From Jackson Hole: A Defense of Debt Ceilings

Fed Chief Ben Bernanke Testifies to House Budget Committee
Fed Chief Ben Bernanke Testifies to House Budget Committee

While much of the coverage of last week’s central banker boondoggle in Jackson Hole, Wyo., has focused on Federal Reserve Chairman Ben Bernanke appearing to scold Republicans for resisting raising the debt ceiling, one of the more important papers revealed that the hardcore Republican argument is essentially right: Public debt is so high that it is restricting growth.

The paper has a deceptively simple title: “The Real Effects of Debt.”

Its authors—a trio of economists from the Bank for International Settlements—demonstrate that when government debt reaches beyond a certain threshold it begins to sap growth from the economy.

Government debt beyond a threshold ranging from 80 to 100 percent of gross domestic product (GDP) begins to thwart growth. Exactly where that threshold lies depends on a number of factors, including whether or not there is a banking crisis. A 10 percentage point increase in the ratio of public debt to GDP is associated with a 0.17 percent to 0.18 percent reduction in subsequent average annual growth.

Public-sector debt in the U.S. grew from 58 percent of GDP in 2000 to 97 percent in 2010. That almost certainly puts us beyond the threshold where our debt is restraining economic growth.

This has serious implications for economic theory. It badly undermines the Keynesian case—made by the like of Paul Krugman—for having government spending and borrowing increase to ameliorate the downturn.

It implies that more spending—at least when financed by debt—will lead to lower growth rather than higher growth.

To put it differently, we may be in a very different kind of recession than many imagine. In the standard Keynesian model, during a recession government should spend and borrow more in order to fill the whole left by the lack of private consumption. But if we are in a debt trap, where government borrowing just makes the recession worse, then this won’t work.

Our recession may be driven, at this point, by the balance sheet of the government. Repairing that balance sheet by lowering spending may be the only way out of the debt trap. Call it the New Paradox of Thrift: the government can stimulate growth only by refusing to borrow. We need thrift all the way down.

It also vindicates the Republican concern over the debt ceiling. If debt constrains growth, it doesn’t make sense to let debt rise during a downturn. It would be better to bring debt levels down.

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