James Pethokoukis

Politics and policy from inside Washington

Japan shows why U.S. must slash debt

March 15, 2011

You never know when a black swan will float your way. And when your credit card is nearly maxed out, dealing with emergencies can be tricky. A massive rebuilding effort may stretch Japan to its financial limits. Politicians in Washington should take note of the warning for several reasons:

1) Trying to calculate a country’s available “fiscal space” — the additional amount they can borrow before markets demand a sharply higher premium — is guesswork. The global financial crisis took the public debt of advanced economies to 75 percent of GDP in 2009 from 60 percent in late 2007. And by 2015, the International Monetary Fund reckons, the average ratio may hit 85 percent. That’s perilously close to the 90 percent level where debt seems to really hamper growth, according to economists Carmen Reinhart and Kenneth Rogoff. (The White House is somewhat skeptical of this research, by the way.)

2) But all nations are not alike in their profligacy. They have different debt levels and different track records in dealing with debt. Based on those variables, new IMF research suggests that some nations — including Japan with its 200 percent debt-to-GDP ratio — have very little room to add new debt before markets balk. (CDS prices for Japanese debt, are closer to that of Mexico’s than America’s or Germany’s.)

The United States and the UK, by contrast, probably have a bit more capacity, the IMF says. But that extra space could easily be gobbled up by unforeseen events, such as the earthquake-triggered disasters that may cost Japan 3 percent to 5 percent of its GDP to address.

3) One unforeseen event that Team Obama might want to consider is a rise in interest rates. If  long-rates are just a single percentage point higher over the next decade than White House forecasts, it will add $1.3 trillion to the national debt.  Or consider these calculations from the e21 think tank:

In the Administration’s baseline estimate, the public debt will rise from 62.2% of GDP in 2010 ($9 trillion) to 77% of GDP in 2021 ($18.9 trillion). … Over this period, the effective interest rate implied by the ratio of net interest expense to public debt is 3.5%. (This happens to be the average for the 5-year constant maturity Treasury rate over the past 10 years.)

However, the average 5-year borrowing cost for the 10 years ending in January 2000 was 6.3%, while the average 5-year borrowing cost for the 10 years ending in 1990 was 10.4%.  If the average effective interest rate on the debt were to climb to the 10.4% average of the 10 years ending in January 1990, the public debt would explode to nearly 150% of GDP by 2021. Under the more modest 6.3% assumption of the 1990s, the debt ratio would exceed 100% of GDP by the end of the decade. Rather than doubling, as assumed by OMB, the public debt would quadruple over ten years to more than $36 trillion.

e21

4) And the unexpected natural disaster isn’t so unusual. Reconstruction after America’s Hurricane Katrina in 2005 cost something of the order of 1 percent of U.S. GDP, while New Zealand’s recent earthquake could cost it more in relation to the country’s output than the current estimates for Japan. Then there’s the question of necessary-seeming activity abroad. President Barack Obama may be pondering the potential $300 million a week tab for enforcing a no-fly zone over Libya; if so, he won’t be alone among NATO members in wondering how to pay for it.

The United States and quite a few other developed nations would appear to have little headroom to deal with the costs of another bank crisis — much less, say, a new war. It’s something for those running cash-strapped governments to remember. If they don’t create breathing room, they not only have to make hard budget choices but also pray that Mother Nature will be kind.

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