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When Is There Too Much Debt?

September 27, 2012

It's easy to see how much federal debt is outstanding. That number is posted in many places, especially this election year. But it is not easy to know how much debt is too much debt.
-Gary Thayer, chief macro strategist, Wells Fargo

Total U.S. federal debt recently surpassed the $16 trillion mark. This debt level has become an important election issue, especially since several European countries are in financial crises because their debts increased to unsustainable levels. Many investors are concerned that the United States could experience similar problems, if the newly-elected Congress does not seriously address the debt and deficit issue after the election.

It's easy to see how much federal debt is outstanding. That number is posted in many places, especially this election year. But it is not easy to know how much debt is too much debt. There is no magic debt number that is too big. The answer depends on economic conditions much like driving speeds depend on road conditions. When driving through a neighborhood with stop lights, 35 miles per hour is an appropriate speed. But on the highway, where there are no stops, a faster speed is appropriate. Similarly, in a weak economy, low debt levels are less of a burden, whereas in a strong economy, investors are often willing to fund high debt levels.

History shows that debt becomes too great when future economic prospects deteriorate and investors worry that the government cannot support that debt. At that point, interest rates often increase to attract unwilling investors. Those higher interest rates can lead to even more borrowing to service that debt. When that happens, investors may worry that the debt is even more unsustainable.

To compare debt levels with economic conditions, many investors look at the amount of debt that needs to be financed relative to the size of the economy as represented by the yearly gross domestic product. In the United States, only $10.8 trillion of the total outstanding debt needs to be financed by investors. The remaining $5.2 trillion is nonmarketable debt held in government trust funds. The U.S. economy is currently producing more than $15.6 trillion of output or GDP. That means that the marketable debt-to-GDP ratio is a little less than 70% of GDP. This compares with 163.3% of GDP for Greece in 2011, 100.4% of GDP for Portugal in 2011 and 99.6% of GDP for Italy in 2011. This comparison indicates that the United States is not at the same crisis point faced by several European countries.

Another important debt comparison is the percent of debt held by the federal government, businesses and households. The following three charts reveal that federal debt as a percent of total nonfinancial debt in the United States has increased during the past four years as the yearly federal deficit increased substantially. However, at the same time, household debt has declined while business debt has grown at a subdued rate reducing their share of total debt outstanding.

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