The Fallacy of Debt/GDP

If you read the news, you will often read about economists, politicians and god knows who opining on countries having excessive debt/GDP ratio and it is all unsustainable because a debt/GDP ratio is bad. Now before you accept that and go down the street with a placard saying that the world is going to end, hang on and think - does it make sense?

What does debt/GDP ratio measure? GDP is akin to the income that a country makes annually - not unlike what my annual income is to me, which by the way is pathetic. So debt/GDP = debt/annual income.

To see why the debt/GDP ratio does not make sense, let us draw a parallel to a common situation that many of us have found or will find ourselves in. Let's say you want to borrow some moola from the bank. What does the bank look at when assessing whether to lend you some money? The bank will look at your debt/asset ratio. The bank will also look at your interest coverage ratio - income/interest payment. But does it look at your debt/income level? No! Because it doesnt make sense. The comparison is flawed because there is no basis of comparison between the numerator and denominator.

The correct way to see it is to look at the debt of a country versus its assets. But admittedly, it will be hard to identify and place a value of the asset. An alternative is to look at the debt payments versus the tax revenue of the country - a much easier analysis. And undoubtedly a more correct one. Moroever, this measure makes more sense, because when we talk about sustainability, we also bring into the concept of solvency - the ability to meet payments. A interest coverage ratio for the country shows that. A debt/GDP ratio does not.

I have yet to done the requisite work to prove this but I am pretty convinced that if we measure sustainability by a debt/asset or a debt payment/tax revenue method, we will see that many countries that are deemed to have a non-sustainable debt level is actually pretty much sustainable.

To include an additional dimension to the analysis, let us expand on the concept of sustainability. Sustainability does not just include the concept of interest coverage and leverage but also the ability to roll over debt. And also equally important - at what terms does the debt get rolled over at? Unlike an individual or a corporation, the government/country is in a unique position to influence the cost of debt. This is because the cost of debt is partially determined by the market (investors) and by the existence of alternative investments which price or return is partly determined by the country's monetary policy. And many a times, the reason why a country's debt gets to roll over may not be based solely on sustainability of the country's fiscal position but could very much be contingent on other factors not dissimilar to factors that influences a bank decision to lend more to existing high risk clients - e.g. a country is too big too fail.

In conclusion, I put forth the hypothesis that many countries have a sustainable debt level if measured by the correct measure. And if that is true, all these concerns by renowned economists are over-hyped. And if the markets move in fear of such concerns, that will represent a golden opportunity to profit at the misinformation of the masses.