The federal debt has grown substantially in recent years. Some observers wonder whether that debt could have a long-term negative impact on the American economy. Thomas Grennes, professor of economics at North Carolina State University, says recent research suggests an answer: Beyond a certain threshold, government debt slows economic growth. Grennes discussed the topic with the John Locke Foundation’s Shaftesbury Society and with Mitch Kokai for Carolina Journal Radio. (Click here to find a station near you or to learn about the weekly CJ Radio podcast.)
Kokai: You and colleagues have looked into this issue empirically, and you’ve found that there is at least roughly some point at which the amount of debt a government has does start to impact economic growth. What can you tell us about this?
Grennes: So we used historical data for many countries, including the United States, over a 30-year period, and the basic result is that when debt gets too high relative to the size of the economy, the rate of economic growth starts going down. And we estimated this “too high” at kind of a threshold of 77 percent of GDP. So above that, economic growth declines. Below that, [there is] no effect of debt on economic growth.
Kokai: So let’s delve into that a bit. Some people think that any level of debt, or at least a high level of debt, is pretty unhealthy. But what you found was that a certain amount of debt either has no ill effect or perhaps might have a small positive effect.
Grennes: Yes, that’s right. And so historically, governments have borrowed for many reasons. All governments have borrowed, including the most prosperous governments. Some of the borrowing is for capital kind of projects like building schools and roads, and those kinds of things are usually paid for over time, rather than by current taxes. And so, those kinds of things haven’t hurt economic growth.
Kokai: But then once you get to that point, which was, as you said, roughly around 77 percent, we see ill effects. What happens at that point?
Grennes: Yes. So it’s different things for different countries. For some countries, it’s the borrowing by the government that crowds out private borrowing and productive private investment. For other countries, it was the government borrowed their money from the central bank. The central bank printed money, and inflation was the result. So those are the main two negatives.
Kokai: Now, once you get to that 77 percent level, then, you ought to be concerned. Are there things governments can do once they’re approaching that point, to sort of switch gears and turn around?
Grennes: Well, many countries are above that now. The United States is above that level now, so this is an appropriate time to talk about this. And the main two things are — the 77 percent refers to debt relative to the [gross domestic product] — so they can run smaller budget deficits and get the debt down, or small surpluses. Or they can pursue policies that promote economic growth, and that raises the denominator and lowers the ratio.
Kokai: And we’ve seen in the past that both strategies have helped reduce that debt level. Is that true?
Grennes: Yes, both of them, and certainly for the United States. So we’re now at a level of about 93 percent of debt to GDP. The highest in history was 120 percent [in] 1945. So it came down from 120 percent to 40 percent in the 1970s, mainly through economic growth — substantial economic growth.
Kokai: Now, you mentioned that the last time it was this high was in 1945, and folks who know their history know this is when we were at the end of World War II. Has it been unprecedented for the United States to have a debt level this high when we’re so-called “at peace” or not in a worldwide conflict?
Grennes: No, it’s definitely unprecedented. So this is by far the largest peacetime debt ratio for the United States, and that’s what worries people. So, yeah, I think in general, when people have the idea that there’s a war like World War II, and it’s supported by the public, it’s thought of as being something that’s temporary, and you borrow to pay for this temporary emergency. But when it’s over, then you want to get the debt down. So, yeah, the current situation is unprecedented.
Kokai: Now in addition to identifying this threshold, which as we said was roughly 77 percent, you, in the report connected with this research, recommended that there were certain policies that could be put in place that would help address this issue, and that dealt with some sort of limit that governments would put in place. What were the policies?
Grennes: Yes. Since we found that the negative effect in economic growth came from some level of debt relative to the GDP, we would propose a kind of target or limit on debt relative to the GDP of maybe 80 percent of the GDP — something like that. And that would protect from these negative effects. And also, we would propose that it be averaged over five years so that you could be just above it temporarily as long as you’re just below it at other times, because we have to take into account business cycles. And when the economy goes into a recession, tax revenue falls, and you get a bigger budgetary deficit. So this would try to take account of this business cycle fluctuation.
Kokai: And the reason that you go over a five-year period, in addition to having the business cycle, as you also pointed out, 77 percent wasn’t a cliff. It wasn’t a point at which — beyond which — the economy goes into a death spiral.
Grennes: That’s right. That’s exactly right. And so the idea is, once you get above 77 percent, the rate of economic growth starts to slow by some small amount. If you get further above that, it slows by more. If you get further above, it slows by more. So, no, it doesn’t fall apart. It’s just starts — the rate of economic growth — starts declining. And the other qualification is, this estimate we did was an average over many countries, so it’s probably not exactly 77 percent for every country.
Kokai: Would it be a good idea to set the limit a little lower? I mean, you set it at 80 percent, which is a little bit higher than that threshold. Would there be any advantage to setting it lower, at 60 percent or 65 percent?
Grennes: I don’t oppose that, and I don’t have great confidence that it should be exactly 80 percent for the United States, but in the neighborhood. I have some confidence that that means something. Sixty percent would probably be OK. If you set it too low, though, we have some evidence that at very low levels, there’s a slight improvement in economic growth. Maybe it’s because the government is making some useful investments that they borrow to finance. But I wouldn’t push too hard on exactly 77 percent.
Kokai: One of the things you mentioned in your presentation was that another approach is a balanced budget amendment. But then you have to worry about the people involved, the politicians, going against that amendment or changing it or tweaking it. Would we have to worry about the same thing with this sort of debt limit?
Grennes: You would always face problems of, one, how do you enforce it if it’s violated? And then, how do you, if somebody wants to introduce some off-budget item, how do you handle that? And of course, what do you do when people want to change the rules? So as the Congress right now changes the dollar value of its limit very frequently, you’d have to deal with that also. But I think if you express it in terms of debt relative to GDP, you wouldn’t have to change it as often. You have some room for economic growth, as a way of changing the ratio, and yet also it takes into account inflation. You don’t have to change it for inflation.
Kokai: Is this the type of provision that would make sense to be added to the U.S. Constitution, or do you think this is something that could be done in statute as a law that would work pretty well?
Grennes: I’m reluctant to change the Constitution. I think the basic Constitution is very important. So one could do that, and I know that some of the balanced budget proposals are in terms of a constitutional amendment. I would think this would be more important for the Congress to do, although I’m not sure exactly what’s the best way to implement it.
Kokai: How important is it that we at least deal with this issue some way and not just say, “You know, the United States has been around for a couple hundred years. We’ve never defaulted. We’re not going to default. We don’t really need to worry about this.” Is that a whistling-past-the-graveyard type of response? Do we need to do something about the debt?
Grennes: Yeah, I think the time is right to do something, partly because, as I say, this is an unprecedented debt level in peacetime. It’s quite unusual. And the other issue is that we now have this kind of implicit debt — in addition to the $14 trillion plus $2 trillion — we have this implicit debt associated with Social Security, unfunded liabilities, Medicare and Medicaid. And those are definitely getting more serious with the aging of the population. So, yes, the time is right for reform.