May 8, 2012
For second time in five years, the world faces a major financial crisis. Whereas the 2007-2008 crisis was driven by excessive mortgage debt owed by households, the current crisis is driven by excessive government debt owed by entire countries. The key factor for both crises is the fear that debt will not be repaid, Waller says. Since a nation's burden of debt is not always a good predictor of default, lenders tend to look at a nation's perceived willingness instead of its ability to repay its debt.
Christopher Waller: Well, thank you for coming. This is one of these things after 25 years of being a college professor I get to give a lecture again, and during the lecture I get to pop a quiz to you every now and then. So this is a topic that has been going on for a while. It's a varied topic. It's mainly over there as opposed to here at home. There's a lot of things that come up. People aren't sure what's going on. So part of what I want to do today is educate, inform, give you some background, and try to give you some insights to where things may go in the future with this debt crisis.
So for the second time in five years the world faces a major financial crisis. The first one in 2007 and '08 was a crisis driven by excessive mortgage debt owed by individual households. The crisis we're facing now is a similar thing. It's driven by excessive government debt owed by entire countries. So we went from households to entire countries. And a key factor in both of these crises is a fear that debts will not be repaid. So this is kind of a common element and we're going to kind of delve into this a bit in the course of this talk.
So whenever you have these kind of crises, and particularly with something such as government debt or sovereign debt—we kind of use these terms interchangeable, government debt, national debt, sovereign debt—we have a lot of questions people start asking. Why do governments borrow? When does the level of debt become a burden on society? What happens if a nation actually defaults on its debt? What are the ramifications from this? How did Europe get in trouble and how can it get out? And finally, is the U.S. in trouble because of the amount of debt that we have? This is something that's very much in the forefront of our current political debate. We saw the debt ceiling debate last summer. So this is exactly the kind of questions that we want to address over the course of this—I don't want to call it lecture—but this dialogue. Okay?
So one of the things I learned in many years of teaching about the national debt and deficits and things is just to define a few things to help people understand. So governments borrow to finance shortfalls in tax revenues, when they spend more than they bring in in taxes. They run a deficit, they have to borrow to finance it. We call that shortfall in a given year or quarter, whatever it is, we call that a deficit. Now, if the opposite situation occurs where your tax revenues exceed your spending, a surplus occurs. The debt—so this is the key distinction to make in your mind—the difference between the debt and the deficit is the national debt is the sum of all current and past deficits and surpluses back to the founding of the country. So it's the accumulation and everything on net of what we've done since the country was founded.
Now, why do governments typically borrow? What is the function of government debt? Now, traditionally governments have borrowed to finance wars, and I'm going to show you some little pictures here in a second. But they also borrow to finance things like civil works—take the Hoover Dam during the 1930s—and other public services. Now, one of the things you could do is the minute you have these large expenditures—take, for example, a war where there's always this immediate need for government spending—you could raise taxes quite high temporarily and then when the war is over go back to where you were. So very high taxation temporarily and then go down. Here's a slightly better idea. Why not borrow the funds and then slowly pay it off over time with slightly permanently higher taxes?
The simplest idea I can think of is think of a mortgage. This is what we do. You're going to have a big expenditure on a house. You could say I'm going to save it all up and pay it all off at one time, or you could say I'm going to borrow it and I'm going to slowly pay the house off over time. And that's what governments do with financing wars. So, for example, here's kind of a simple picture of this. So this is a percent of GDP. This is deficits or surplus. So when they're negative you're running deficits. And so if you see that, you know, in the 1800s pretty much a balanced budget. Here's the Civil War. Suddenly we ran a big deficit, and then we ran surpluses after that to kind of pay it down. Here's World War I, surplus, Great Depression, World War II, back up, and then it's been kind of a series of deficits for the last 40 years. Woops, I guess I had these on there.
Now, another thing is just to look at the level of debt as a percentage of GDP which is our national income. If you're going to talk about national debt, you need to talk about the national income which is GDP. So you can see the debt level after the Revolutionary War, falls down, goes up in the Civil War, is paid down, goes up from World War I, down, up, and then slowly paid down, and then we've had kind of a run-up.
All right. So that's just kind of the definition of a deficit, kind of a behavior of time at least for the U.S. Over historical periods it's been driven by debt until we see the last 40 or 50 years. So when we ask how burdensome is debt, how big of a debt burden do we have? So if I were to tell you that the U.S. has a national debt of $15 trillion, is that a lot? Sure sounds like a lot, doesn't it? But if I told you we had $15 trillion in income, that sounds like a lot too. So absolute numbers are sometimes very hard to get your head around. I always have a difficult time when astronomers tell me the nearest planet or star is 20 light years away. Light travels 186,000 miles per second, you'd multiply that by 60—I have no concept of how far that is. Tell me that dinosaurs lived on the Earth 63 million years ago—no idea. I understand the human life span, and that's about it.
So when you start throwing numbers around like 14 or 15 trillion dollars, I don't deal with numbers like that in some sense of my daily life. So we want to put these kind of numbers in perspective, particularly if we want to look at this issue of measuring the burden of the national debt. So what economists like to do is we look at what we call the debt-to-GDP. We take an idea of your debt to your income. Much like if you went to the bank, they'd look at your debt to your income. So we do a similar thing for the nation. Now, there's a couple of ways to think about debt, so I'll just say this right now. Often we look at all the debt that's outstanding, no matter who holds it. Sometimes we say, you know, Social Security Administration is a part of the government and they're holding government debt. Do we really want to count that in? Nah, maybe not. Sometimes we take that out. The Federal Reserve holds a lot of government debt. Do we want to count another semi-government agency holding debt? Ah, maybe, maybe not.
So what we're going to do, or a lot of things I'm going to do is I'm going to think about everything except the Social Security Administration debt. But then later we'll talk about, let's just take the total number and see what it is. So we look at the debt-to-GDP. So we're looking at your total debt to one year's income. Now, what this kind of gives you an idea is it measures the ability to pay off your entire country's history of debt with one year's income. Okay? That's the way to think of what this measures. How hard would it be to pay off all my debt with one year's income? Ask yourself that question. How hard would it be to pay off all your debt with one year's income? Any of you in here with a decent size mortgage on your house, it might be a little tricky to do. So this is why we think of this as a conservative measure of burden. It's like, how hard would it be in one year to pay off everything you own?
Now, some have argued that anytime you get over about 90 percent to 100 percent or higher, you're now in a situation that will cause some concern that this is becoming a burden. Okay? There's some evidence out there that once you cross over this kind of threshold you start seeing impacts on your economy. Now, in normal times most governments roll over their debt. They pay off some of it, but they roll it over. So what's this concept of rollover? Rollover means you pay off your old debt by issuing new debt. So I would go to Julie and I would say I owe you $100. Just a second. I run over here. I come to Victor and I say, Victor, lend me $100. Take the $100, give it to Julie. I've paid off Julie but I incurred a new debt to Victor. So that's what we mean by rolling over the debt. And most governments do this. But somebody's got to be willing to roll it over. So I go to pay off Julie, I go to Victor, I say, Victor, lend me $100. He goes, "oh, oh, no, no, no, I'm not lending you $100." And I say, "Julie, okay, Victor won't lend it, let me give it to you again." She goes, "no, no, no, I want my money now." So that's what rollover risk is that you won't get this debt rolled over.
Now, one of the key things I'm going to talk about here in a second is the interest rate that you pay on that debt depends on the maturity or length of the debt, the time that you're promising to repay, when you're going to repay it. So this is what we call a yield curve. Those of you in finance, this is kind of a straightforward thing. It just plots the interest rate against years to maturity of the debt. So you can borrow at, say, three years, 15 years or 30 years. And all it says is the longer it takes for you to repay your debt on average, we're going to tend to see a higher interest rate charged to borrow. So that's the kind of picture. Now, if you were thinking of borrowing and you wanted to have low cost of borrowing, where would you want to borrow? At this end of the maturity or at this end of the maturity? Well, if you wanted to keep your low interest cost, you'd be borrowing down here.
So what governments tend to do, like anybody might want to do, is say, look, here's what I'd like to do. I'll borrow at the short end of that yield curve because it's a very low interest, I have very low borrowing cost if I do that. But when you start borrowing at the short end of the maturity structure, you've got to roll that debt over more often. And if you do that, you're facing this rollover risk problem I was just describing. So you're making a trade-off between a low interest rate and rollover risk. Every time you roll it over you're giving investors this opportunity to say, Can you meet your debt obligations? If you borrow for 30 years, I'll say, I'll tell you what, come back in 30 years and I'll answer that question. But if you're borrowing every six months or every 12 months, you've got to answer that question a lot more often. Now, the minute a lender fears that you may not be able to settle up this debt, they may refuse to rollover the debt. Or they may say, okay, from now on, if you want this debt, I'm going to raise the interest rate that you have to pay on this debt. It's like a risk premium to me that you're not going to pay me back.
All right, now, the debt burden is kind of a common rule of thumb that we like to use to look at, but it's not always a good predictor of default. So, for example, Brazil and Mexico defaulted on their debt in the early 1980s even though their debt-to-GDP ratios were around 50 percent, which are considered relatively low. Japan's current debt-to-GDP ratio is over 200 percent—the highest in the world that I'm aware of. No one's worried about Japan defaulting, per se. So what this kind of points out—and this is a critical thing I'll come back to towards the end and we're maybe starting to see in the recent elections in Europe—it's not necessarily a nation's ability to repay the debt but their willingness to repay the debt. That's one thing we have to keep in mind. That's what these two numbers are kind of showing you.
Now, if you default, what happens? The first recorded default turns out to be guess who? Oh, the irony. The Greeks in the fourth century B.C. defaulted on loans to the temple, which I assume went out of business because they didn't get repaid. Now this might be unfair because there's not too many other countries that have been around continuously, like the Greeks. But that was kind of a fascinating little fact we found. Typically when you default, what happens is capital markets shut you off from borrowing. Or even a fear of default, they stop lending. So if you need funds, you may be completely cut off, and they may affect a lot of your economy. If you come back into the market at some point, they're typically going to charge you a premium because of your history, just like if any of us defaulted in some sense. And usually we see a severe recession, not always, but we often see a severe recession contraction in the economy when they lose access to the financial markets. So those are really the reasons why countries don't like to default on their debt.