Personal Finance Friday - Should I Worry about the $22 Trillion Government Debt?

I got this question from a friend recently and I have to say the answer is kind of complex but I wanted to put a few things out there for people to be thinking about.

So, is government debt a bad thing in general? Not necessarily, it can serve a useful purpose, it creates a market for interest rates, it can provide funding in times of emergency or war, it can be used to build infrastructure that will have a lasting positive impact on the country.

So if government debt isn't necessarily bad, CAN it be bad? Yes, of course. If debt is created that doesn't serve a useful purpose (like paying for promises that couldn't be paid for otherwise,) you are basically taking from the future to pay the present. Also, if a country becomes overly indebted, it can have a debt or currency crisis. This means that people don't trust the debt or the currency of a country which can cause a bunch of major issues for the people in that country (much higher costs, unemployment, etc).

So is $22 trillion too much? Well that's a hard one, there is some research that suggests anything over 90% of GDP starts to become problematic (on average). You can think of that on a personal finance level like your total debt divided by our total income. So if you make $50,000 a year and have $200,000 of debt (credit cards, mortgage, etc) then you'd have a 400% debt to income ratio. Our GDP is about 19.4 trillion, so its about 113% certainly not a great situation to be in. On the other hand, Japan currently has debt to GDP of about 300%. Things aren't great there but actually not terrible either.

So right now we are probably okay, the question then becomes what happens in the future? The debt goes up because of budget deficits. Right now we are running 500 billion to $1 trillion deficits a year so that is adding right on top. But here is where the math gets interesting and what makes me not worry as much (at least right now). If we were just to maintain our 100% debt to GDP ratio we can run a annual deficit of about $1 trillion a year. How does that work? Well the math is the US economy grows at 2.5% a year plus 2.5% of inflation, so in dollars it grows 5% a year (roughly). $20 trillion times 5% is $1 trillion. That means we could maintain or lower our Debt to GDP ratio by keeping deficits at or below $1 trillion. For the time being that seems that is our current path, but when you go out further because of promises in Medicare and Social Security those numbers could start to grow much larger.

Another risk to my base case that things are okay but not great, is interest rates. If something were to happen to push interest rates up dramatically. That could be a major, major issue and start a death spiral... Why? Because currently 21% of the federal budget is used to pay interest on the national debt. 1 in ever 5 dollars of your taxes just pays interest, that's about $800 Billion a year. Now imagine if interest rates doubled? that would add $800 Billion to the budget deficit each year! Given how low interest rates are, thats not out of the question given what has happened in the past. Along with the already pretty high level of debt, things could get out of control.

So should you worry, ya maybe a little but not as much as some would say... But what should you do about it? Well, that's probably a subject for another post.