Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

The Debt Threshold: An Open Question

US Capitol Building with cash

Why does the accumulation of public debt beyond a certain threshold lead to lower economic performance?

A good deal of recent economic workhas demonstrated that at very high levels, government indebtedness flips from being expansionary to constraining economic growth. The most famous of these is Carmen Reinhart and Kenneth Rogoff's debt studies, which found that when the debt-to-gross-domestic-product ratio crosses a 90 percent threshold, it starts to thwart growth. Another study found growth is constrained at a much lower level: 77 percent. A study presented at last week's Jackson Hole, Wyo., summit found a range of constraints kicking in somewhere between 80 percent and 100 percent of GDP.

My question, then, is what is the mechanism for constraint? Monday, I posed a somewhat messy guess at the answer. But it's clearly not fully satisfactory.

One typical answer is the "crowding out" hypothesis, which says that government borrowing "crowds out" private investment by taking up too many private resources. But this hypothesis doesn't seem to hold in an economy that is suffering from a recession in which demand is so low that would-be investors are unwilling to take on risk.

So if the crowding out explanation is inadequate, how do we explain the debt threshold?


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