Blame outsized debt if we can’t hit 3 percent growth consistently

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Opinions remain divided about whether government debt constitutes a serious problem. Putting aside the simpler issue of future tax burdens, should we be worried about whether government debt bogs down America’s economy?

Federal Reserve Chairman Jerome Powell said he is “very worried” about the growing amount of U.S. debt. University of Chicago economist Harald Uhlig, meanwhile, recently argued that debt will not be a serious problem as long as the interest rate paid on it does not exceed the economy’s growth rate.

{mosads}Separately, an ongoing discussion continues about whether the U.S. growth rate, which has averaged around 2 percent in recent years, can ever return to its earlier rate of 3 percent.

Our recent research looks at both issues and shows that excessive debt does indeed reduce economic growth. This reduction is not just a vague possible problem for the future, but rather a reality we live with today.

In fact, the effect of debt explains the difference between 2 percent and 3 percent growth. U.S. GDP was lower by $175 billion dollars in 2017 because of it. 

It is true that the problem is less severe if economic growth is large relative to debt interest payments. However, debt and growth are not independent from each other. 

Think of it like a bell curve. At first, small increases in debt can add to economic growth by financing productive government investments, such as basic research and infrastructure, which can help the economy. However, there is a threshold at which point further debt increases start to reduce growth.

The United States and other Organization for Economic Cooperation and Development countries are on the wrong side of the line and have already seen the reduction.

Interest rates are one source of major confusion. They’ve remained low relative to their long-run average, causing some analysts to conclude that debt is not a problem. But if the U.S. government were expected to default, rates would rise to compensate bond holders. 

However, slower growth is the more immediate problem, and it has already arrived without an increase in interest rates. Politicians — biased as always toward satisfying today’s voters over shoring up tomorrow’s finances — have come to rely more and more on debt finance and switched government spending away from investments that pay off in the future. They favor entitlements that provide current benefits, particularly related to an aging population.

Discretionary government spending, which includes basic research and infrastructure, has declined dramatically relative to mandatory spending, which is dominated by entitlements such as Social Security, Medicare and Medicaid. Discretionary spending, which was once 70 percent of the budget, has dropped to 30 percent in recent years. 

U.S. fiscal institutions demonstrated order and discipline until about 1968. Debt was relatively stable relative to the size of the economy, increasing during wars and decreasing after wars. However, since 1968, the debt-to-GDP ratio has increased steadily.

The baby boom beginning in 1945 was a critical juncture: Congresses and presidents should have anticipated an increase in Social Security and medical expenditures kicking in about 65 years later, in 2010, and adjusted revenue and benefits accordingly.

Instead, government officials repeatedly refused to act, resulting in a chaotic debt policy that has shackled the American economy.

Other countries have faced debt problems, and many have responded by adopting some form of debt rule. Switzerland adopted a “debt brake” in 2003 that limits spending to expected tax revenue over the business cycle.

Rep. Kevin Brady (R-Texas) has introduced a similar bill, “Maximizing America’s Prosperity Act.” After a debt crisis, Sweden adopted a balanced budget and reform of its national pension program in 1997.

Debt has already reached a level that is slowing the rate of economic growth. Lacking a coherent answer, the United States would benefit from a well-designed debt rule. However, the optimal rule will depend on U.S. institutions, which differ from those of Switzerland or Sweden.

The future is now. The longer the delay, the larger the losses of output per year will be.

Economists Thomas GrennesQingliang Fan and Mehmet Caner are the authors of the recent Mercatus Center study, “New Evidence on Debt as an Obstacle to U.S. Economic Growth.”

Tags Debt-to-GDP ratio Deficit reduction in the United States economy Government debt Kevin Brady National debt of the United States

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