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How Debt Shrinks the Economy

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What is it about a very high debt-to-gross-domestic-product ratio (GDP) that constrains growth?

One of the studies presented at Jackson Hole, Wyo., last week demonstrated that beyond a certain threshold—somewhere between 80 percent and 100 percent of GDP—government debt leads to weaker economic growth.

Advocates of counter-cyclical deficit spending argue that this cannot apply while there is lots of slack in the economy. But if you follow their arguments closely, they aren’t really arguing that public debt doesn’t constrain growth. They’re just arguing that it doesn’t constrain growth through something called “crowding out.”

“Some economists worry that the growing government debt will itself become a constraint on growth,” former Clinton economic adviser Laura D’Andrea Tyson wrote in a recent piece for the The New York Times’ Economix blog. “But that certainly is not the case now—with weak private-sector demand and a huge output gap, spending and borrowing by the government are not crowding out spending and borrowing by the private sector.”

What this assumes, of course, is that “crowding out” is the only mechanism by which very high government borrowing could constrain growth. This assumption is implicit and never actually defended—probably because it is indefensible. It’s just a failure of imagination.

As a matter of logic, of course, it simply will not due to swat away empirical findings by disproving that one possible cause is not applicable.

Imagine if you went to a doctor because you had been limping. She examines you and determines that your limp is not caused by Plantar fasciitis, and concludes that you don’t actually have a limp at all.

Would you go back to that doctor?

Any examination of the role of debt in constraining growth should begin with at least an openness to the possibility that we do not know the mechanism. Our economic system is very complex. We might not understand the causal relationships all that well. In fact, the introduction of government intervention—such as, say, government borrowing—into market processes may create calculational chaos that prevents us from understanding causes.

What’s called for when we encounter a phenomenon that apparently disproves our theory—debt constraining growth despite a lack of crowding out—is the formulation of new hypothesis. So let’s give that a try.

I suspect that the reason very high government debt constrains growth arises from what it signals to consumers. The growth of debt indicates that taxes are at their political or economic limits, as high as they can practically go. This is itself an indicator of a constrained economy, one operating near its capacity and unlikely to grow much further.

This indicator of economic constraint applies even when there is an “output gap,” because it indicates that government will very likely not be able to fill the gap with spending. If government is already taxing so much that further spending can only be financed through the accumulation of a mountain of public debt, it is unlikely that spending will be able to increase too much more.

Why won’t spending increase much more? The answer is not because of imaginary “bond vigilantes” curtailing government borrowing.

Certainly, that’s not the case these days. The federal government can currently borrow funds and repay less than it borrows in constant dollars. If anything, we’ve learned recently that there is almost an unending appetite for the debt of the U.S. government.

Instead, I’d hypothesize that the spending constraint comes from the realization that too much government spending disorganizes and crony-izes the economy. When government borrowing reaches 90 percent of GDP, it implies that total government spending has been accounting for far too great of a share of the economy for far too long. The economic disorganization that stems from that spending both reduces economic growth and is a signal of future contraction, which households react to by delevering and reducing consumption.

What’s more—and here I’m going to get a bit technical—government borrowing usually implies future taxation to pay for the debt. (This isn’t necessarily the case, since the government can always fund itself autonomously by creating new money to pay down debts or current bills. But a government that borrows 90 percent of GDP may be indicating its unwillingness to monetize expenditures.) This also leads to contraction because households react to the information about future taxes by increasing their savings to preserve wealth. If you think your tax rate is going up, better save the low taxed income now.

In short, the government has gotten itself into a debt trap. It cannot borrow more without reducing growth—but consumers have gone into wealth preservation mode, which means that reducing spending will also be contractionary, at least in the short term.

Is this why very high debt constrains economic growth? It’s only a hypothesis, I admit. But it’s a heckuva lot better than simply denying the contractionary effect of huge debts because one mechanism—crowding out—doesn’t work.

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