How Much Debt Is Too Much?

Default is one of the risks of excessive sovereign debt, but a relatively remote one. Much more immediate is the damage that excessive debt can do to a nation’s economy. Republicans like to cite a study by Carmen Reinhart and Kenneth Rogoff which found that once sovereign debt gets to 90% of GDP–a level we are rapidly approaching–economic growth is significantly impaired.

Last Wednesday, Reinhart and Rogoff authored an op-ed titled Too Much Debt Means the Economy Can’t Grow. It explains their research in accessible form:

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such.

Indeed, there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus. …

Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt.

Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.

While we expect to see more than one member of the Organization for Economic Cooperation and Development default or restructure their debt before the European crisis is resolved, that isn’t the greatest threat to most advanced economies. The biggest risk is that debt will accumulate until the overhang weighs on growth.

In our study “Growth in a Time of Debt,” we found relatively little association between public liabilities and growth for debt levels of less than 90 percent of GDP. But burdens above 90 percent are associated with 1 percent lower median growth. Our results are based on a data set of public debt covering 44 countries for up to 200 years. The annual data set incorporates more than 3,700 observations spanning a wide range of political and historical circumstances, legal structures and monetary regimes. …

There also is the question of how broad a measure of public debt to use. Our empirical work concentrates on central- government obligations because state and local data are so limited across time and countries, and government guarantees, as noted, are difficult to quantify over time. (Until we developed our data set, no long-dated cross-country information on central government debt existed.) But state and local debt are important because they so frequently trigger federal government bailouts in a crisis. Official figures for state debts don’t include chronic late payments (arrears), which are substantial in Illinois and California, for example.

Indeed, it isn’t unusual for governments to absorb large chunks of troubled private debt in a crisis. Taking this into account, chart 1, attached, shows the extraordinarily high level of overall U.S. debts, public and private.

… Those who remain unconvinced that rising debt levels pose a risk to growth should ask themselves why, historically, levels of debt of more than 90 percent of GDP are relatively rare and those exceeding 120 percent are extremely rare (see attached chart 2 for U.S. public debt since 1790). Is it because generations of politicians failed to realize that they could have kept spending without risk? Or, more likely, is it because at some point, even advanced economies hit a ceiling where the pressure of rising borrowing costs forces policy makers to increase tax rates and cut government spending, sometimes precipitously, and sometimes in conjunction with inflation and financial repression (which is also a tax)?

It is noteworthy that Reinhart and Rogoff’s study is titled, “This Time is Different: Eight Centuries of Financial Folly.” Sure, excessive debt has been a problem for 800 years, but, hey–the Democrats say–we’re different! Maybe this is the only form of American exceptionalism they believe in.