The Non-linear Relationship between Debt and Economic Growth
Rinehart and Rogoff (2009a, 2009b, 2010) launched an ongoing debate regarding the relationship between debt and economic growth. Their empirical evidence for a large sample of countries revealed that public debt in excess of 90% of GDP was associated with significantly lower economic growth.
From this historical perspective the financial crisis that began in the U.S. in 2007 is consistent with their finding of a nonlinear relationship between public debt and economic growth. The sharp buildup in public indebtedness reflected the direct cost of government bailouts, the adoption of a stimulus package, and a marked decline in revenue. As total public debt pushed above the 90% threshold, growth rates declined well below the long term average rate of economic growth. A deleveraging of private debt dampened economic growth in the medium term.
What is different about the Great Recession is depressed rates of economic growth a decade after the start of that financial crisis. Rinehart and Rogoff argue that high levels of debt have a negative impact on economic growth in the medium term. Secular retardation in economic growth over the past decade suggests a discontinuous change in the relationship between debt and economic growth in the long term. The Congressional Budget Office (2017) projects lower rates of growth over the next several decades in their long term forecast.
The heavy debt burden in the U.S. is now acting as a drag on economic growth, and will limit the fiscal space to pursue countercyclical fiscal policy in the future. The clue that this economic recovery is different from previous recoveries is the divergence in interest rates on long term government bonds in the U.S. compared to other OECD countries (Wall Street Journal 2017e, 2017f, 2017g). Prior to the recent financial crisis the interest rate on long term U.S. debt was below that in other OECD countries. Today the interest rate on long term government debt in the U.S. is higher than that in every OECD country, except Italy, Portugal, and Greece. The OECD (2017) forecasts the interest rate on long term U.S. debt in 2018 at 3.4%, a rate higher than that in all other OECD countries except Portugal and Greece.
It is tempting to dismiss this divergence in interest rates on long term government debt in the U.S. and other OECD countries as a reflection of the recent monetary policies. But the tighter Fed monetary policy has so far had a modest impact on interest rates, and there is some skepticism regarding this shift in Fed policy.
There is an alternative explanation for the divergence in interest rates on long term U.S. debt compared to that in other OECD countries. For more than half a century the U.S. government has failed to pursue fiscal stabilization policy. Except for a few years in the late 1990s the federal government has incurred deficits and accumulated debt at an unsustainable rate. During the Obama administration U.S. debt roughly doubled from $10 trillion to $20 trillion; the ratio of debt-to- GDP in the U.S. is now one of the highest in the world. In contrast, over the past two decades most OECD countries have enacted fiscal rules designed to eliminate deficits and debt. Except for a few highly indebted countries, these OECD countries have had success in stabilizing, and in some cases reducing, their debt-to-GDP ratio. These countries were able to respond to the recent financial crisis without a massive accumulation of debt (Merrifield and Poulson 2016a, 2018).
Is the U.S. Heading Toward a Perfect Fiscal Storm?
Investors in the U.S. appear to have a sanguine view of the prospects for economic growth and stability. The stock markets continue to notch higher records each week. Loanable funds continue to pour into higher risk investments in search of higher yields. But there is reason to doubt this sanguine view, and indeed reason to suspect that the U.S. is heading toward a prefect fiscal storm.
The classic example of a collapse in the stock market occurred thirty years ago on Black Monday October 19, 1987, when the Dow Jones Industrial Average fell 508 points (Wall Street Journal 2017h). That 22.6% decline remains the largest ever. A critical factor in that market collapse was a reversal in monetary policy. In the mid-1980s stocks benefited from an accommodative monetary policy and declining interest rates. In 1987 the reversal in Fed policy accompanied by higher interest rates is widely regarded as the trigger for the market collapse.
The parallels between the financial markets today compared to that in 1987 are eerie. The Fed has launched a tighter monetary policy, increasing the discount rate. It has begun to reduce assets in its balance sheet after years of quantitative easing.
What is different today is the relationship between debt and economic growth. In 1987 the federal government had a relatively low level of debt compared to other OECD countries. After a sharp recession the economy quickly recovered high rates of economic growth that would be sustained for more than a decade. The stock market quickly recovered and resumed a long upward trend over this period.
Market sentiment can change very quickly. If the U.S. were to experience another Black Monday the impact would be devastating. A 22.6% fall in the stock market would reduce the Dow Jones Industrial Average from 23,000 to 18,000. The impact of such a stock market collapse in today’s market is difficult to predict. The combination of low growth and high debt means that a financial crisis would be quite different today. We should not expect a modest recession followed by rapid economic recovery. A more likely scenario is that during the Great Depression, a decade of secular stagnation in economic growth, accompanied by greater economic instability.