Does debt matter?

Position:A SYMPOSIUM OF VIEWS - Cover story

The global consensus on debt is in disarray. The recent scrutiny of the popularized version of the Rogoff-Reinhart thesis (that growth plummets when debt exceeds 90 percent of GDP) makes clear there are no simple formulas for determining the risks in the level of a nation s debt. Nevertheless, there still seems to be a consensus that high levels of debt can, in many but certainly not all cases, lead to underperforming economies (no financial crisis but a lot of jobless heartache). But there is also a consensus that austerity policies to deal with debt can often be counterproductive, producing their own heartache.

Can a realistic guide be fashioned for determining whether a nation's debt has reached a danger zone? Or are countraes from here on expected to pursue fiscal reforms only if and when a crisis sets in? What are the factors--exchange rate regimes, macroeconomic conditions, level of real interest rates, direction and level of capital flows, and so on--that might provide clues as to whether an economy is approaching a point of concern over debt? Or does the level of debt even matter in today's climate of huge excess capacity and historically generous central bank liquidity?



Member of the Executive Board, European Central Bank, and

former Deputy Finance Minister, Germany

This question has recently gained prominence following the controversy over the Reinhart and Rogoff findings but, in my view, it is a short-sighted debate. The argument in favor of fiscal consolidation to stabilize public debt levels has never been based exclusively on the existence of a "cliff effect" for economic growth when borrowing exceeds 90 percent of GDP. It is based on the long-term consequences of letting public debt rise to unprecedentedly high levels--consequences that are especially serious for countries in the euro area.

First, we have had a clear empirical test in the euro area that, at high and rising debt levels, market reactions become unpredictable. There can be no guarantee that if countries delay fiscal consolidation and allow debt to keep increasing, markets will continue to finance it at affordable rates. We should not forget that in the euro area, markets create a de facto "debt ceiling" for member countries, and several are already pressing up against it.

Second, very high debt levels will reduce our ability to fight future crises and to invest in future growth. As we do not have a federal budget in the euro area, national budgets play an essential stabilizing role which will be heavily diminished if debt rises too high today. Moreover, that debt will have to be serviced, which will lead to ever more revenue being diverted from growth-enhancing investment. In Italy, for instance, around 80 billion [euro] a year goes on debt service--this is more than 10 percent of the total public expenditure that is not being spent on education or infrastructure.

Third, high debt levels in the euro area have important inter-generational consequences. Under the new EU debt rule, all euro area countries are legally bound to start reducing their public debts below 60 percent of GDP. This means that the more debt rises today, the more it will have to be brought down by the next generation--and average public debt in the euro area already exceeds 90 percent of GDP. On top of this, the next generation will have to deal with the fiscal consequences of aging populations. To give a sense of that challenge, the working age population in Germany is projected to fall by more than 30 percent by 2060 while age-related expenditure will continue to rise. In other words, fewer taxpayers will be carrying an ever greater burden.

In sum, debt clearly does matter in the euro area--and reducing it is essential for long-term growth, stability, and inter-generational fairness. But it is also important to stress that the euro area's approach is not rigid. The Stability and Growth Pact ensures that fiscal consolidation can be both credible and flexible: if a country sticks to its commitments but short-term growth turns out lower than forecast, its fiscal targets can be adjusted.



President, Deutsche Bundesbank

In the wake of the financial crisis and the ensuing recession, public (and private) debt in many advanced economies has soared to unprecedented peacetime levels. The current debate strongly focuses on the effects of fiscal consolidation in the immediate future. Usually, consolidation is expected to have a negative impact on growth in the short run, although the size of the effect is controversial and depends on the instrument and the countries' specific situation. However, there is more consensus on the long-run detrimental effects of high public debt for growth. In more closed economies, high public debt crowds out private investment as interest rates tend to increase. The resulting lower capital stock implies lower labor productivity and wages and has a negative effect on GDP. In more open economies, a comparable mechanism depresses the net foreign asset position and capital income. The pressure on monetary policy increases, potentially resulting in a deanchoring of inflation expectations. Once debt ratios are regarded as a potential threat to fiscal sustainability, these effects are exacerbated by rising risk premia on interest rates and can have a disruptive impact on growth even in the short run.

Although many empirical studies point to a negative and often non-linear relation between public debt ratios and growth, the precise impact has proven difficult to determine. The negative impact on productivity may be less important (or might even be positive) if the debt is used to finance productive public investment instead of current consumption. The long-term outlook for growth also plays a role, as well as the structure of debt (for example, shares held domestically, currency of denomination, maturity), the implicit liabilities due to aging societies, and many other factors. Moreover, there may be considerable uncertainty about future political developments in a given country and overall risk appetite might change suddenly. Therefore, there is not one unique threshold above which debt ratios become dangerous. Instead, the impact of debt on growth is case-specific and might change rapidly.

Given that the debt ratio is very difficult to influence in the short term, and given the large volatility and uncertainty surrounding the level of debt that can still be regarded as growth-friendly and safe, there is a strong case to be made for erring on the side of caution. We tend to complain about the burden of the existing debt and the failure to control it in the past; we promise to reduce debt in the medium term (at least the next government should do this)--but at the same time we always tend to find good reasons why "not just now." There is a real risk that recognition of the longer-term benefits of sound public finances is "crowded out" by short-term political considerations, thereby making consolidation a moving target.



Chairman and Chief Executive, Sonecon, and former U.S.

Under Secretary of Commerce for Economic Affairs

There is no economic law dictating that government debt will slow growth in a predictable way, or at a predetermined point, because the connections between a nation's public debt and its growth rate are complex and sensitive to many conditions. The basic notion underlying the search for a direct relationship is that a nation's supply of savings is limited. Therefore, savings that go to finance its public debt will limit the private investments that underlie long-term growth. Yet Japan and a few other countries with very high levels of public debt also have very high savings to provide the capital required for both public debt and normal levels of private investment. And while Japan also suffers from substandard growth, its slowdown began in the early 1990s, considerably before its government debt rose so sharply.

In America's case, our deficits and demands for private investment would outstrip our private savings, but the conflict is resolved by attracting foreign savings. The reason, again, lies in our particular economic conditions: Investments produce higher returns here than in most other advanced economies, and for more than twenty-five years, the dollar has held its value better than the currencies of Europe and Japan. Britain provided an even more vivid example through much of the nineteenth century, when public debt as high as 250 percent of GDP did not derail the Industrial Revolution that produced strong growth.

The telling signal that high government debt is impinging on private investment and growth, of course, is rising real interest rates as scarcity of capital drives up its price. The negative real interest rates that have prevailed here for years are strong evidence that a strategy of reducing government debt to spur stronger growth has no sound economic basis. It was the misfortune of Carmen Reinhardt and Kenneth Rogoff that their flawed economic analysis, which never focused on current conditions in the United States, was ultimately hijacked by partisan advocates of smaller government.

The debate over debt and growth suffers from another incoherency. The current case for austerity--as well as the case for stimulus--has been framed by a traditional view of what drives growth in an industrial economy. To go beyond those flawed alternatives, we have to consider what can drive higher growth in a post-industrial economy, beyond the traditional model. Higher growth in such an economy comes not simply or mainly from expanding the purchases and use of physical assets--plant and equipment--and applying excess labor to those assets. Those factors still matter in a post-industrial economy. But in achieving higher growth, they don't matter as much as the development, diffusion, and efficient use of...

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