The Morning After America's Debt Binge
The hangover will likely last two decades
President Barack Obama is adamant that he will not be held "hostage" by the Republicans in the House of Representatives, who are threatening not to raise the U.S. debt ceiling without some concessions on future spending and Obamacare. If the debt limit is not raised, allowing the Treasury Department to borrow more money, the federal government will default on some of the bills it owes in the next couple of weeks. Lots of commentators believe that such a default would have significant, if not devastating, downside economic effects.
Maybe so. But we should also want to consider the ways a relentlessly rising level of debt could damage our economic prospects. The debt ceiling for the United States is currently set at $16.7 trillion. In 2000, the U.S. national debt stood at $5.7 trillion. The amount of the U.S. national debt is now roughly the same size as the annual output of the economy. Is this a problem?
Yes, suggests recent research by numerous macroeconomists. Specifically, they find that a big public debt "overhang" likely slows down future economic growth for more than two decades. In other words, excessive national debt racked up now will make future Americans considerably poorer than they would have been otherwise.
Let's start with a 2012 study in the Journal of Economic Perspectives, conducted by the Harvard economists Carmen Reinhart and Kenneth Rogoff and Morgan Stanley chief economist Vincent Reinhart. In that study, which looked at 22 advanced countries, the researchers identify in the years between 1800 and 2011 some 26 episodes lasting more than five years in which public debt to GDP ratios exceeded 90 percent. They argued that if the public debt-to-GDP ratio is greater than 90 percent for five or more years, then, on average, economic growth rates fall from an average of 3.5 percent to 2.3 percent annually, a drop of 1.2 percent. Even the fierce critics who pointed out a major error in the earlier work of Rogoff and Reinhart find that when the debt-to-GDP ratio is greater than 90 percent that subsequent economic growth averages 2.2 percent annually, falling from 4.2 percent when the ratio is below 30 percent.
Similarly, a 2010 working paper by the International Monetary Fund economists Manmohan Kumar and Jaejoon Woo looked at the effect that high public-debt-to-GDP ratios had on the economic growth of 38 advanced and emerging economies between 1970 and 2007. The study found evidence that surpassing a debt-to-GDP threshold of 90 percent has a significant negative effect on growth. The researchers also reported that a 10 percent increase in the debt-to-GDP ratio is associated with a 0.2 percent slowdown in annual real per capita GDP growth. As it happens, America's debt-to-GDP ratio climbed from around 60 percent in 2003 to a projected 108 percent this year. If the IMF's findings are accurate, that implies that future economic growth rates will be about one percent lower than they would otherwise have been. Kumar and Woo concluded that the chief cause for depressed economic growth is less investment in capital goods, which in turn produces a slowdown in labor productivity.
A 2011 Bank for International Settlements working paper, drawing on data on government debt in 18 economically developed countries from 1980 to 2010, found that passing a debt-to-GDP threshold of 85 percent slowed growth. Specifically, the study found that a 10 percent increase in the debt-to-GDP ratio resulted in a nearly 0.2 percent reduction in subsequent average annual growth. "The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems," the researchers concluded. "The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds."
In a 2012 article in the Journal of Accounting and Finance, economists from the University of Dallas and Hofstra University assessed the maximum sustainable level of national debt for the United States. Assuming that the economy was operating at its full potential, the researchers estimated the sustainable upper limit of the debt-to-GDP ratio is around 93 percent. "A higher debt to GDP ratio is unsustainable and will drive the economy into a succession of lower growth periods accompanied by increased unemployment," they concluded.
Rogoff and colleagues acknowledge that the 90 percent ratio "should not be taken as a law of nature." Nevertheless, most recent research on the effects of a sustained debt-to-GDP ratio higher than 90 percent has converged on the finding that it reduces future economic growth by more than one percent from what it would have otherwise have been. A one percent cut in economic growth may not sound like much, but over time it means that Americans in the coming decades will be a lot poorer than they would have been. Rogoff and colleagues estimated that effects of such a public debt overhang last about 23 years.
Before the financial crisis, U.S. economic growth averaged 3.2 percent annually. If a high debt-to-GDP ratio reduces growth by one percent each year, future annual growth will likely average 2.2 percent. With a population of 315 million, the U.S. currently has a GDP per capita of roughly $53,000. The Census Bureau expects U.S. population to grow to about 375 million over the next two decades. In 20 years, the difference between economic growth of 3.2 versus 2.2 percent amounts to $5.5 trillion. At an annual economic growth rate of 3.2 percent, per capita income would rise to $84,000 over the next 20 years. On the other hand, growth at 2.2 percent would yield a per capita income of $72,000.
In other words, Americans two decades hence would be, on average, $12,000 poorer than they would have been had our leaders the foresight to rein in our burgeoning levels of public debt.
Such a long-term economic slowdown does not have the fiscal drama that the White House and Congress are using to entertain the rest of us. Yet, as Rogoff and company comment, the "debt-without-drama" scenario is reminiscent of T.S. Eliot's famous lines: "This is the way the world ends/Not with a bang but a whimper." When then-Senator Barack Obama opposed raising the debt ceiling back in 2006, he warned, "Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren." He added, "America has a debt problem and a failure of leadership. Americans deserve better." We still do.