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

How the Magical Threshold of Debt Works

It’s surprising the lengths some of the more rabid pro-deficit spending folks will go to deny the plain facts about the debt trap.

All the empirical evidence we have shows that extremely high debt is correlated with slower growth. This creates a problem for those who want the government to balance out private-sector contractions with increased spending accompanied by government borrowing—if the debt level is too high, the borrowing undermines the boost you get from spending.

Joseph Weisenthal at Business Insider describes this as a “magical threshold of debt.” But there’s nothing magical about it.

As I’ve explained before, the precise mechanism for this isn’t well understood. I suspect it may largely be an effect of signaling. Very high levels of debt indicate the economy has broken down and that government’s room for ameliorative spending may be reaching its limit, which causes further private contraction. So you get into a reflexivity trap.

Weisenthal thinks the government needs to spend and borrow in order to combat the economic effects of household deleveraging. (Why he insists the government must borrow to finance its spending is a bit of mystery, however.) I think a lot of business leaders agree with him on this.

The problem is that very high levels of debt lead business leaders to believe the government will not and cannot keep spending. They think it will necessarily lead to spending cuts, which is a scary prospect in the face of an economy already slumping.

In short, it’s not the debt itself that slows the economy but how we react to debt.

In the most recent PriceWaterHouseCooper survey of chief executives, 67 percent of the executives said that “public spending cuts or tax increases to address rising public debt in the country in which I am based will slow domestic economic growth.” Forty-one percent indicated that they “strongly agreed” with that statement.

Doug Baker, chairman and CEO of Ecolab, “expresses the views of many” according to PWC, when he says: “As for government debt, the uncertainty it creates erodes the willingness and ability of businesses like ours to invest and expand.“

It's just ridiculous to think that this mindset doesn't slow the economy.

There are a couple of important things to take away from this.

First, it is possible that a government like ours that seems to have nearly unlimited borrowing capacity could somehow convince the business community it won’t enact tax increases or spending cuts just because the debt has reached such high levels. I’m not sure how this could be done—especially with a government dominated by deficit hawks on the left and right—but it’s theoretically possible.

Second, the real problem here is the government has borrowed too much for too long. If we hadn’t accumulated such a large amount of debt prior to the crisis, we wouldn’t be knocking on the door of the debt threshold. You can’t have counter-cyclical public borrowing without restraint during economic booms.

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