The Debt/GDP Ratio Is NOT Useful. What You Need To Know 1
The world has a debt problem.
Governments all over the globe were already heavily indebted going into 2020; and the wave of lockdowns, and in many countries re-lockdowns, only made things worse – to the tune of $24 trillion.
Rising global debt piles are not a new phenomenon, and many forecasts have been made over the years predicting a wave of government defaults. Japan is the best example of this, with predictions of its imminent default stretching back decade.
Japan still hasn’t defaulted.
As a matter of fact, a good number of traders betting on a Japanese default have instead gone bust themselves.
So much so that shorting Japanese Government Bonds (JGBs) has been nicknamed the “widowmaker” trade. Ostensibly because Traders who have gone bust shorting JGBs proceed to take their own lives, making widows of their wives.
But why hasn’t the Japanese government defaulted yet?
After all they are in debt to a tune of about 1.2 quadrillion Yen, that’s 1 with 15 zeros behind it, plus an extra 200 trillion for good measure; which works out to be around 11 trillion USD.
Surely any government would have crumbled underneath such an enormous debt load by now, with the Japanese debt to GDP ratio at 266% in 2021, having first moved above 200% in 2009.
That’s 12 years of owing twice as much as the country produces!
Since debt to GDP is the most prevalent, if not popular, metric used when discussing public debt loads, and Japan’s ratio is mind-blowingly high, let’s answer the question of why Japan hasn’t yet defaulted by first understanding what the ratio does and does not represent.
All the ratio represents is how much the country has borrowed relative to how much it produces, and that’s all it is.
It doesn’t tell us how much more a government can borrow before markets stop lending to it, Japan is the perfect example of this.
It also doesn’t tell us if or when a government will default. Again, Japan is a perfect example.
However, a lot of folks intuitively equate production with income, and therefore take the debt to GDP ratio as an indicator of a country’s ability to repay its debts, which just isn’t the case.
Because, firstly, governments do not pay off their debts using GDP. Governments pay off the interest and principal amounts of their debt using public sector revenues (mostly from taxation).
Since taxes can only be a portion of GDP, this means that the debt to GDP ratio overstates a country’s ability to repay its debt, that is if one interprets the ratio in the conventional way.
But, even with this overstatement, Japan still hasn’t defaulted.
There has to be something more going on.
Which takes us to the next problem of the conventional interpretation – misunderstanding measures of stock and flow.
To be continued…
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