Debt and the Threshold of Growth Destruction

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It would be comforting to believe that very high levels of debt don’t impose constraints on growth for the U.S. Unfortunately, there’s not much reason to believe that its different for us.

At least three studies have found that when public debt crosses a certain threshold—they differ exactly where the threshold lies—economic growth begins to trail off. None of the studies, however, have really explained why this should be.

It’s a bit mysterious. All of the studies find that at lower levels, public debt is actually expansionary. It helps the economy grow. But at some point, debt flips and starts hurting the economy. Why does this happen?

Some people react to this mystery by denying it happens at all. That’s the tactic taken by scholars L. Randall Wray and Yva Nersisyan in their 2010 paper “Does Excessive Sovereign Debt Really Hurt Growth.”

Praise is due to Wray and Nersisyan for pointing out that there are important distinctions that are not often clearly emphasized—or even noticed—in the literature about public debt. The most important, of course, is whether the debt issuer is truly sovereign. That is, do they issue their debt in their own floating, fiat currency?

The sovereignty of the issuer matters. As we’re seeing in places such as Greece and Italy, governments that issue debt in currencies they cannot control run the danger of defaulting involuntarily. They face very real solvency risk.

Governments, such as the U.S., that issue debt denominated in their fiat currencies are not at risk of involuntary default or insolvency. They can default on debt—but only by choice or by accident. They can never be forced by bond markets to default because they cannot roll over debts or make payments. When push comes to shove, they can pay any obligation by spending fiat money that, quite literally, comes from nowhere.

This role of fiat money is a confusing one to many people. Can funds to pay debt obligations really “come from nowhere?” The answer is yes.

Our government doesn’t need to tax or borrow in order to spend. It doesn’t even need to print money. Instead, simply increase the balances on electronic banking ledgers to represent the payments.

Wray and Nersisyan knock down a couple of potential mechanisms through which the debt threshold could work. One would be default. A government that needs access to the bond market could find that access cut off after a default, which could constrain public spending and therefore slow the economy. But Wray and Nersisyan point out that that in the most famous study demonstrating a debt threshold, by Carmen Reihnart and Ken Rogoff, there does not appear to be any instance of a government default on debt in the case of a floating rate currency.

This is likely because a government that is in charge of its own currency cannot be forced to default.

At a less extreme level, you have the “bond vigilante” theory, in which investors demand very high interest rates when debt goes beyond a certain level because they fear a default could be in the offing.

But the examples of Japan and the present day U.S. seem to disprove this idea. Debt is high, interest rates at rock bottom.

Another theory for the debt mechanism, one that Reinhart and Rogoff seem to accept, is that people slow consumption in anticipation of higher taxes to pay off the mounting. Wray and Nerisisyan are skeptical about this, most likely because they understand that the government never needs to raise taxes to meet its obligations.

All of these arguments show that the usual descriptions of the mechanisms through which a debt threshold could constrain growth are inadequate. But they do not undermine the core empirical finding that very high debt constrains growth.

And with minor tweaks each of the theories could be made to explain lower growth.

The default theory could result in slower growth if we posit that consumers don’t understand that default is almost impossible and irrationally fear a default. Or even if we posit that consumers hold back on spending for fear of a voluntary default, such as the one we nearly witnessed during the debt ceiling debate. Just because a viewpoint is irrational doesn’t make it economically unimportant.

The same thing could apply to the fear of higher taxes. Just because taxes aren’t necessary to fund government operations, that doesn’t mean that taxes won’t be raised as higher debt payments come due or that people won’t irrationally fear a need for higher taxes.

For example, a government finding that it is paying off large amounts of debt by issuing new deposits during a period of peak economic performance should cut spending in order to avoid inflation. But political constraints might make spending cuts impossible, which would mean that an anti-inflation government would need to hike taxes. So, although the mechanism is “raising taxes to avoid inflation” and not “raising taxes to pay debt,” the result is the same: higher taxes.

You can pick up the newspaper almost any day of the week and find prominent business leaders worrying about government debt. This concern with debt—even if it is misplaced (and it may or may not be)—influences their decisions to invest and expand. This is in itself a good indicator that when public debt grows too large, it begins to eat away at economic growth.

Just because you do not understand the mechanism—or think the mechanism is irrational—by which something happens, doesn’t mean it doesn’t happen.

So, sadly, we still do have reason to worry about whether our debt crosses the threshold of growth destruction.

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