Debt and Economic Growth

In a few posts I’ve noted that we can expect lower economic growth in the future and one reason is the enormous amounts of debt that the country has been taking on. Carmen Reinhart and Kenneth Rogoff layout why this is so here.

In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.

We do not anticipate outright defaults in the largest crisis-hit countries, certainly nothing like the dramatic de facto defaults of the 1930s when the US and Britain abandoned the gold standard. Monetary institutions are more stable (assuming the US Congress leaves them that way). Fundamentally, the size of the shock is less. But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

[…]

Another big unknown is the future path of world real interest rates, which have been trending downwards for many years. The lower these rates are, the higher the debt levels countries can sustain without facing market discipline. One common mistake is for governments to “play the yield curve” — as debts soar, shifting to cheaper short-term debt to economise on interest costs. Unfortunately, a government with massive short-term debts to roll over is ill-positioned to adjust if rates spike or market confidence fades.

Given these risks of higher government debt, how quickly should governments exit from fiscal stimulus? This is not an easy task, especially given weak employment, which is again quite characteristic of the post-second world war financial crises suffered by the Nordic countries, Japan, Spain and many emerging markets. Given the likelihood of continued weak consumption growth in the US and Europe, rapid withdrawal of stimulus could easily tilt the economy back into recession. Yet, the sooner politicians reconcile themselves to accepting adjustment, the lower the risks of truly paralysing debt problems down the road. Although most governments still enjoy strong access to financial markets at very low interest rates, market discipline can come without warning. Countries that have not laid the groundwork for adjustment will regret it.

This is why I’ve been seemingly wishy-washy on things like deficits and tax cuts. On the one hand tightening the belt by reducing spending could send the economy back into recession (assuming we are indeed out, if not it would just make the recession worse). If we raise taxes across the board, same thing. Yet if we keep spending as we are then we can expect lower growth for quite some time. Add on things like Social Security and Medicare and we have a very bleak picture indeed.

FILED UNDER: Economics and Business, Government, US Politics
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Dave Schuler says:

    As I understand the general theory counter-cyclical expansion of spending should be followed by pro-cyclical real spending reductions. Consequently, I think it’s reasonable to ask of those advising increased spending to commit to the conditions under which they would advise spending reductions in advance. If there are no such conditions or if the conditions are unrealistic, that should be taken into account.

  2. agorabum says:

    I’m sure you’ve seen the graph of the recession (in comparison to other, post WWII downturns) that pretty much shows us at the bottom of the trough right now.

    Which implies that keep up with the spending for the next two years, but once the econemy “breaks even” (is back into full recovery and has at least regained the jobs it lost) then you can put the extraordinary efforts aside and craft a long term policy of fiscal sustainability (that will ease into effect, so as not to kill the recovery).

    To a certain extent, that is what was proposed by the current Admin. Although who knows if it can be implemented, especially with one party dedicated to tax cuts without any change in expenditures.

  3. Steve Verdon says:

    Which implies that keep up with the spending for the next two years, but once the econemy “breaks even” (is back into full recovery and has at least regained the jobs it lost) then you can put the extraordinary efforts aside and craft a long term policy of fiscal sustainability (that will ease into effect, so as not to kill the recovery).

    You are very optimstic, IMO.

  4. Drew says:

    “You are very optimstic, IMO.”

    I was thinking “delusional.”

  5. Zelsdorf Ragshaft III says:

    I tried to spend my way out of debt some time ago. The result was chapter 11.

  6. steve says:

    We have gotten out of bigger debt, as a percentage of GDP. It is mostly a matter of political will. We need both parties to commit to fiscal responsibility, ie, pay as you go and debt reduction. The Republicans need to join the Dems in that effort.

    I agree with Steve that what to do about taxes is difficult in this situation, as I noted in a prior post. IIRC, the Romer’s suggested in a paper that tax increases that are viewed by the market as intended to reduce deficits do not have much, if any, negative effect on GDP. (BTW, I appreciate your honesty on this issue.)

    Steve