The first step in a rules based approach to fiscal policy is setting a target for debt. In this literature economists provide evidence for both positive and negative impacts of debt on economic activity. This evidence is used in setting debt targets for individual countries.
At low levels, debt can have a positive impact on economic activity. Government debt can have a positive role in the functioning of financial markets by providing a safe, low risk asset. This is especially true for the debt issued by the U.S. government. U.S. Treasuries are the foundation for the global financial system, as well as the U.S. financial market. Impairment, let alone default on U.S. debt could trigger a global financial crisis.
Government Debt and Economic Growth
Government debt can have a positive impact on economic growth. When government debt is used to finance infrastructure investments, this this can positively impact economic growth, but only up to a certain point. The empirical literature suggests that this point is reached between 50 and 80% of GDP for OECD countries (Fall et al. 2015).
There is a large and controversial economics literature on the impact of debt on economic growth. This controversy was launched by the Reinhart and Rogoff (2010) study showing that debt levels above 90% of GDO have a negative impact on economic growth. Subsequent studies found a non-linar realtions hip between debt and economic growth (Kumar and Woo 2010; Rohn 2010; Cecchetti 2011; Baum et al. 2013; Chuddik et al 2013; Panizza and Presbitero 2014; Fall et al 2015; Fournier, and Fall 2015; Lo and Rogoff 2015). The studies differ in estimates of the level at which negative impacts of debt on economic growth are triggered. Fall et al. (2015) in surveying this literature conclude that for high income countries the negative impact of debt on economic growth kicks in at debt levels of 70 to 90% of GDP. This threshold level is unique to the risk factors encountered in each country. Risk factors include: levels of taxation, population aging, the composition of debt, and most importantly vulnerability to shocks.
Setting a Debt Target for the U.S.
With total debt estimated at 128% of GDP, the U.S. now falls into the category of highly indebted countries vulnerable to macroeconomic shocks. The U.S. is not immune to the negative impact of shocks in the form of loss of market confidence, rising interest rates, and difficulties in servicing debt that could result in default and restructuring. The recent financial crisis revealed the vulnerability to risks in th domestic financial market, and the potential for financial market instability in the U.S. financial market to spread to the global financial market.
Setting a debt target for the U.S. must take into account this vulnerability to shocks. Fall et al (2015) take vulnerability into account in estimating a prudent debt target for the U.S. That debt target provides a cushion required so that macro-economic shocks do not push U.S. debt to levels where negative impacts on economic growth are triggered. The prudent debt target is the median level of debt by 2040 such that debt does not exceed that threshold. The prudent debt target is an increasing function of this tolerance (probability) level. At a tolerance level of 25% the debt target is roughly 70% of GDP; at a tolerance level of 10% the debt target is roughly 60%.of GDP. Fall et al. (2015) estimate that to reach the target debt by 2040 would require a primary balance surplus equal to roughly 1% of GDP.