To the Editor:

This is my third letter on the economic issues involved in this year’s presidential election.

III. THE U.S. FEDERAL DEBT.

At the end of 2011 the gross U.S. Federal Debt stood at about $14.8 trillion dollars. Although it’s hard to grasp a number this large, maybe it’s not as big a problem as the deficit hawks would have you believe.

Gross Federal Debt includes federal interagency debt. Public debt amounted to a more modest amount of $9 trillion dollars at the end of 2010. Public debt is held by foreign governments, businesses and individuals as well as U.S. state and local governments, businesses and individuals. U.S. entities hold about 53% of the debt and foreign entities hold the remaining 47%. Mainland China holds about 22% of the public debt held by foreign entities.

The deficit hawks always include federal interagency debt in the Federal Debt when they want to scare you about the level of the Debt. The Social Security Trust Fund represents the lion’s share of interagency debt. The addition to the Trust Fund in a given year is the amount that Social Security contributions exceed the cost of benefits in that year. The deficit hawks, when they are talking about how long Social Security will be able to pay out the present level of benefits, exclude the Social Security Trust Fund. For consistency the Social Security Trust Fund needs to be included or excluded in both discussions of the level of the Federal Debt and the health of the Social Security System. Social Security Trust Fund additions, instead of being segregated and invested, have been added to the General Fund and spent on government operations. Some would say Congress has been guilty of theft.

The absolute amount of the U.S. Federal Debt doesn’t really matter. What matters is the ratio of the public debt to gross domestic product (GDP). This figure stood at 62% at the end of 2010. Only public debt really affects the willingness of governments, businesses and individuals to hold Treasury Securities. After Moody’s downgraded the U.S. Government’s credit rating last year, funds in search of a safe haven flooded into Treasury Securities and interest rates dropped to unbelievably low levels. The dollar is still the world’s reserve currency and the euro is no longer a viable candidate to replace it.

In 1946 the U.S. public debt to GDP ratio hit 109%, its highest level. It dropped to 80% in 1950, 46% in 1960 and 28% in 1970. The driving force behind this decline was vigorous economic growth, moderately increased inflation and reasonable deficit spending.

We have heard that, if we don’t begin to repay the debt, we will end up like Greece or Ireland. All of the debt of developed countries other than the U.S. is generally public debt. The ten highest debt to GDP ratios in the developed world at the end of 2011 were found in: Japan (204%), Greece (165%), Italy (110%), Ireland (108%), Portugal (108%), Belgium (98%), France (86%), United Kingdom (86%), Germany (81%) and Hungary (81%). It is interesting that Germany and France, Europe’s two strongest economies, made the top ten, but Spain with a debt to GDP ratio of 69% didn’t make the list. Obviously, GDP growth potential affects the markets’ view of developed countries sovereign debt.

The U.S. doesn’t even make the top ten developed countries on this list. A very rough estimate of the decline in the debt to GDP ratio in a given year can be obtained by adding the GDP growth rate to the inflation rate and subtracting the deficit as a percentage of GDP. Deficit hawks in the U.S. and in Germany reject a temporary modest increase in inflation to decrease the debt to GDP ratio. However, a GDP growth rate of 3 to 4 percent with a modest inflation rate of 5% and a deficit to GDP ratio 4 to 5 percent would take care of the debt to GDP ratio within a decade. The trick is to stimulate an ailing economy until it reaches a point where it’s momentum will carry it to the desired growth and inflation rates and then eliminate the stimulation.

Ed Smith

The Elk Ridge Economist