Narrow Margin

Here come the world
With the look in its eye
Future uncertain but certainly slight
--INXS

James Kostohryz downplays America's debt problem, citing a McKinsey study showing that US debt levels are not out of line with the rest of the developed world.

Dismissing the severity US debt issue based on this type of analysis seems imprudent for a number of reasons. How meaningful are relative debt comparisons, for example? If all developed countries are carrying on average 200%+ debt levels relative to GDP, it seems unwise to conclude that because the US falls somewhere in the middle of the pack that we don't have a problem. On an absolute basis, there's an argument to be made that the entire developed world is essentially broke due to chronically borrowing from the future to live better in the present.

During the ~20 yr period of the McKinsey report, debt levels of all developed countries have been increasing substantially--in some cases 2x or 3x. As we've observed in sector markets over the past couple of years, accumulating debt eventually leads to levels that can no longer be serviced or funded. Exactly what that level is, no one knows. But if creditors get risk averse and no longer fund chronically increasing borrowing habits, then the world has a problem.

Moreover, the McKinsey analysis ignores future liabilities. In the US and elsewhere, this would easily double or even triple country debt levels. Moreover, leverage baked into debt-related derivatives, the notional values of which run in the hundreds of $trillions, are not considered. Given the world's leveraged, interconnected state, a seemingly 'small' problem eminating from an isolated part of the world could knock dominos onto the US and elsewhere. We've seen hints of this over the past two years. Ignoring this scenario given what we've already witnessed just doesn't make sense to me.

Leverage is a measure of debt to the value of underlying assets. If the underlying assets are valued at inflated levels, then leverage will appear lower than actual. There is a good case to be made that asset levels are being propped up by interventionary policies. If market forces re-exert their influence and take prices lower, then measured leverage will increase accordingly. And then selling begets selling as folks seek to delever...

In short, grounding a risk assessment of US debt levels in a report such the McKinsey analysis seems a myopic approach to the problem.