I used Google to research the idea of what is America’s debt to equity ratio, a common ratio when considering investment. The closest thing Google came up with was the country’s debt to income ratio, and that led me here to something called The Credit Blog. Anyway, it turns out the blog itself wasn’t all that helpful, but a comment to the blog was very impressive. She here’s what the commentator, identified as Chip Marks, wrote.
This blog prompted me to do some research about current and historical aggregate debt (C + I + G) to GDP levels and its implications for forecasting the depth and length of the present recession. Below are some random musings regarding the above.
During the Great Depression we hit our previous peak in Total Debt to GDP at 2.6 to 1. My gut feeling is that this ratio probably was exacerbated because GDP contracted by 20% or so during the Great Depression, which made the ratio look much worse than it might have on a stabilized basis; so, let’s say the number should have peaked at only 2.1 to 1 had the economy not derailed.
Today the Total US Debt is about 53 Trillion and GDP is about 14.3T; therefore, the ratio is now something like 3.7 to 1 (before accounting for the slow down in the current US economy).
So there you have it: 2.1 to 1 (pre-Great Depression) versus 3.7 to 1 (Today). This is really terrible, no doubt.
The good news is that our economy in 2009 is so much more robust, diverse and stable and therefore able to handle vastly higher leverage ratios than in 1935. Ergo, this analysis probably defies an apples to apples to comparison. (Btw, it is nearly impossible to obtain similar numbers on other countries’ current and historical total debt burdens relative to their GDP numbers…so, the US may win an award for transparency…although, unfortunately, it’s likely to be a boobie prize.)
Notwithstanding, this disturbing revelation about the absolute level of US Total Debt to GDP begs a slew of pertinent questions such as (1) what does this ratio really mean?, (2) why is it relevant? and (3) is there some other metric that is more relevant? And, perhaps most importantly, (4) in the calculation of national levels of debt, what is the level of net EXTERNAL debt, i.e., the amount of debt owed to other sovereigns and non-US creditors in general?
1: Debt to GDP
Basically, GDP is a measure of income. In fact, before it was called GNP it was sometimes referred to as Gross National Income. Therefore, in order to assess the measure of risk associated with a run up in debt it is rational to get a handle on a party’s ability to service it.
2: Relevance of Ratios
At the current level of US Public Debt (only a mere 10.5T) to GNP, there seems to be no particular reason to be very afraid…none at all. At 0.73 to 1 (or even at 0.86 to 1 given another $2T of Federal deficits and assuming we get NO fixed asset creation, e.g., bridges, tunnels, aircraft carriers, etc. and NO financial asset recoveries, e.g., TARP bank preferred stock redemptions), this amount of indebtedness appears absurdly manageable to our economy. If we turn this ratio into something more familiar to businessmen, we see that this degree of leverage is indeed low. For instance, if GDP were a proxy for a company’s EBITDA, for USA Inc., then USA Inc. is levered to the extent of 0.73x EBITDA in 2008 and 0.86x EBITDA in 2010. If we add to this number another 2.5T to account for all state and local government debt in 2008, which should rise to 3T by 2010, the ratios still seem manageable at 0.91x EBITDA and and 0.93x EBITDA, respectively.
From a commercial real estate lender’s perspective we might look at these leverage ratios in terms of debt service coverage. The Federal DSC ratio is currently 14.3T over 455B (2008) or 31.42 times…wow, no problem!!! Correct? With 2T of additional Federal deficits, by 2010 the number hardly budges to 27 times coverage (assuming similar interest rates). Adding the state and local debts, for 2008 the coverage is 25.77 times and by 2010 the number is 24.97 times. So, if you, as a potential US creditor, were evaluating USA Inc. as a LBO (or an office building), I would bet Goldman’s credit committee be pretty happy to lend to this customer for quite some time.
The leverage issue becomes much worse, however, once you heap all of the other debt owed by US consumers and businesses. Then the numbers change pretty dramatically. To the best I can determine, the aggregate of all indebtedness in the US (from the consumer to Uncle Sam) is about $53T…this changes the ratios as shown below:
2008 Total Debt to EBITDA is 3.7 times
2008 DSC Ratio is 3.8 times (assuming 8%+/- on 40T of all non-governmental debt)
Even this doesn’t seem fatal when viewed through the lens of a businessman. In fact, by 2010, the numbers actually get better in spite of the deficits because the amount of debt “destruction” that is highly likely in the consumer and corporate sectors, which will exceed the incremental deficits run up by all government sectors.
2010 Total Debt to EBITDA is 3.5 times (assuming no growth in GDP, 3T in Federal, state and local government deficits, and 6T in debt cancellation in the consumer and business sectors).
2010 DSC Ratio is 4.1 times
3: Is there a better metric?
Perhaps a National Debt to Equity Ratio based on an annual determination of National Net Wealth would be a better gauge. Before the current financial crisis, I estimate the US possessed about 110T of tangible assets (commercial real estate, infrastructure (but not valued at replacement cost), trains, aircraft, homes, etc.) and financial assets. Of these assets, as stated above, 53T represents the aggregate debt encumbrance from C + I + G, which leaves a pre-crisis Debt to Equity Ratio of 0.93 to 1 based on a National Wealth of 57T.
Here is where it gets a little scary…assuming that by 2010 there was an decrease in Total Debt of 3T (the sum of old debt cancellations plus new government deficits), but National Assets declined by 20%, then our National Wealth plummets from 57T to 35T…a stunning 39% decline. Were this to occur our National Debt to Equity Ratio increases to 1.42 to 1, which is a hugely material drop in our national credit capacity and worthiness…probably the equivalent to a drop from AAA to Baa from a Moody’s or S&P perspective.
4. Is there a better way to look at this?
Probably, yes. One of the big differences between our Government debt and the debt of other countries is that [I suspect] a much smaller percentage of our debt is owned by foreigners. This is debt is referred to by economists as External Debt. Currently, only 30% (tops!) of our 10.5T of Federal Government debt, or 3.2T, is owned by other nations or foreigners. Add to this, say, 20% of the remaining 42.5T of our non-government debt being owned by foreigners (i.e., 8.5 T, then the total US Debt in foreign hands is only about 11.7T. Now, here comes the leap of faith. If one assumes that debt America owns to Americans cancels itself out [just like bilateral Credit Default Swap liabilities between financial institutions are canceled out in bankruptcy (an under-appreciated fact that reduces aggregate CDS exposure to the financial markets by nearly 85%)], then our “External” Debt to Equity ratio post-crisis is only 11.7T to 35T or 0.33 to 1, which is represents a solid AAA credit.
What does this mean? This means there might be a wealth transfer from the US investor class to the US non-investor class to the extent massive debt cancellation is required to solve our country’s financial dilemma. In other words, if the wealthiest 5% of Americans are willing to take a huge financial hickey, we are still in good shape.
5. Then where’s the rub?
There are still another 50T of social security, pension, medicare and veteran’s benefits to be paid out over the next 30 years? At PV this is probably only 20T in 2008 dollars. Still, it’s a big, big number that must be whittled down. Although a possible silver lining here — if one can call it a silver lining with everyone’s savings being recently wiped out — is that most US workers will now have to remain in the work place much longer, sadly, to a point in time much closer to their actual life span, thereby requiring them to pay into social security and medicare longer, and stay healthier in order to work so as to support themselves, which will serve to reduce the amount of their public sector draw downs, thus reducing the looming “twin towers” of entitlement deficits…perhaps massively.
Anyway, this is all b.s. to some extent but it’s also good food for thought. The big problem is “C” in the master economic equation. The Consumer is 71% of GDP and its indebtedness throws all the ratios deep into the red zone. Consequently, this is different than past recessions. This is the lens one needs to continually use to watch this monster because, as Yogi Berra said (or should have said), “the future sure ain’t what it used to be!”
Beezer here. What Credit Marks is identifying is that the ‘C’ in the equation is over-indebted. Households are broke, or at minimum, severely income constrained. All those folks pointing out a huge number of working people cannot afford to pay, net, income taxes are identifying the problem, but totally mis-identifying the cause. The cause is that income has been hoovered up by a very small percentage of the population, and this mis-allocation of income has totally screwed up our economy. But if you’re part of the hoover cohort, it’s easier to blame everyone else as being lazy, or shiftless, or born in Africa, or being a Muslim, or coming from Nogales,Mexico–whatever, just as long as the real culprits are not mentioned!