Paul Krugman just posted a piece defending deficit spending. In it, he argues that while $9t seems like a big number, it’s very manageable as a percent of GDP. In his words:

“Right now, federal debt is about 50% of GDP. So even if we do run these deficits, federal debt as a share of GDP will be substantially less than it was at the end of World War II.”

A chart like this seems to support his case at first:

public-debt-gdp

There are two glaring flaws with Mr. Krugman’s argument, however. The first is that total US debt has increased dramatically, and is far higher than any other time in history. At the end of WWII, consumers didn’t have $50k credit card balances and underwater mortgages worth 20x their annual salary. Companies weren’t nearly as highly leveraged as they remain today.

total-debt-gdp

Is GDP Indicative of a Country’s Ability to Pay off Debt?

Krugman states, “What you have to bear in mind is that the economy — and hence the federal tax base — is enormous, too. Right now GDP is around $14 trillion.” (added 8/24/09 for clarity).

But does GDP really indicate federal tax base? How much does a debtor country’s GDP really say about their financial health? Fifty years ago, GDP included our strong manufacturing base. Today it includes massive government entitlement programs, war, and financial products that provide zero real value to the economy. In 2007 financial services represented 40% of corporate profits in America. Will medicare, social-security, the War on Terror, CDS, and CMBS increase productivity and pay the bills? Hell no.

Examine this chart showing Government Spending as a % of GDP:

debt-percent-gdp

The trend is clear. Government spending has steadily increased as a percentage of GDP.  The picture will worsen considerably as baby-boomers retire, putting pressure on Medicare, Social Security, pensions, etc. QE and bailouts have really only just begun.

Inflation seems inevitable with this much debt, and a full pipeline. We’re reflating the bubble temporarily, and if it works, the Fed’s job is to reign in all the money that “saved” us. They won’t, can’t. Those who think we’re going to get out of this mess by cutting expenditures and raising taxes will be proven wrong, I think. See Flaws in the Deflation Case for more on that.