A reader emails,

what is a sustainable level of US debt % to GDP?

I usually think of our debt as government debt. But adding up total private and public debt, we have something like 350 percent for a debt-GDP ratio, more than double the level of 1980. Most of the increase in the past 20 years or so has been in household debt and financial sector debt. See this post from a blog called the Elephant Bar.

Suppose that I borrow $100 K to buy a house. A lender sticks it into a security. A bank buys the security and issues debt to buy the security. I send the household sector debt up by $100,000. When the lender sells the security, does my mortgage increase the lender’s debt by $100,000? I don’t know exactly how the Fed does its flow of funds calculations, but I imagine that the lender’s debt goes up, at least in gross terms (maybe not on net, because they have an asset as well as a liability). Similarly, in gross terms the bank has more debt, and I’m guessing that this shows up in the flow of funds. So in some sense, the same debt could be double- or triple-counted. Still, even taking that into account, the leverage in the household and financial sectors certainly has gone up.

In some sense, the Bernanke-Paulson plan is to substitute government debt for financial-sector debt. (The Bair plan is to substitute government debt and/or financial sector debt for household debt, by bailing out mortgage borrowers.)

Suppose that these plans succeed in dramatically boosting the ratio of government debt to GDP. Whether or not this is sustainable is in the eye of the debtholders. If enough of them get scared, they’ll start a stampede out of Treasuries. At that point, our options will be (a) raise taxes, (b) cut spending, (c) formally default, or (d) print money. We could “borrow from the IMF,” but in our case I think that just boils down to (d) by another name.

I’d be surprised if we chose a formal default. Doing so would effectively kill financial markets for generations. My guess is that we would mostly raise taxes and print money.

A fiscal stimulus would increase the risk of the this sort of “sudden stop” in which creditors panic about U.S. government debt. We might instead want to err on the side of risking a steeper recession, taking Tyler Cowen’s advice:

Spend less, save more, be poorer for a while.

Nobody who wants to be elected could campaign on that platform.