NATIONAL DEBT - HOW HIGH CAN IT GO?

I am watching the Senate grill Fed Chief Bernanke about his injections of funds into the economy in an effort to restore bank balance sheets to a sound state and prime the consumer pump. I am appalled by the shallow understanding of the situation shown by most of the members of the Senate's banking committee. Here is one worrying about his local banks not having access to the TARP funds when they do. Another worries about banks receiving money but are keeping on their failed executives. And other such trivia.

In spite of their shallow knowledge of the subject in which they set the standards, the Senators did have one question that was worth answering - how large a Federal debt can we support? Bernanke responded by pointing out the familiar fact that our federal debt to national income ratio at the end of WWII was debt amounting to 120% of GDP. He said we now have a ratio of 60% and said that we should try to keep it at that level. But he also said there is no way to know what the maximum debt could be since it depends on willingness to buy our debt, which means essentially Treasury Bills.


Bernanke did not mention it, but the debt is now owned in the main by the US Government itself, mainly through Social Security purchase of T-Bills. Foreign ownership accounts for about 25% of the debt, with China and Japan owning about 20% each of that 25% and the UK about 10%. The rest is owned by various investors.

The question of how large a debt we can support may be answered in several ways. First, the US central government debt as a share of national income ranks 23rd among the major national economies of the world. Using this yardstick, and it is the IMF's ruler, we have a long way to go to reach our limits to borrowing.

Another way to measure national debt would be to compare it to personal debt. The average American family has a debt to income ratio of over 100%, thus the national debt has not yet reached the level of personal debt. One should also note that the standard rule for issuing a new prime rate mortgage is that the home should not cost more than three times the buyer's income, e.g. someone with $100,000 income can buy up to a $300,000 home.

The rule I use in assessing a company's cash flow is that the firm's indebtedness should not exceed one year's gross income, e.g. a million dollar a year cash flow means you can borrow up to one million. I do not know if others use this same rule but it has served me well in providing accurate cash flow analysis.

Using the available measures - historical, international comparisons, personal indebtedness, business indebtedness - it would appear that the national debt can be 100% of GDP without causing alarm. Adding the expected up to $3 trillion that the Obama administration plans to spend this year to revive the economy to the current $11 trillion in national debt, we should wind up with a national debt to national income ratio of about 85%, which is within the 100% guideline.

But there is a dimension to this debate that transcends the debt to income ratio. The national debt is backed by the "full faith and credit of the Republic." This is the same backing for the bucks in your pocket. Does the "full faith and credit" of the USA mean one year's GDP, or more? The critical question here is, how long will the debt holders hold the debt? If they hold it ad infinitum, there is theoretically no limit to what Uncle Sam can borrow.

The other relevant question is how much does it cost Uncle Sam to carry his debt? I have pointed out that at present the Treasury is issuing bonds that pay less than the inflation rate, some with 1% interest. In other words it will cost Uncle Sam probably less than $200 billion a year to carry this expected debt of $14 trillion, a small part of the Fed's budget expected to be some $3 trillion in 2009.

There is another factor to consider. What are the alternatives for foreign holders of US national debt? Fortunately for the USA, unfortunately for the investor nation, there are insufficient alternative instruments available in which to place these funds. They have to hold US national debt.

What does all of this mean? First, Fed Chief Bernanke was correct in saying it is hard to see how far US national debt can go. If one uses debt service ratio, i.e. how much does it cost to pay the debt, Uncle Sam has a very long way to go since he is only paying 6% of his current income to pay the debt. Assume we let debt service reach 12% of the national budget we could have a national debt of twice what it is expected to be in 2009 or $28 trillion.

If I were the Fed Chairman I would respond that we are at a high debt level now, but we can support a much higher debt. I believe President Obama should keep this in mind as he presents more programs to save the economy.

Leo Cecchini
March, 2009