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A government that does not tax sufficiently to cover itsspending will eventually run into all manner of debt-generated trouble. Itsnominal interest rates will rise as bondholders fear inflation. Its business leaders will hunker down and try tomove their wealth out of the companies they run for fear of high futurecorporate taxes.
Moreover, real interest rateswill rise, owing to policy uncertainty, rendering many investments that are truly sociallyproductive unprofitable. And, when inflation takes hold, the division of labor will shrink.What once was a large web held together by thin monetary ties will fragmentinto very small networks solidifiedby thick bonds ofpersonal trust and social obligation. And a small division of labor means lowproductivity.
All of this is bound to happen –eventually – if a government does not tax sufficiently to cover its spending.But can it happen as long as interest rates remain low, stock prices remain buoyant, and inflationremains subdued? Iand other economists – including LarrySummers, LauraTyson, Paul Krugman, and many more – believe that it cannot.
As long as stockprices are buoyant, business leaders are not scared of future taxes or ofpolicy uncertainty. As long as interest rates remain low, there is no downwardpressure on public investment. And as long as inflation remains low, the extradebt that a government issues is highly prized as a store of value, helpssavers sleep more easily at night, and provides a boost to the economy, becauseit assists deleveraging and raises the velocity of spending.
Economists, in short,do not watch only quantities – the amount of debt that a government has issued– but prices as well. And, because people trade bonds for commodities, cash,and stocks, the prices of government debt are the rate of inflation, thenominal interest rate, and the level of the stock market. And all three ofthese prices are flashing green, signaling that markets would prefer governmentdebt to grow at a faster pace than current forecasts indicate.
When Carmen Reinhartand KenRogoff wrote their influential study “Growth in a Time ofDebt,” they asked the following question: “Outsized deficits and epic bank bailouts may beuseful in fighting a downturn, but what is the long-run macroeconomic impact ofhigher levels of government debt, especially against the backdrop of graying populations andrising social insurance costs?” Reinhart and Rogoff saw a public-debt“threshold of 90% of [annual] GDP,” beyond which “growth rates fall…. in [both]advanced and emerging economies.”
The principal mistakethat Reinhart and Rogoff made in their analysis – indeed, the only significantmistake – was their use of the word “threshold.” That semantic choice, together with the graphthat they included, has led many astray. The Washington Post editorial board, for example, recently condemned what it called the “Don’t worry, behappy” approach to the US budget deficit and government debt, on the groundsthat there is a “90% mark that economists regard as a threat to sustainableeconomic growth.”
To be sure, The Washington Posteditorial board has shown since the start of the millennium that it requireslittle empirical support for its claims. But the phrasing in “Growth in a Timeof Debt” also misled European Commissioner Olli Rehn and many others to argue that “when [government] debt reaches 80-90% ofGDP, it starts to crowdout activity.” Reinhart and Rogoff, it is widely believed, showed thatif the debt/GDP ratio is below 90%, an economy is safe, and that only if thedebt burden is above 90% is growth placed in jeopardy.
Yet the threshold isnot there. It is an artifactof Reinhart and Rogoff’s non-parametricmethod: throw the data into four bins, with 90% serving as the bottom of thetop bin. In fact, there is a gradual and smooth decline in growth rates asdebt/GDP ratios increase – 80% looks only trivially better than 100%.
And, as Reinhart andRogoff say, a correlation between high debt and low growth is a sign that oneshould investigate whether debt is a risk. Sometimes it is: a good deal of therelationship comes from countries where interest rates are higher and the stockmarket is lower, and where a higher debt/GDP ratio does indeed mean slowergrowth.
Still more of therelationship comes from countries where inflation rates are higher whengovernment debt is higher. But some of it comes from countries where growth wasalready slow, and thus where high debt/GDP ratios, as Larry Summers constantlysays, result from the denominator,not the numerator.
So, how much room isleft in the relationship between debt and economic performance for a countrywith low interest rates, low inflation, buoyant stock prices, and healthy priorgrowth?
Not much, if any. Inthe United States, at least, we have learned that there is little risk to accumulatingmore government debt until interest and inflation rates begin to rise abovenormal levels, or the stock market tanks. And there are large potential benefits to be gained from solvingAmerica’s real problems – low employment and slack capacity – right now.
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