with a primary deficit of 1% or so of GDP. 

Japan of course needs much more than debt stabilization; it needs sharp debt reduction.  The other side of the coin for Japan and the US (and to a lesser extent the UK, where tax revenues represent around 40% of GDP, lower than most European countries) is that, should the Tea Party in the US and the factions in the Japanese diet allow some tax increase, then these countries could dramatically improve their debt dynamics.  Europe, on the other hand, can’t really afford to raise taxes, even though some countries are going ahead and doing it anyway.