National Debt Matters, Here’s Why
National Debt is the total amount of debt a government owes to investors who own Treasury securities (bonds and notes), which the government offers to the public to fund programs or day to day operations. When the government spends more than it taxes at any given fiscal year, it is known as a deficit. If the government taxes more than it spends, it has a surplus.
As of the writing of this post, the US owes about $28 trillion in debt. When comparing debt to GDP (size of the economy), it’s around 125%. Each year, the federal government must pay that debt back in the form of interest payments. For the fiscal year of 2021, the government must pay $378 billion.
So does government debt matter? Well it depends on who you ask. Most economists agree that it does matter, but it’s in the specifics where they disagree. Some economists, like Jason Furman and Larry Summers believe that the US government has a greater ability to spend more due to historically low interest rates. When rates are low, the cost to borrow money reduces.
This has caused annual interest payments to not increase dramatically even with higher debt:
But many economists believe that interest rates will rise this decade and beyond. The Congressional Budget Office, a nonpartisan research agency that reports economic information to Congress, projects that interest rates will rise this decade and beyond, making it harder to finance deficits.
By 2031, according to the CBO, net interest costs will increase to 2.4% of GDP compared to 1.4% of GDP in 2021. A 1% increase might not seem like much, but America’s GDP is roughly $21 trillion as of 2021 and will continue to grow, meaning that a 1% increase in interest rates translates to hundreds of billions of dollars in increased net costs annually.
Beyond 2030, the increases are even more sharp, with the CBO projecting that net interest costs with account for 27% of all federal outlays in 2051:
Interest rates are not the only component of government spending that is projected to grow. Entitlement programs, such as Medicare and Social Security, are expected to grow as well.
CBO projects that both programs and their trust funds will be exhausted in a few years, meaning their shortfalls will add to the deficit, as well as the interest costs on those shortfalls. During the 2040s, CBO projects that the deficit will be 10.9% of GDP, compared to 5% for the 2020s. The major drivers of the deficit will be healthcare programs and interest costs.
By 2050, the accumulation of entitlement shortfalls and rising interest rates would increase national debt to an astonishing 195% of GDP.
The negative effects of having such high debt are profound, and can even be playing a role in the current US economy.
The Negative Effects of High Debt Levels
With the 125% debt to GDP ratio we have currently, we could already be experiencing the negative effects of high debt levels.
Large borrowing could significantly reduce the level of private investment in the economy. Since many investors of treasury securities are domestic banks and funds, increased borrowing could deter investors from making more productive investments into the economy.
This theory is called the Lazy Bank Hypothesis, and has been tested several times by economists. Let’s go over some of the studies.
This first paper, done by George Washington University economists M. Shahe Emran and Subika Farazi, use panel data of 60 developing countries to determine the causal effects of government borrowing on private credit from 1975 to 2006. They find significant crowding out effects, meaning that increased borrowing results in lower private credit.
The evidence shows that there is a significant crowding out effect of government borrowing from the domestic banks on private credit. Averaging over the different point estimates from alternative specifications and estimators, we find that when government borrowing increases by one dollar, it reduces credit to the private sector by about one dollar and forty cents.
Now critics will rightfully suggest that this paper does not apply to the US, because it only looks at developing countries. But there is still other evidence which finds that crowding out negatively impacts private savings and investment in more advanced nations.
One paper, this time conducted by the CBO, looks into the effects of deficits on private domestic savings and investment. They review past literature on the effects of deficits on saving, all of which find significant negative effects. Edwards (1996) finds that each additional dollar borrowed leads to a 55 reduction in private savings.
CBO also looks at Loayza, Schmidt-Hebbel, and Servén (2000), which finds crowding out effects, albeit to a lesser degree in the short run:
Loayza, Schmidt-Hebbel, and Servén (2000) report that it takes time for the private sector to change its saving behavior in response to changes in deficits and that the saving offset is small in the same year but larger over the longer term. Their estimate of the short-run offset that is most related to the saving-offset parameter used by CBO is between 6 cents and 39 cents per dollar of additional deficit. For the long run, their estimate of the offset is larger — between 34 cents and 93 cents. When the authors restrict their sample to the member countries of the Organization for Economic Co-operation and Development, the short-term offset is just 11 cents per dollar, increasing to about 34 cents in the long run.
CBO looks at other papers such as Chinn and Ito (2005) and Röhn (2010), which show various results depending on if the country is developed, industrial, etc.
The reduction in private savings and investment eventually leads to slower economic growth. Most studies show that it is important to stabilize debt to around 80–90% of GDP, with growth significantly decreasing beyond that point.
Growth in a Time of Debt is an influential paper which looks at the debt levels and it’s effect on growth. The authors uses data from 44 countries spanning several decades. Their main findings suggest that debt levels above 90% can have serious negative effects on economic growth in advanced countries. Developing countries can handle 60% debt to GDP before experiencing lower economic growth.
Economists Manmohan Kumar and Jaejoon Woo corroborated the findings made Reinhart and Rogoff (2010). They control for other factors that negatively impact growth to determine a causal relationship.
The empirical results suggest an inverse relationship between initial debt and subsequent growth, controlling for other determinants of growth: on average, a 10 percentage point increase in the initial debt-to-GDP ratio is associated with a slowdown in annual real per capita GDP growth of around 0.2 percentage points per year, with the impact being somewhat smaller in advanced economies
Similar to Reinhart and Rogoff (2010), this paper finds reduced growth mainly takes place when the debt to GDP ratio is above 90%. The main reason for the slowdown as the authors pointed out is due to reduced labor productivity.
This adverse effect largely reflects a slowdown in labor productivity growth, mainly due to reduced investment and slower growth of the capital stock per worker. On average, a 10 percentage point increase in initial debt is associated with a decline of investment by about 0.4 percentage points of GDP, with a larger impact in emerging economies
So basically, banks and domestic investors seek treasury securities since they are a safer investment instead of making more productive investments into the economy that grow labor productivity.
Another paper published in the European Economic Review looks into 12 countries in Europe from 1990–2010. They find that debt has an initial positive effect on GDP but it quickly decreases and starts to harm the economy beyond 67% debt to GDP. They also find that having beyond 70% debt puts additional pressures on long term interest rates.
Economists Mehmet Caner, Thomas Grennes, and Fritzi Koehler-Geib also authored an expansive study on the topic. Using data from the World Bank, they examined debt levels of 99 countries from 1980 to 2008 and specifically where the ‘tipping point’ of debt is. For all countries, the threshold was 77%, with countries seeing significant reductions in growth afterwards. For just developing countries, it was 64%.
Probably one the most ambitious paper on the topic was done by economist Vighneswara Swamy titled Debt and growth: Decomposing the cause and effect relationship. It was published in International Journal of Finance & Economics and uses macroeconomic data from 252 countries from 1960–2009. The primary source used was the World Development Indicators (WDI) database from the world bank as well as IMF data from the World Economic Outlook (2014).
Swamy divides the countries into 5 groups, countries with 0–30% debt, 31–60%, 61–90%, 91–150%, and >150%.
Debt tends to have a positive relationship with growth when debt levels are 0–60%. For countries with 61–90% debt, there is no relationship. Afterwards, there is an increasing negative relationship between debt and growth, even when you isolate the sample to only advanced economies, like the US.
The budget outlook in the next few decades does not look great. Rising interest rates and entitlement spending is going to further increase the national debt to incredibly high levels. As time goes on the reform needed to stabilize debt levels will become more drastic. But with debt levels being as high as they are currently, they already could be having serious detrimental effects on savings, investment, and economic growth.
