Growth in a Time of Debt Explained

The global debt has reached a staggering $188 trillion, with the United States accounting for over $23 trillion of that total.

This level of debt is unprecedented in history, and it's natural to wonder how growth can occur in such a debt-ridden environment.

The answer lies in the concept of "debt monetization", where central banks print more money to pay off debt and stimulate economic growth.

This approach may seem counterintuitive, but it's a common practice that's been used in various forms throughout history.

The key is to understand that debt monetization can create a temporary economic boost, but it also carries significant risks, such as inflation and asset bubbles.

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A large federal debt can have a significant negative effect on the economy. Economists have long noted several macroeconomic channels through which debt can adversely impact medium- and long-run economic growth.

High public debt can lead to higher long-term interest rates, which can stifle innovation and productivity. This, in turn, reduces the growth potential of the economy.

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Studies on the channels through which debt adversely impacts growth have found that when the debt-to-GDP ratio reaches elevated levels, the private sector starts dissaving. This contradicts the Ricardian equivalence hypothesis, which holds that households are forward-looking and increase their saving in response to increases in government borrowing.

The Congressional Budget Office (CBO) predicts that by 2049, the cost of paying the interest on the nation's debt will be the third-largest budgetary item after Social Security and Medicare, constituting almost 6 percent of GDP.

Research has consistently shown that high public debt levels have a negative effect on economic growth. A summary of studies on the relationship between debt and economic growth is shown below:

The effects of a large and growing public-debt-to-GDP ratio on economic growth could amount to a loss of $4–$5 trillion in real GDP over the coming 30-year period. In per capita terms, this would be the difference between a baseline real GDP per capita of $95,339 and a debt-drag-affected real GDP per capita of $82,376–$86,021.

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High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates, inflation, and a general constraint on countercyclical fiscal policies.

The Congressional Budget Office (CBO) predicts that by 2049, the cost of paying the interest on the nation's debt will be the third-largest budgetary item after Social Security and Medicare, constituting almost 6 percent of GDP.

Studies on the channels through which debt adversely impacts growth find that when the debt-to-GDP ratio reaches elevated levels, the private sector seems to start dissaving.

A further cost resulting from increased government borrowing is the crowding out of public investment as growing interest payments consume an ever larger portion of the federal budget, leaving lesser amounts of public investment for research and development, infrastructure, and education.

More than 20 studies have examined the relationship between government debt and economic growth, and the majority find a negative effect.

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Here are the findings from some of these studies:

These studies suggest that a high debt-to-GDP ratio can lead to reduced economic growth, lower productivity, and declining social mobility.

A large federal debt can have negative effects on the economy, including reduced private investment and crowding out of public investment. This can lead to lower productivity and growth rates.

Economists have found that high public debt can also lead to higher long-term interest rates, which can further reduce investment and economic growth. Studies have shown that when the debt-to-GDP ratio reaches elevated levels, the private sector starts to dissave, contradicting the Ricardian equivalence hypothesis.

The Congressional Budget Office predicts that by 2049, the cost of paying the interest on the nation's debt will be the third-largest budgetary item, constituting almost 6 percent of GDP. This will leave lesser amounts of public investment for research and development, infrastructure, and education.

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Table 1 summarizes the findings of various studies on the relationship between debt and economic growth.

The studies listed in Table 1 demonstrate a consistent finding that high public debt is associated with negative effects on economic growth.

When analyzing growth in a time of debt, it's essential to consider the debt-to-GDP ratio. The average debt-to-GDP ratio for advanced economies has risen from 70% in 2007 to 120% in 2020.

The debt crisis has led to a significant increase in debt servicing costs, which can be a major obstacle to growth. In some countries, debt servicing costs have exceeded 10% of GDP.

A key challenge in addressing debt is the distinction between debt and deficits. While deficits are the annual increase in debt, debt is the total amount of debt accumulated over time. This distinction is crucial for understanding the root causes of debt accumulation.

The debt burden can have a significant impact on economic growth, particularly if it leads to a decrease in investment and consumption. In some countries, high debt levels have resulted in a decline in investment, which can have long-term consequences for economic growth.

The impact of debt on growth can vary depending on the type of debt and the economic conditions of the country. For example, high-interest debt can have a more significant impact on growth than low-interest debt.

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A recession can actually help reduce debt by decreasing interest rates, making it easier to pay off loans.

Low interest rates can also boost economic growth by encouraging people to take out loans and invest in new projects.

The COVID-19 pandemic has had a significant impact on global debt, with many countries taking on large amounts of debt to finance their responses to the crisis.

In 2020, global debt reached a record high of $258 trillion, up from $144 trillion in 2009.

Monetary policy, such as quantitative easing, can also influence debt levels by increasing the money supply and reducing borrowing costs.

The European Central Bank's quantitative easing program, launched in 2015, injected over €2 trillion into the European economy.

Economic growth can also be influenced by government policies, such as tax cuts or increased government spending.

In 2018, the US government passed the Tax Cuts and Jobs Act, which cut corporate tax rates from 35% to 21%.

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