Debates about government debt, whether in the United States, Japan, the eurozone, or elsewhere, have been missing one fundamental point: The composition of both debt and spending matters just as much as the size. This is such a basic, obvious notion, yet it seems to have eluded many of the politicians, pundits, and credit-raters who have been obsessing about the billions or trillions of dollars that may be spent or saved. In the case of the United States, it is particularly germane.
For American politicians, the big numbers are the ones that invariably get top billing, as they did at U.S. President Barack Obama's Monday-morning press conference on the debt ceiling fight. Yet whether it's $970 billion (the projected deficit after the "fiscal cliff" deal) or $11 trillion (the debt held by the public), these numbers say nothing about how money is borrowed and spent. In Washington, the only difference between good and bad spending is usually 'spending in my district' versus 'spending somewhere else,' as Obama mockingly remarked. It doesn't take much brainpower to see how much important information such a simple, shortsighted distinction omits.
Imagine two people with similar assets and incomes who are both seeking to borrow $100,000 for 10 years. One plans to spend the money on a master's degree that will improve her options in the labor market. The other plans to take a luxurious vacation with his family and buy a pleasure boat. To whom would you charge the higher interest rate? By investing the money in her ability to repay, the first borrower is increasing her credit-worthiness. She should be able to obtain a lower interest rate on the $100,000; she should also be able carry more debt than the other borrower at any given interest rate.
Now imagine that two other people with similar assets and incomes both plan to carry $100,000 in debt for 10 years. One has a fixed interest rate of 3 percent for the entire period. The other has borrowed for two years at 2.5 percent and plans to roll over the debt -- repay and then borrow again -- four times. Which borrower has the bigger risk of default? Since interest rates can fluctuate a lot over the years, and they seem pretty low right now, the long-term borrower probably has the safer strategy.
The lesson is clear: How you borrow and spend can make as much difference to your credit-worthiness as how much. And it's no different for governments. A government that uses borrowing to invest in its economy's future growth -- and hence its ability to repay -- should be able to borrow more than one that doesn't, all other things equal. By the same token, a government that borrows at low, fixed rates for the long term should be able to borrow more than one that constantly rolls over short-term debts.