Government Debt and Its Effects on Growth

As the government debt is swelling dramatically in the U.S. and other countries, there is concern that such high levels of debt will depress economic growth in the future. Research by Reinhart and Rogoff (2010) and Reinhart, Reinhart, and Rogoff (2012) indicate the threshold in which the level of debt as a proportion of GDP where growth rates start to decline is ninety percent. Others have argued that such a threshold does not exist because it is not the high debt that is causing growth to slow, but rather, it is slow growth that is causing the level of debt to escalate (Panizza and Presbitero, 2012; Herndon, Ash, and Pollin, 2013).

Pescatori, Sandri, and Simon (2014) take a little different look at the possibility of the existence of such a threshold and contribute some interesting insights. They look at different thresholds instead of focusing on just one, such as ninety percent, and they analyze growth performance over longer periods of time (5, 10, and 15 years) instead of just during the year after which a country’s debt level cross a threshold. This allows them to analyze the effects of changes in debt levels on growth and the longer-term effects. It also accounts for the potential reverse causality effects and the outlier periods of growth. Additionally, it mitigates some of the effects of omitted variables, such as automatic stabilizers (e.g., unemployment insurance).

Their findings are quite interesting.

…The sharp reduction in the following year’s growth that we observed in countries whose debt rose above 90 percent is no longer present for countries that have high but declining debt. In fact, even countries with debt ratios of 130 to 140 percent that are on a declining path have experienced solid growth. This suggests that high debt itself is not causing the low growth in these episodes. Furthermore,…the initial debt trajectory remains important event after 15 years, with falling debt associated with higher growth. That is, the trajectory of debt appears to be an important predictor of subsequent growth, buttressing the idea that the level of debt alone is an inadequate predictor of future growth [emphasis mine] (Pescatori, Sandri, and Simon, 2014, p. 41).

The data they analyzed covered the period from 1875 through the end of the last century. Recognizing that the wide variability in growth rates over some periods of this history (e.g., Great Depression, period following World War II) might distort their results, they “compared an economy’s average growth rate during an episode with the simple average of growth rates for all economies over the same period” (p. 41). Even after this adjustment, they still found

“that, in general, the growth performance of economies with high debt is fairly close to that of their peers with lower debt…Furthermore, we found that an economy’s debt trajectory still matters. Among economies with the same debt levels, the growth performance over the next 15 years in countries in which debt is initially decreasing is better than in countries where it is initially increasing…It is particularly striking for debt levels between 90 and 115 percent of GDP (for which average growth is 1/2 percentage point higher). Furthermore, there is no unique threshold that is consistently followed by a subpar growth performance…Economies with a debt level between 90 and 110 percent of GDP outperform their peers when debt is on a declining trajectory. At the least, this suggests that the debt level alone is insufficient to explain the growth potential of an economy. It also suggests that countries that have dealt with their budget deficits (as indicated by a declining debt level) may be well placed to growth in the future despite high debt levels” (Pescatori, Sandri, and Simon, 2014, p. 41).

They develop a few policy implications from this research. One is that since there does not appear to be any threshold effect, governments can engage in short-term fiscal stimulus, such as is being done in many countries in response to the pandemic, without being concerned that once they cross a certain threshold with debt, economic growth will slow. It is the trend in the debt to GDP ratio that matters, so what has the trend been in the U.S.?

The chart above shows the debt to GDP ratio in the U.S. The data only go through Q4 2019, so it does not include the current stimulus in response to the coronavirus pandemic. Once that is taken into account, this ratio will move even higher. It does not appear that the trajectory of the level of U.S. is moving in the right direction over the past decade. This is clearly due in part to the response to the Great Recession, but even during the historically long growth period following that recession, the level of debt compared to GDP continued to grow. This does not mean we should not be pursuing a stimulus in response to the pandemic, but as noted by the authors, the U.S. will need to reverse this trend once the economy gets back on track if the high level of debt is not going to have deleterious effects on the future growth rate of the U.S. economy.

References:

Herndon, T., Ash, M., and Pollin, R. (2013). Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff. Political Economy Institute Working Paper No. 322 (Amherst, Massachusetts).

Panizza, U., & Presbitero, A.F. (2012). Public debt and economic growth: Is there a causal effect? MoFIR Working Paper No. 65 (Ancoma, Italy: Money and Finance Research Group).

Pescatori, A., Sandri, D., & Simon, J. (2014). No magic threshold. Finance and Development, 51(2), 39-42. Retrieved from: https://www.imf.org/external/pubs/ft/fandd/2014/06/pescatori.htm.

Reinhart, C.M., & Rogoff, K.S. (2010). Growth in a time of debt. American Economic Review, 100(2), 573-78.

Reinhart, C.M., Reinhart, V.R., & Rogoff, K.S. (2012). Public debt overhangs: Advanced economy episodes since 1800. Journal of Economic Perspectives, 26(3), 69-86.