Yesterday I was on a panel at Heritage looking at a Swiss-style debt brake and whether it was appropriate for the US.
US federal debt is now at its highest level as a proportion of GDP since 1950. Even prior to the recent tax cuts and budget-cap busting omnibus spending deal, debt was forecast to rise to 150 percent of GDP over the next three decades, primarily due to an aging population interacting with existing entitlement promises. Next week the Congressional Budget Office will publish its economic and fiscal outlook, which will show much higher deficits over the coming years following recent policy changes, and hence an even worse baseline of debt to ride into this fiscal headwind. Analysts expect the annual deficit could rise to around 5.3 percent of GDP in the next year or so.
Why does this matter from an economic perspective?
There are good economic reasons why we should desire a lower long-term debt-to-GDP ratio. For starters, a lower debt burden is insurance against the kind of “earthquake” debt crisis that John Cochrane and his Hoover Institution colleagues wrote about in the Washington Post last week. There are also obviously significant intergenerational consequences for taxpayers stemming from continually kicking the can down the road with ever-rising accumulated debt, with rising debt interest payments taking up a much higher proportion of government spending.
But a new Dallas Fed Economic Letter builds on previous research suggesting potentially the most damaging consequence: a rising debt trajectory seems to be associated with slower economic growth.
Back in the early part of this decade there was a huge debate about this. Ken Rogoff and Carmen Reinhart published a paper suggesting that growth across countries tended to slow substantially when government debt exceeded 90 percent of GDP. This “threshold effect” was taken by some commentators and politicians as gospel, but economists were more skeptical of thinking 90 percent represented a magical threshold beyond which disaster would strike. Then mistakes were found in the Reinhart-Rogoff work, and that hook was used to discredit the idea that there was a negative transmission mechanism between high debt and low growth at all.
This was an overreaction. Reinhart and Rogoff were not the only ones to find such an association. In fact, there was a lot of evidence out there that high debts were associated with slower growth. Stephen Cecchetti, M. S. Mohanty, and Fabrizio Zampolli identified a debt-to-GDP threshold of about 85 percent as a point beyond which growth tends to slow. Even Thomas Herndon, Michael Ash, and Robert Pollin, who replicated Reinhart and Rogoff’s work correcting for the errors, found that, on average, growth was 1 percentage point per year lower when government debt exceeded 90 percent of GDP than when debt levels were between 60 and 90 percent.
That’s what makes the new Dallas Fed note so interesting. They acknowledge, in line with basic intuition, that “the debt–growth relationship is complex, varying across countries and affected by global factors.” They also highlight the problem of disentangling the two-way causality between the two, and the possibility of discontinuities. Nevertheless, looking at a panel of advanced and emerging economies they conclude:
persistent accumulation of public debt over long periods is associated with a lower level of economic activity. Moreover, the evidence suggests that debt trajectory can have more important consequences for economic growth than the level of debt to gross domestic product (GDP).
Although there is no universally applicable threshold beyond which growth slows, countries with “rising debt-to-GDP ratios exceeding 60 percent tend to have lower real output growth rates.” What’s more, persistent accumulations of debt are associated with worse long-run growth outcomes:
These estimates are all negative and in the range of -5.7 to -9.4 percent, suggesting that a persistent accumulation in the debt-to-GDP ratio at an annual pace of 3 percent is eventually associated with annual GDP growth outcomes that are 0.2 to 0.3 percentage points lower on average.
Though the authors are careful to point out that this does not prove causality, the study does present evidence that if there is a transmission mechanism from high debt to low growth, the key to overcoming it is credible commitments and action to ensure debt increases are temporary phenomena. For the US federal government, rising debt looks a permanent reality right now as far as the eye can see.
For more on how fiscal rules could help play a part in changing this, read here.
And here’s the full discussion at Heritage from yesterday.