Resulting empirical literature on debt thresholds
The historical work by Reinhart and Rogoff has stimulated a more technical empirical literature seeking to estimate a threshold or tipping point for government debt relative to GDP beyond which adverse effects on economic growth appear (Grennes 2013). A common result is that a threshold for gross government debt is in the neighborhood of 80% of GDP, and the U.S. and many European countries now exceed this ratio. Beginning at debt ratios below the threshold, small increases in debt have no harmful economic effects, but increases above the threshold decrease the rate of real GDP growth.
Not involved in a world war, just consuming
The current U.S. government debt level relative to GDP of over 100% is unprecedented in peacetime history. For over 200 years U.S. policymakers produced debt ratios that fluctuated without a trend. Debt ratios increased during wars and recessions decreased during peacetime and periods of rapid economic growth. However, fiscal policy has changed since 2001 (Grennes, Thornton), and policymakers seem unwilling to make difficult choices about spending and taxing that would keep debt under control.
This would be somewhat less worrying, if the government during the crisis had embarked on a large-scale investment program thereby substantially improving the quality of the U.S. infrastructure. However, as we mentioned in an earlier blog post (see” The U.S. Is Sliding Down an Investment Slope”), the weight of investment in GDP in the U.S. has been declining since the onset of the financial crisis and the low ratio of public infrastructure investment to GDP is particularly worrying. Deficit spending has propped up current consumption (and imports) rather than laid solid fundamentals for future growth. At the same time the U.S. infrastructure liability keeps growing alongside with the pile of debt.
Deteriorating quality of U.S. fiscal institutions
The quality of U.S. fiscal institutions has deteriorated. Recent actions by Congress and Presidents indicate no willingness to recognize limits to debt and to engage in fundamental fiscal reform. They have reacted to each deadline, such as the recent fiscal cliff, by taking minimal action and delaying fundamental reform that would stabilize the debt ratio. The fiscal cliff problem was addressed by delaying decisions about cutting spending for two more months. The legislation intended to demonstrate fiscal discipline added insult to injury by including tax breaks to various industries, including NASCAR racing tracks, which will increase future fiscal deficits.
As a result of fiscal procrastination, the debt gets larger and the government limps on until it faces the next fiscal deadline. In the words of President Obama: “We’ve got to stop lurching from crisis to crisis to crisis.” The Congressional debt limit has already been reached, and the sequestration will be reached in March. This awkward fiscal process cannot contribute to either short-run or long-run stabilization of the economy. The proposal for the Treasury to produce a trillion dollar coin is a gimmick that represents the extreme desperation of some members of Congress.
The global reserve currency status as a resource curse
Contrary to many European countries, the U.S. has so far not been subject to market discipline in the form of rising interest rates, largely due to the status of the U.S. dollar as the global reserve currency. Given the opposition in some euro zone countries, most notably Germany, against common euro zone debt issuance, this status is unlikely to be challenged in the medium term. However, similarly as the abundance of natural resources in some countries in the past has led to a “resource curse” that has hampered long-term development, abundance of cheap funding to finance government deficit today might have an adverse impact on the future economic growth in the US.
Conclusion
Historical evidence on debt suggests that procrastination on the debt issue is wishful thinking by the fiscal authorities. The global reserve currency status of the dollar has given the U.S. government additional time to address its fiscal challenges. However, it might also have resulted in a false sense that this time is different for the United States.
References
Grennes, Thomas. 2013. “The Deteriorating Quality of Fiscal Institutions: U.S. and EU”. Cato Journal, forthcoming.
Klein, Ezra. 2013. “Treasury: We Won’t Mint a Platinum Coin to Sidestep the Debt Ceiling.” Washington Post, January 12
Reinhart, Carmen, and Kenneth Rogoff. 2009. “This Time is Different: Eight Centuries of Financial Folly.” Princeton: Princeton University Press.
Taylor, Alan M. 2012.”Global Financial Stability and the Lessons of History”. Journal of Economic Literature. December.
Thornton, Daniel. 2012. “The U.S. Deficit/Debt Problem: a Longer-Run Perspective”. Federal Reserve Bank of St.Louis Review. November/December.