The Problems with Debt-to-GDP Ratios

U.S. debt is climbing toward 100% of GDP — a figure that many are seeing as magic number that portends doom. But Yale Economist Robert Shiller says that logic is flawed — very flawed.

“Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?” Shiller writes for Project Syndicate. “That would clearly be nonsense. After all, debt (which is measured in currency units) and GDP (which is measured in currency units per unit of time) yields a ratio in units of pure time. There is nothing special about using a year as that unit. A year is the time that it takes for the earth to orbit the sun, which, except for seasonal industries like agriculture, has no particular economic significance.”

Economists annualize quarterly GDP data, multiplying it by four, Shiller notes. A more relevant approach, he says, would be “decadalizing” GDP — that is, multiplying quarterly GDP by 40 to estimate GDP over a decade, since countries don’t have to pay off all their debt in a single year.

In fact, Shiller says current debt poster child Greece’s biggest problem isn’t debt, but psychology.

“What is really happening in Greece is the operation of a social-feedback mechanism,” he says. “Something started to cause investors to fear that Greek debt had a slightly higher risk of eventual default. Lower demand for Greek debt caused its price to fall, meaning that its yield in terms of market interest rates rose. The higher rates made it more costly for Greece to refinance its debt, creating a fiscal crisis that has forced the government to impose severe austerity measures, leading to public unrest and an economic collapse that has fueled even greater investor skepticism about Greece’s ability to service its debt. This feedback has nothing to do with the debt-to-annual-GDP ratio crossing some threshold, unless the people who contribute to the feedback believe in the ratio.”

Shiller also discusses the oft-cited study that indicates countries grow significantly more slowly when debt/GDP ratios exceed 90%, pointing out several flaws with that analysis. “The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon,” he says. “They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures. The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.”