Academics and economists have been studying the relationship between government debt and economic development in the decade since the financial crisis of 2007–2008 and the ensuing European sovereign debt crisis, which began in late 2009. Carmen Reinhart and Kenneth Rogoff, for example, wrote a noteworthy study in 2010 “In the debate over austerity and fiscal policy in debt-burdened nations, “Growth in a Time of Debt” became extensively cited and influential among commentators, academics, and politicians.
We review the research on the debt-growth relationship since the publication of in this policy brief “To assess the argument that high government debt-to-GDP ratios have negative or significant (or both) consequences on an economy’s growth rate, see “Growth in a Time of Debt.” Furthermore, we examine the argument that debt has a nonlinear barrier, about 90% of GDP, past which it has a considerable negative influence on growth rates. Given that some European countries have successfully reduced their debt-to-GDP ratios in recent years, it is critical for Americans to gain a better grasp of the possible negative consequences of debt on growth potential, especially given America’s present fiscal trajectory.
The vast majority of studies on the debt-growth link indicate a debt-growth threshold of 75 to 100 percent of GDP. Furthermore, every study, with the exception of two, indicates a negative association between high government debt and economic development. This is true even if no common threshold is discovered in the investigations. The empirical evidence overwhelmingly supports the assumption that a substantial quantity of government debt has a negative influence on economic growth potential, and that this impact grows in many circumstances as debt grows. According to the United States’ present fiscal trajectory, the effects of a large and growing public debt ratio on economic development over the next 30 years might equal to a loss of $4 trillion to $5 trillion in real GDP, or as much as $13,000 per capita, by 2049.
Why Would a Large Federal Debt Have Negative Effects on the Economy?
Before looking into the existing literature on the relationship between government debt and economic development, it’s a good idea to review the economic reasons why the US economy’s growth potential could be harmed by a big and growing debt burden. Economists have long recognized a number of macroeconomic pathways via which debt might stifle medium- and long-term economic growth. Recent evidence suggests that massive debt-to-GDP ratio increases could result in much higher taxes, reduced future incomes, and intergenerational injustice.
More long-term interest rates, greater distortionary tax rates, inflation, and a general constraint on countercyclical fiscal policies can all have a detrimental impact on capital stock accumulation and economic growth, resulting in increased volatility and lower growth rates. When the debt-to-GDP ratio hits high levels, the private sector appears to start saving, according to studies on the mechanisms via which debt negatively effects growth. The Ricardian equivalence hypothesis states that households are forward-looking and increase their savings in response to increases in government borrowing.
In order to sustain its broad spending initiatives, the government needs increase borrowing as the federal debt load grows. Increased government borrowing puts pressure on the country’s capital markets, raising interest rates and crowding out private investment. Because private-sector entrepreneurs face greater capital costs, innovation and productivity are inhibited, limiting the economy’s development potential. If the government’s debt level continues to rise, investors may begin to doubt the government’s ability to repay the loan and demand even higher interest rates. This pattern of crowding out private investment, along with increased interest rates, will erode corporate confidence and investment over time, further reducing productivity and growth.
Another cost of higher government borrowing is the crowding out of public investment, as interest payments devour an ever-increasing share of the federal budget, leaving less money for research and development, infrastructure, and education. Indeed, according to the Congressional Budget Office (CBO), the expense of paying interest on the nation’s debt will be the third-largest budgetary item after Social Security and Medicare by 2049, accounting for nearly 6% of GDP. Americans will find it more difficult to buy a home, finance a car, or pay for college as a result of the combination of lower private investment and crowding out of governmental investment. The economy’s growth potential will continue to be stifled by lower investment, poorer productivity, and decreased social mobility.
How Might Debt Drag Affect Future US Economic Growth?
The CBO publishes annual and updated long-term growth forecasts for the United States. We use estimates from two of the studies in our literature analysis to project real GDP growth rates for 2019 to 2049 in order to predict the detrimental effects of high public debt levels on growth rates. Our prediction is based on studies by Caner, Grennes, and Koehler-Geib, as well as Alfonso and Jalles. The first study finds a lower debt barrier (77%) but a smaller debt drag effect on economic growth; the second study finds a higher debt threshold (90%) but a somewhat bigger debt drag effect on economic growth. Alfonso and Jalles’ calculations are likewise essentially compatible with Kumar and Woo’s anticipated debt drag findings.
The differences in real GDP from 2019 to 2049 are depicted in Figure 1. The black line is the CBO baseline estimate, the orange line is projected real GDP under debt drag effects calculated by Alfonso and Jalles, and the red line is projected real GDP under debt drag effects calculated by Caner, Grennes, and Koehler-Geib. The findings show that the effects of a significant and expanding public debt-to-GDP ratio on economic growth over the next 30 years could equal to a $4–$5 trillion loss in real GDP. This is the difference in real GDP per capita between a baseline of $95,339 and a debt-drag-affected real GDP per capita of $82,376–$86,021. This range is about $9,000–$13,000 per capita lower than the baseline, implying a significant drop in typical American living standards.
Does public debt affect the economy?
This suggests that at debt levels above 90-100 percent of gdp, a larger public debt-to-gdp ratio is associated with weaker long-term growth rates on average. Annual variations in debt levels (initial difference in debt ratio) are also found to be inversely related to annual economic growth rates.
How does debt affect the economy?
However, if we do nothing, the converse is also true. Our economic environment will deteriorate if our long-term fiscal challenges are not addressed, as confidence will erode, access to capital will be limited, interest costs will crowd out key investments in our future, growth conditions will deteriorate, and our country will be at greater risk of economic crisis. Our future economy will be harmed if our long-term fiscal imbalance is not addressed, with fewer economic possibilities for individuals and families and less budgetary flexibility to respond to future crises.
Public investment is being reduced. As the federal debt grows, the government will devote a larger portion of its budget to interest payments, squeezing out public investments. Under existing law, interest expenses are expected to total $5.4 trillion over the next ten years, according to the Congressional Budget Office (CBO). The United States currently spends more over $900 million each day on interest payments.
As more federal funds are diverted to interest payments, fewer resources will be available to invest in areas critical to economic growth. Although interest rates are now low to aid the economy’s recovery from the pandemic, this condition will not persist indefinitely. The federal government’s borrowing expenses will skyrocket as interest rates climb. Interest payments are expected to be the highest federal spending item in 30 years, according to the CBO “More than three times what the federal government has spent on R&D, non-defense infrastructure, and education combined in the past.
Private investment is down. Because federal borrowing competes for cash in the nation’s capital markets, interest rates rise and new investment in company equipment and structures is stifled. Entrepreneurs confront greater capital costs, which could stifle innovation and hinder the development of new innovations that could enhance our lives. Investors may come to distrust the government’s ability to repay debt at some point, causing interest rates to rise even higher, increasing the cost of borrowing for businesses and people. Lower confidence and investment would limit the rise of American workers’ productivity and salaries over time.
Americans have less economic opportunities. Growing debt has a direct impact on everyone’s economic chances in the United States. Workers would have less to use in their occupations if large levels of debt force out private investments in capital goods, resulting in poorer productivity and, as a result, lower earnings. Reduced federal borrowing, on the other hand, would mitigate these effects; according to the CBO, income per person might grow by as much as $6,300 by 2050 if our debt was reduced to 79 percent of the economy by that year.
Furthermore, excessive debt levels will have an impact on many other elements of the economy in the future. Higher interest rates, for example, as a result of increasing federal borrowing, would make it more difficult for families to purchase homes, finance vehicle payments, or pay for college. Workers would lack the skills to keep up with the demands of an increasingly technology-based, global economy if there were fewer education and training possibilities as a result of decreasing investment. Lack of support for R&D would make it more difficult for American enterprises to stay on the cutting edge of innovation, and would stifle wage growth in the US. Furthermore, slower economic development would exacerbate our budgetary woes, as lower earnings result in reduced tax collections, further destabilizing the government budget. Budget cuts would put even more strain on vital safety net programs, jeopardizing help for those who need it the most.
There is a greater chance of a fiscal crisis. Interest rates on government borrowing could climb if investors lose faith in the country’s fiscal position, as greater yields are sought to buy such instruments. A rapid increase in Treasury rates could lead to higher inflation, reducing the value of outstanding government securities and resulting in losses for holders of those securities, such as mutual funds, pension funds, insurance companies, and banks, further destabilizing the US economy and eroding international confidence in the US currency.
National Security Challenges Our budgetary stability is intertwined with our national security and ability to retain a global leadership position. As former Chairman of the Joint Chiefs of Staff Admiral Mullen put it: “Our debt is the most serious danger to our national security.” As the national debt grows, we are not only increasingly reliant on creditors throughout the world, but we also have fewer resources to invest in domestic strength.
The Safety Net is in jeopardy. The safety net and the most vulnerable in our society are jeopardized by America’s huge debt. Those critical programs, as well as the people who need them the most, are jeopardized if our government lacks the resources and stability of a sustainable budget.
Is high public debt harmful for economic growth?
A yes answer implies that, even if beneficial in the short run, expansionary fiscal policies that raise the debt-to-GDP ratio may impair long-run growth, partially (or completely) negating the fiscal stimulus’ favorable impacts.
What happens when government debt increases?
Lower national savings and income are the four main outcomes. Higher interest payments will result in significant tax increases and budget cuts. Ability to respond to situations has deteriorated.
What is public debt describe its role in the economy?
The total amount borrowed by the government to satisfy its development budget, including total liabilities, is known as public debt. It must be paid from India’s Consolidated Fund. Dated government securities (G-Secs), Treasury bills, external aid, and short-term borrowings are all sources of public debt.
What are the advantages of public debt?
When the debt was paid off, the debtor received regular interest. The following are some of the benefits of public debt: 1. Increase in Money Origin: – Public debts support the development of industries in the country, resulting in increased production and national income, raising the living standards of the country’s population. 2.
Why is high government debt bad?
Refinancing a country’s existing debt becomes more expensive when interest rates climb. Over time, revenue must be directed toward debt payments rather than government programs. A scenario like this could lead to a sovereign debt crisis, similar to what happened in Europe.
In the long run, excessive public debt causes investors to raise interest rates in exchange for a higher risk of default. As a result, economic expansion components such as housing, business growth, and auto loans are becoming more expensive. Governments must carefully locate the sweet spot of public debt in order to avoid this burden. It must be large enough to stimulate economic growth while being small enough to maintain low interest rates.
Why does having a large debt have such a negative effect on developing countries?
In actuality, much of the money borrowed was spent on initiatives that did not benefit the poor, such as arms, large-scale construction projects, and private ventures benefiting government officials and a small elite, due to the reckless behavior of both creditor and debtor governments. The spike in oil prices in 1973 also triggered inflation in the United States and other developed countries.
OPEC raised the price of oil for the second time in 1979. Meanwhile, in order to curb inflation, the United States pursued extraordinarily tight monetary policies, resulting in a domestic recession. The combined combination of rising fuel prices and rising interest rates resulted in a global recession.
The poorest countries were the hardest hit. Their exports fell as local production costs climbed and big importers reduced their purchases of commodities from other countries. The interest rates on Latin American governments’ debts skyrocketed after they took out loans from commercial banks at floating interest rates (rates that fluctuate according to the current market interest rate). In response to the worldwide drop in commodity prices, African governments borrowed substantially from foreign governments and multilateral banks at both market and concessional (very low) interest rates. The international financial system appeared to be on the verge of collapse when Mexico finally stated that it could not pay its foreign debt. The world’s largest creditors intervened to save commercial banks and the global economy.
According to the UN Development Program, heavily indebted impoverished countries have greater rates of infant mortality, sickness, illiteracy, and malnutrition than other developing countries (UNDP).
Six of Africa’s seven deeply indebted impoverished countries spend more in debt service (interest and principal repayments) than the total amount of money required to make significant progress against malnutrition, avoidable disease, illiteracy, and infant mortality prior to the year 2000. An estimated 3 million children would live until their fifth birthday if governments engaged in human development rather than debt repayments, and a million cases of malnutrition would be averted. According to the UNDP, governments in Sub-Saharan Africa transfer to Northern creditors four times what they spend on their people’s health (Human Development Report, 1997). Heavy indebtedness, on the financial side, signals to the world financial community that the country is a risky investment, that it is reluctant or unable to repay its loan. As a result, impoverished countries are either cut off from international financial markets or have to pay higher interest rates on their loans. Poor countries’ interest rates were four times higher than affluent countries’ in the 1980s, according to the UNDP, due to lower credit ratings and the likelihood of national currency devaluation. Another cost of debt is the lack of infrastructure, such as roads, schools, and health facilities, which may help to combat poverty while also fostering economic growth. The time spent by civil servants arranging debt repayments is a separate form of cost. Since 1980, according to Oxfam International, there have been over 8,000 debt negotiations for Africa.
The demand on heavily indebted governments to create foreign cash in order to pay their debt service and acquire necessary imports is considerable. International financial institutions frequently provide financial aid to countries in this scenario and use their clout to convince them to embrace structural adjustment and stabilization policies. These structural adjustment policies (SAPs) and the austerity measures that go along with them have the potential to have a significant detrimental impact on the poor, both immediately and over time.
How does public debt affect inflation?
Although there is no consensus on whether there is a positive or negative association between public debt and inflation, the analysis found that among the studies analyzed, a positive relationship between public debt and inflation predominates.
Why is the increasing amount of public debt an upcoming concern for the economic growth of Bangladesh?
The purpose of public debt is to close the gap between domestic savings and investment. The findings show that funds earned through public debt are not being put to productive economic use, which could improve Bangladesh’s growth prospects.
What are the effects of public debt?
The net effect of government borrowing is said to be expansionary. Scarce resources can be dispersed rationally if loans are raised for productive uses. To put it another way, resource allocation will be based on national interests. As a result, national income will increase.
However, if loans are collected to fund non-productive activities such as debt repayment, resources may not be allocated optimally. Even yet, the impact of government borrowing on consumer spending is likely to be minimal. Public borrowing, once again, has no discernible negative impact on investment. As a result, government borrowing can have a positive multiplier effect on national income.
To fund its loan payback scheme, the government frequently charges taxes. High tax rates deter people from working more. Despite the fact that public borrowing entails a transfer of resources (from taxpayers to lenders), the negative effect of taxes (i.e., the incentive to labor less when taxes are raised) has a negative impact on revenue.
The current generation receives less capital as a result of debt. As a result, public borrowing is not always expansionary. A reduced capital stock reduces an economy’s production and productivity.
