GibranNicholas.com

Many thanks to those of you who have commented on my two previous posts!

The main concern that some of you have expressed is that I am calculating the US debt ratio using our total national economic output (GDP) as opposed to looking at the actual tax dollars received by the government.  This is quite normal when discussing the economics and debt ratios of sovereign governments like the United States.  Here’s why:

Let’s go back to the homeowner in my example who is earning $140,000 per year.  Part of that $140,000 is being budgeted for food, part of it is going toward clothing, part of it is being spent on shelter, etc.  No one area of that person’s life is receiving the full $140,000.  You see, if the household spends their entire $140,000 of income on just one area of their life such as food or shelter, there would be no money left over for anything else.  The household would quickly die of either starvation, exposure to the elements, or both.

The same is true with the total economic output of a sovereign nation like the United States.  Part of the $14.5 trillion we produce collectively as a nation is going toward consumption, part of it is being taxed and going to support our government.  No one area of our economic “life” gets the full $14.5 trillion.  If the government were to tax the full $14.5 trillion at 100%, our economic output would quickly collapse because there would be no cash left over for anything else.  Let’s not forget however, that just like a household can decide how to manage its $140,000 of annual income, our government (all of us collectively through our elected officials) can choose how to manage our $14.5 trillion of annual economic output. In other words, a sovereign government does have the authority to raise taxes to 100%, just like a household has the authority spend 100% their income on only one area of life.

THAT my friends, is the reason why economists look at total debt levels compared to total economic output when calculating the debt ratios of sovereign nations like the United States!

Here’s an interesting fact:

During World War 2, the US debt ratio (using these exact same metrics) reached a high of over 100%.  Interest rates remained low and we did not collapse from over-indebtedness.  After the crisis was over, our economy came back to life and grew at a much faster rate than the growth of our national debt burden.  So yes,we have been through this before and we came out on the other side just fine.

Also, let’s remember that although this method of calculating the debt ratio is the most popular among economists, there are other measurements that are sometimes used by economists to judge the solvency of a sovereign nation.  For example, let’s go back to the homeowner in our example with a total debt burden of $120,000.  Assume that this homeowner has a home worth $720,000.

The total loan-to-value ratio would be 16.67%.

($120,000 debt burden / $720,000 home value)

Now, let’s apply this concept to the United States as a sovereign nation.

As of the third quarter of 2008 (the latest available statistics), US households and businesses had a total net worth (assets minus liabilities) of over $72.6 trillion.  Let’s calculate a loan-to-value ratio on the United States:

If you don’t include the liabilities of Fannie and Freddie, the total US loan-to-value ratio is approx. 9.6%

($7 trillion total US debt / $72.6 trillion total US net worth).

If you do include the liabilities of Fannie and Freddie, the (as yet) unused bailout funds, and the latest economic stimulus package that is likely to pass in the next week or so, the US loan-to-value ratio would be 16.7%

($12.14 trillion total US debt ceiling / $72.6 trillion total US net worth)

So in other words, the US has a loan-to-value ratio of 9.6% – 16.7% and equity of 83.3% – 90.4%.

Would you make a loan to this borrower?