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Yes, the National Debt Still Really Matters
By Jack Salmon
When the president released his profligate budget proposal earlier this year, Treasury Secretary Janet Yellen described the plan to raise the debt ratio (total public debt as a share of GDP) to 117% within the decade as “fiscally responsible.” The increasingly popular notion that the debt ratio doesn’t matter has gained prominence among economists and policymakers in recent years—especially among those with ambitious public spending proposals.
While several dangers arise from ignoring the upward-spiraling debt ratio, in a recently published journal article I focus specifically on the negative growth effects of a high and rising debt ratio. A review of 40 studies published over the past decade reveals a notable pattern: that high (and growing) levels of public debt have a negative impact on economic growth.
How High Levels of Public Debt Reduce Growth
A high and growing public debt ratio negatively affects economic growth rates in several ways. As governments increase borrowing to finance their ever-growing debt obligations, less money is available for private businesses and individuals to invest. Two recently published studies find that every 1 percentage point increase in the public debt ratio reduces private investment by 0.23-0.24 percentage points.
Debt also dampens growth by increasing the risk of holding U.S. debt, which causes investors to demand a higher rate of interest on debt service payments. The resulting increase in interest rates reduces both public and private investment as the government is forced to allocate a larger share of its spending power toward debt service financing instead of funding other services.
Another channel through which public debt reduces growth potential is one that myopic and self-interested advocates of growing debt often conveniently overlook—namely, higher distortionary future taxes. Eventually large tax hikes will be necessary to fund future liabilities and rising debt repayments. These future tax hikes will negatively affect investment and productivity and will significantly dampen future economic growth rates.
When Will the Growth Rate Start Decreasing?
Because high and growing levels of debt have negative and significant effects on economic growth, economists have sought to find out if there is a specific threshold level at which these negative effects will start to kick in.
Of the 31 studies on the debt-growth relationship published since 2010 that explore the existence of a threshold, 25 studies find that a threshold level does exist. Taking this sample of 25 studies together, a threshold level (mean and median) for developed countries is around 80% of GDP. Studies that estimate the growth effects of increasing debt levels above this threshold find that on average, every 10-percentage-point increase in the debt-to-GDP ratio reduces economic growth by 0.2 percentage points.
To put this into perspective, if the U.S. economy were to grow on average 2.5% (real GDP) per year with a debt ratio of 80%, all else being equal, the debt ratio would grow to 120% and average growth would fall to 1.7% per year. This difference in growth rates may seem negligible to some, but the difference between 2.5% annual growth and 1.7% growth is the difference between doubling national GDP every 28 years versus every 41 years.
Debt dynamics in Europe demonstrate why the debt ratio matters for growth. From 2000 to 2019, European Union countries with debt ratios that never fell below 80% (high-debt countries) averaged only 0.8% real GDP growth, while EU countries with debt ratios that never exceeded 80% (low-debt countries) averaged 3.1% growth.
Avoiding a High-Debt, Low-Growth Future
While future technological innovations have great potential to boost productivity and growth, high and growing levels of public debt may push growth rates in the opposite direction. With lower rates of economic growth, the U.S. has less ability to grow its way out of debt, and a smaller economy means a reduced ability (relative to a low-debt economy) to collect sufficient revenues to finance growing debt repayments. In a fiscal environment where budget deficits, the annual additions to the debt stock, are 5% of GDP in good times and 15% in bad times, U.S. policymakers must consolidate our fiscal finances to avoid the impending possibility of economic stagnation.
With a debt ratio exceeding 100% in 2020, the U.S. fiscal condition is already having a deleterious impact on the country’s growth potential. Policymakers need to stop kicking the can farther down the road and act now to return sustainability to America’s federal budget and fiscal condition.
Policymakers should consider implementing real institutional reform to change the debt trajectory, including meaningful budget rules that have broad scope, few and high-hurdle escape clauses, and minimal accounting discretion. To reduce the debt burden, policymakers should instill a program of fiscal consolidation that focuses at least two-thirds of the consolidation measures on spending reductions, rather than tax increases, to maximize chances of success.
While several options for improving fiscal sustainability are available to policymakers, reducing the national debt is a key measure to implement now, when the benefits will be greatest. The future growth potential of the U.S. economy and comparative living standards of the average American ultimately depend on the willingness of our political leaders to address the issue at hand.