Saturday, June 1, 2019

The U.S. Federal Debt - How big is too big?

The Federal debt has risen on average +8.5% each year over the last 52 years, from $320bn in the beginning of 1966 to $22tn at the end of 2018.

At the same time, national income, as measured by nominal Gross Domestic Product (GDP) has increased on average only +6.4% per year. As the Federal debt increased at a faster pace than GDP the debt to GDP ratio has increased from 40.3% in 1966 to 105.3% in 2018.

Policy makers and economists alike have become concerned regarding the debt level. Is the current debt level sustainable?

Historically low interest rates make the direct cost of the U.S. Federal debt, the interest payments on the debt, far from their historical maximums. Interest payments depend not only on the size of debt but also on interest rates. Since the 1980’s interest rates on the 10-year Treasury bonds have declined from a maximum of 15.15% in 1981 to 2.53% in 2019.

As a result, interest payments on the current Federal debt has declined from a maximum of 5.0% in 1995 to 3.2% in 2019.

We must not forget the indirect costs of the U.S. Federal debt. There are several channels through which high U.S. Federal debt could adversely impact medium- and long-run growth which have received attention in the economics literature. High public debt can adversely affect capital accumulation and growth via higher long-term interest rates, higher future taxation, inflation, and greater uncertainty regarding economic policies and prospects. In more extreme cases of a debt crisis, by triggering a banking or currency crisis, these effects can be magnified. High debt is also likely to constrain the scope for stabilization policies during recessions, which may result in higher volatility in terms of GDP growth, inflation and employment and further lower growth.

Today U.S. real GDP growth is on average 1.3 percentage points lower, relative to 1966 due to the increase in the debt-to-GDP ratio. In general, the estimated impact of the U.S. Federal debt on growth is small, with a 10 percentage points increase in the initial debt-to-GDP ratio leading to 20 basis points slowdown in annual real per capita GDP growth . This implies that the U.S. economy could have grown at 4.2% in 2018 instead of the 2.9% recorded at the end of the year, if the debt-to-GDP level had remained at its 1966 level.

A large number of empirical papers find that the relationship between debt and growth is non-linear and characterized by the presence of a threshold, around 90 to 100 of debt-to-GDP, above which debt starts having a larger negative effect on economic growth. However, the negative relationship between debt and growth and the classic 90 percent threshold are not robust across samples, specifications, and estimation techniques. In particular, there is evidence that the effect of debt depends on the quality of institutions and that its negative effect is confined to non-democratic developing countries and economies in which the majority of debt-holders are non-resident. It is not clear whether a debt overhang argument can be easily applied to the U.S. economy.

In conclusion, the cost of the Federal debt in terms of real GDP growth could already be large and the U.S. economy could benefit from a reduction in Federal debt. However, it is unlikely that U.S. economic growth will collapse if it passed a certain critical level of debt-to-GDP.

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