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Economists Carmen Reinhart, Vincent R. Reinhart, and Kenneth Rogoff (from here on out referred to as R3) have a new study out looking at the economic impact of high debt levels:
— We identify 26 episodes of public debt overhang–where debt to GDP ratios exceed 90% of GDP–since 1800. We find that in 23 of these 26 episodes, individual countries experienced lower growth than the average of other years. Across all 26 episodes, growth is lower by an average of 1.2%.
— If this effect sounds modest, consider that the average duration of debt overhang episodes was 23 years. In 11 of the 26 high debt overhang episodes, real interest rates were the same or lower than in other periods.
— Obviously, it is possible that new developments in technology and globalization will provide such a remarkable reservoir of growth that today’s record debt burdens will eventually prove quite manageable. On the other hand, the fact many countries are facing “quadruple debt overhang problems”—public, private, external, and pension–suggests the problem could in fact be worse than in the past, a question we do not tackle here.
— Nor have we paid attention here to the likely possibility of significant “hidden debts”, especially public sector, which Reinhart and Rogoff (2009) find to be a significant factor in many debt crises, and as documented in detail in the Reinhart (2010) chartbook. Another line of reasoning for dismissing concerns about public debt and growth is the view the causality mostly runs from growth to debt.
— Our analysis, based on these cases and the 23 others we identify, suggests that the long term risks of high debt are real.
This paper represents a deeper dive into the issue than previous research by Rogoff and Carmen Reinhart, though their general conclusion — high debt lowers growth — is the same. And the chart at the top of the post shows the cumulative impact of years of slower growth. There’s a big different between having a $21 trillion economy in 2035 and a $28 trillion one. Anyone have use for an extra $7 trillion?
Two other key points that R3 make:
1. Don’t wait for markets to freak out before cutting debt levels. “Contrary to popular perception, we find that in 11 of the 26 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for financial markets to send the warning signal through higher interest rates that government policy will be detrimental to economic performance may be waiting a long time.”
This observation fits well with one now being made by Eurasia Group. As the consulting firms sees things, the U.S. will continue to be able to finance its deficit and debt cheaply in part because of continued global safe haven status. “But while this is a benefit, it also ‘curses’ the U.S. into a period of fiscal complacency.” As long as rates are low, there will be little pressure for a “grand bargain” to cut debt, according to the firm. But as R3 show, that path may doom America to years or decades of subpar economic growth.
2. We need to cut, but not tomorrow. R3 make a clear point of saying that their research “should not be interpreted as a manifesto for rapid public debt deleveraging in an environment of extremely weak growth and high unemployment. However, our read of the evidence certainly casts doubt on the view that soaring government debt is a non-issue simply because markets are presently happy to absorb it.”
Good thing few voices in the U.S. are calling for a balanced budget in 2013. With entitlement reform, pro-growth tax reform, and modest trimming of current government spending over the next decade, we can get America on the right trajectory to avoid R3’s low-growth, high-debt scenario.
But will we? The Obama administration doesn’t seem to agree with R3. It only wants to stabilize the debt at current levels for the next decade with no plans to do much of anything beyond that. Indeed, Team Obama does just what R3 warn against: They point to the current low level of interest rates as a sign that no urgent action is necessary.
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