Spain and the United States have roughly the same debt-to-GDP ratios. So why has Spain been suffering through a debt crisis while US interest rates remain low? The key metric isn’t debt/GDP but rather the difference between government interest costs (the yield on government debt) and the growth rate of nominal GDP.
After Greece fessed up to cooking its books, borrowing costs jumped for highly indebted European countries such as Spain. Then tax-hike heavy austerity slowed Spain’s economy. The difference between interest costs and nominal GDP growth grew so fast that even with reductions in the primary deficit, the debt-to-GDP ratio doubled. This chart shows the sharp rise in Spain’s borrowing cost minus growth gap after 2007.
Greece is even a better example. AEI’s John Makin explains in a new report:
From the late 1990s, when Greece was scheduled to adopt the euro (most notably from 2000, when Greece was able to issue eurobonds) to 2008, Greece and the United States experienced virtually identical gaps, including negative gaps (borrowing costs below growth) during the 2002–07 “golden years” for debt accumulation.
After late 2009, when Greece revealed that its primary deficit had been far larger than previously reported, its borrowing costs soared while growth collapsed. The growth collapse was exacerbated by austerity programs aimed at reducing the primary deficit. Such ill-conceived efforts to condition bailouts on austerity were designed to reduce Greece’s debt-to-GDP ratio but actually caused it to rise.
This happened because growth fell so rapidly that tax collections collapsed and the primary deficit was little affected while the borrowing cost to growth gap soared, (see chart at top of post) . The gap then soared to 65 percentage points, while the US gap fell to a remarkably favorable –2.2 percent, where it remains today.
Now, none of this means the US doesn’t have a huge debt problem to deal with. It just means the US economy needs to a) keep growing and b) needs to deal with the approaching entitlement debt tsunami to reassure financial markets. But we are not Greece, at least not yet. Again, Makin:
Specifically, a nominal growth rate of 5 percent, composed of 3 percent real growth and 2 percent inflation, will, given 2 percent average borrowing costs, stabilize the debt-to-GDP ratio given a 3 percent primary deficit. That is the meaning of long-run deficit sustainability. By 2018, once the debt-to-GDP ratio has stabilized under such a program, reducing the primary deficit to 2 percent a year (given a growth rate 3 percent above borrowing costs) will reduce the debt-to-GDP ratio gradually by 1 percent a year. That is the meaning of sustainable long-run reduction of government debt relative to income that will ensure moderate deficit financing costs for decades to come.
Scott Sumner also made a good point on this topic and the importance of NGDP growth to debt sustainability:
Lots of news articles on the eurocrisis focus on the sky-high interest rates now being paid by the Spanish and Italian governments, roughly 6%. But I rarely see people pointing out that until a few years ago 6% interest rates on government bonds were completely normal. As was the 70% ratio of public debt to GDP that you see in Spain. So why is this interest rate now such a crushing burden? Simple, in the old days 6% interest rates were accompanied by much more robust NGDP growth rates. The problem today in the periphery is that NGDP growth has collapsed.
If structural problems prevent a return to normal real growth rates, then the living standards in those countries must take a hit. If you continued the normal pre-2008 NGDP growth rates, then the burden would be shared by both debtors and creditors. If you have near zero-NGDP growth and keep paying 6% interest to creditors, then the entire burden falls on debtors. Indeed creditors would be receiving a much greater share of GDP than they anticipated—a windfall.