U.S. debt: A four-letter word or a necessary evil?

August 11, 2011

Los Angeles Times

Ken Bensinger

Standard & Poor's decision to downgrade U.S. debt helped trigger the volatile turmoil that has rocked global financial markets. The ratings bombshell also fueled scoldings that America was finally getting a comeuppance for its spendthrift ways.

Nearly 1 in 2 Americans thinks the country should not borrow more money, and deficit hawks on Capitol Hill have portrayed the $14.5 trillion in debt as a national emergency. "The dysfunction in Washington is the belief that we can live beyond our means forever," Sen. Tom Coburn (R-Okla.) said recently. "We can't."

Yet economists were largely unperturbed by both the debt debate and the downgrade. That's because many of these experts view the nation's current debt level as both modest and necessary.

Like taking out a mortgage to buy a home, sovereign debt — the short-, medium- and long-term bonds that are essentially IOUs issued by a country — is crucial to maintaining and expanding an economy.

"People think that debt is terrible, end of story," said Jared Bernstein, senior fellow at the Center on Budget and Policy Priorities and former economic advisor to Vice President Joe Biden. "I'd argue we have to take on some more of it to get the country in the right direction."

Federal debt not only helps pay the bills but also allows a government to undertake new infrastructure projects, develop new technologies and finance programs like education and scientific research.

And debt is hardly a new tool: The Louisiana Purchase in 1803 was financed by federal bonds underwritten by banks in London and Amsterdam, with the U.S. putting down only $3 million of the $15-million total price in cash.

All this may seem obvious to anyone who closely follows the economy, yet debt, in recent months, has become something of a four-letter word. Presidential candidate and U.S. Rep. Michele Bachmann (R-Minn.) recently declared that our "national credit cards are maxed out."

Tell that to the market. In the first three full days of trading after S&P's decision to drop U.S. long-term credit to AA+ from AAA for the first time since America received the top grade in 1917, investors raced to buy star-spangled bonds — exactly the opposite reaction from what might be expected in a downgrade.

In a key indicator of demand, prices of 10-year U.S. Treasuries have risen for three straight days after the S&P downgrade late Friday.

"If everybody thought the U.S. was in trouble, we'd see bond yields go up," said John Cochrane, a University of Chicago economist and an expert on monetary policy. "What investors are really worried about is the risk of a double-dip recession and about the economy in general."

Too much debt, of course, isn't good either — as the mortgage meltdown illustrated. Argentina is still recovering from its default on $100 billion in debt a decade ago.

China, which holds more than $1.2 trillion in U.S. Treasuries, is constantly pressuring America to get its debt situation under control. But economists say the key issue is not the size of the debt but the debtor's ability to keep up with the payments.

And many believe that although the U.S. needs to put the brakes on rising debt levels, this is not the best time to do that — especially with interest rates at record low levels.

Neither Fitch Ratings nor Moody's Investors Service, the other major rating firms, have moved to downgrade U.S. debt; both reaffirmed their AAA ratings last week.

In its downgrade, S&P focused particularly on America's political gridlock, exemplified by the recent debate over raising the debt ceiling. The rating firm, a for-profit company owned by McGraw-Hill Cos., said it had found that Washington had "become less stable, less effective and less predictable than what we had previously believed."

But S&P also expressed concern over the nation's "rising public debt burden" as compared with " 'AAA' rated sovereign peers."

Yet of the world's 17 countries with the gold-plated AAA credit rating, seven have a higher ratio of public debt to gross domestic product, a key indicator of national indebtedness, according to Eurostat. Among them: the Netherlands, Britain and France.

Germany, also AAA-rated and currently viewed as the paragon of international financial virtue, had a nearly 80% debt-to-GDP ratio in 2010, according to Eurostat, compared with a U.S. figure below 65% at the time. Even pessimistic projections by S&P have America's debt ratio reaching 79% by 2015; the bipartisan Congressional Budget Office, by comparison, forecasts a debt ratio of only 74% by that date.

Indeed, the national debt isn't even that elevated by historical standards. In the wake of World War II, U.S. debt peaked at almost 109% of GDP in 1946, federal figures show.

To put it another way, consider that a typical mortgage is four to five times a borrower's annual income; add to that student loans and credit card debt and a family's debt load can easily match or surpass the U.S. government's current ratio of about six times more debt than revenue.

Regardless, economists say that too much emphasis on the debt ratio may be a distraction from more important issues.

Take Australia. In 1986, S&P downgraded Australian debt, dropping it from its vaunted AAA status.

Chastened, Australia put its head down and worked hard to win back the rating company's good graces. It took 17 years, but in 2003, Australia had clawed its way back to AAA status, slashing its debt and running a perpetual budget surplus in the process. Today, S&P crows about the land of kangaroos in its reports.

Investors couldn't care less. Time and time again, they choose to buy U.S. Treasuries, even though they carry a far lower interest rate.

That's in part because the U.S., as the holder of the world's reserve currency, has a unique ability to print dollars to help pay down its debt — something that Australia, Germany or Brazil cannot do, said Barry Eichengreen, an economist at UC Berkeley.

But investor enthusiasm for U.S. debt doesn't mean the country doesn't have problems, he added.

"There is concern about the U.S. fiscal situation in the medium term," Eichengreen said, pointing to the nation's dwindling revenue and lack of fiscal clarity, high unemployment, stagnant economy and flagging consumer confidence.

Rather than racing to pay down the debt, he and others argue, the country needs to find a way to spark growth and get on track to reach a stable level of indebtedness for the foreseeable future. And one of the best ways to do that, history has shown, is for a country to invest in expansion.

"You want to show you can have a strong economy," said Adam Lerrick, an economist at the American Enterprise Institute who as an investment banker a decade ago helped restructure Argentina's defaulted national debt.

How that can be accomplished is a matter of charged debate, as the country has witnessed in recent months, but inevitably it will require borrowing more money to do it, at least in the short term.

For Bernstein, that means investment in America. "For now," he said, "we continue to need to spend more than we take in to improve the economy."

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