Debt’s Impact on the Economy and the Value of a Ceiling

There is a range of economic literature starting to flow out of academia on the impact of debt and I anticipate over the next 18 months we will see a lot more in anticipation of another debt ceiling fight come 2013. One such paper is worth considering in the near term, as it should inform the Joint Committee on their deficit and debt reduction negotiations over the next few months. (At the very least they should give consideration of this paper more priority than I have, seeing as it has been sitting my “too read pile” for about two weeks now and I am just now getting to it on a security intense train from New York back to D.C. It was both encouraging and disconcerting to see cops every 15 yards lining the streets of Manhattan this morning.)

At Jackson Hole in August, three economists from Bank for International Settlements presented a paper that looked at the impact on economic growth government debt can have. Republicans like the talking point that all we need to do to fix the economy is cut spending, but typically don’t articulate the economics of how that could be true. Progressives in turn laugh this away, nestled into their New Keynesian multiplier beliefs (with Krugman has the high priest of the faith). A deep look at the fundamentals of the economy indicates that unemployment and growth are not only a demand problem. I’d say the lines already forming for iPhone 5s and the explosion of self-serve froyo are visual representations of this. There is a serious household debt problem, which is one reason why those lovely tax cuts from POTUS for the middle class don’t generate the flood of spending that the stimulus advocates would hope.

Still, this does not leave the GOP with a winning hand in the debate. Discounting the progressive view of the economy does not necessarily mean that shedding the commerce department, Amtrak, and farm subsidies equals economic recovery. Those also ignore that household delveraging will take a while, not to mention the evolution of new industries in our increasingly automated world of efficiency (recall this eyeopening manufacturing chart from Labor Day). So what is the intellectual support for cutting spending?

The BIS paper finds that, once the ratio of government debt to GDP hits 80 percent to 100 percent that it has a causal negative impact on economic growth. To start they identify this cycle:

“For a given shock, higher debt raises the probability of defaulting. Even for a mild shock, highly indebted borrowers may suddenly no longer be regarded as creditworthy. And when lenders stop lending, consumption and investment fall. If the downturn is bad enough, defaults, deficient demand and high unemployment might be the grim result. The higher the level of debt, the bigger the drop for a given size of shock to the economy. And the bigger the drop in aggregate activity, the higher the probability that borrowers will not be able to make payments on their nonstate-contingent debt. In other words, higher debt raises real volatility, increases financial fragility and reduces average growth. (Emphasis added.)

When New Keynesians look at this scenario they focus on this part: “when lenders stop lending, consumption and investment fall.” And they tend to believe that the government can get the economy back on track by borrowing money (or printing it) to spend and fix the consumption part of that equation. And the idea behind the stimulus’—and recently proposed Jobs Act—is at its core to prop up consumption until lenders decide to open their wallets up again, allowing the public sector support to recede.

Ignoring for a moment the inefficiencies of government spending, the authors counter this that the flaw in the New Keynesian argument is that the government can not borrow forever. And particularly if the progressives want to engage Uncle Sam in the business of spending to help the government then they should believe that deficits do matter because the higher the level of debt, the higher the probability that a government will hit a borrowing threshold.

A fair counter to this argument is that even in the face of a debt downgrade by one ratings agency that Treasury yields are scrapping the bottom of the ocean floor in historical fashion. Is there anything that might cause investors to loose faith in the U.S. government? It is an open question at the moment, and as long as Europe flounders there is even more of a flight to safety pushing down yields.

The BIS authors look to answer the question by examining annual data on GDP per capita and the stock of non-financial sector debt for a group of 18 OECD countries over the period 1980—2006. Some snapshot findings:

“when we disaggregate debt, we see that public debt has a consistently significant negative impact on future growth. And, the impact is big: a 10 percentage point increase in the ratio of public debt to GDP is associated with a 17—18 basis point reduction in subsequent average annual growth.”

This means that for every 10 percent of debt-to-GDP, output declines 0.17 percent to 0.18 percent. Put another way, if debt-to-GDP is currently at 100 percent, that means GDP is 1.8 percent lower than it otherwise would be. Ouch.

“The graph shows that 96% of GDP is the point estimate of the threshold level. At the 1% confidence level, the threshold level lies between 92 and 99% of GDP — that is, the level at which we estimate that public debt starts to be harmful to growth may be as low as 92% of GDP and as high as 99% (using 5% or 10% confidence levels would not change the interval much).”

“with government debt, depending on the exact specification, our estimate is in the range of 80—100% of GDP. And, when government debt rises to this level, an additional 10 percentage points of GDP drives trend growth down by some 10—15 basis points.”

Based on this, the authors suggest that “The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. 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.”

Naturally this is not a definitive paper. And the BIS authors note as much early on in their paper, suggesting that more work needs to be done to refine the understanding of impact on growth. But, they authors also argue that,

“Like a cancer victim who cannot wait for scientists to find a cure, policymakers cannot wait for academics to deliver the synthesis that will ultimately come. Instead, authorities must do the best they can with the knowledge they have. As they make their day-to-day policy decisions, central bankers, regulators and supervisors need some understanding of the role of debt in the economy. When is debt excessive? When should we worry about its level, growth rate and composition?”

The paper also looks extensively at the impact of other types of debt and interestingly estimates that when corporate debt surpasses 90 percent of GDP and/or when household debt grows to be more than 85 percent they tend to have a “drag on growth.”

At very least papers (and hopefully more like it) can help build the case that the Joint Committee needs not just figure out how to lower the deficit over 10 years by $1.2 trillion or so, but rather than they consider how to turn downward the growth of spending so as to cut into the national debt in a substantive way. And as John Carney wrote last month: “Public-sector debt in the U.S. grew from 58 percent of GDP in 2000 to 97 percent in 2010. That almost certainly puts us beyond the threshold where our debt is restraining economic growth.”

In sum, it makes a pretty good case for a debt ceiling and for the value of cutting spending so as to reduce the national debt as beneficial for economic growth. That wouldn’t be enough to bring us out of the great contraction overnight, since household and business debt still are deleveraging. But it would help. Again, read the whole Cecchetti, Mohanty, Zampolli paper here.

P.S. regarding my opening comment on the future of new papers covering the debt ceiling—I would particularly be interested in a paper looking at whether the politics of the debt ceiling have something to do with a Tea Party moment (and as a corollary set of questions did the GOP give Bush increases without a whimper because they wanted to support their guy? or because of post-9/11 patriotism? or because they really are the phony fiscal conservatives they seem to be when in power?)… or was the recent fight more about the level of debt being so dramatically more than when previous debt ceiling hikes were raised—and the size of the deficit, only passing the trillion mark for the first time in the past three years?