- Beyond a certain level, government debt is a drag on growth.
- Research shows the estimated threshold is in the area of 85-115%.
- We are nearing the top of that range with potentially negative implications for future economic growth.
- Financial plans should at least consider that there might be a negative impact on economic growth caused by the rising debt and that it would likely lead to lower equity returns. Lower potential economic growth when combined with elevated valuations should at least raise concerns.
The Relationship Between Public Debt and Economic Growth
The massive fiscal stimulus, producing the largest deficits as a percentage of GDP the U.S. has ever experienced during peacetime, has pushed the U.S. debt-to-GDP ratio to in excess of 100 percent. In addition, large deficits are projected for the foreseeable future, which will lead to further increases in that ratio. This has led to concerns about not only the possibility of rising inflation (fueled by very stimulative monetary policy as well as the stimulative fiscal policy) but to negative effects on future economic growth. Concerns about the potential for negatively impacting economic growth once debt-to-GDP approaches 100 percent are based on prior research findings.
The authors of the 2011 study by the Bank for International Settlements, " The Real Effects of Debt," concluded: "Beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems." The authors estimated that after the threshold, an increase of 10% in the government debt-to-GDP ratio will lower annual economic growth by 0.17-0.18% over the following five-year period. Carmen Reinhart and Kenneth Rogoff came to a similar conclusion in their 2010 study, " Growth in a Time of Debt." Their threshold was a bit higher, at a 90 percent debt-to-GDP ratio. And Alexandru Minea and Antoine Parent, authors of the 2012 study " Is High Public Debt Always Harmful to Economic Growth?" found the same negative relationship, though their estimate of the threshold was somewhat higher, at 115 percent (a level the U.S. will reach in the near future).
Dimitrios Asteriou, Keith Pilbeam and Cecilia Eny Pratiwi contribute to the literature on public debt with their study " Public Debt and Economic Growth: Panel Data Evidence for Asian Countries," published in the April 2021 issue of the Journal of Economics and Finance. Using data from 14 Asian countries, they analyzed whether rising public debt is harmful for growth, in both the short run and long run. These countries experienced two major crises during the 33-year period covered, 1980-2012-the Asian financial crisis of 1998 and the global financial crisis of 2008, which boosted their public debt-to-GDP ratios. The sample included very poor countries such as Bangladesh, Nepal and India, and wealthier countries such as Singapore and South Korea. These countries provided an interesting test, as in 2010 only two had debt-to-GNP ratios in excess of 67 percent (Sri Lanka at 82 percent and Singapore at 101 percent), while six had ratios below 40 percent. Following is a summary of their findings:
- Trade openness is significantly negative in the short run when it might be the case of trade liberalization undermining domestic production due to import competition. However, trade openness is positively associated with economic growth in the long run.
- In both the short and the long run, government debt is significantly related to negative economic growth.
- The negative relationship is more significant when using common correlated factors to address the issue of cross-sectional dependence among countries.
Their findings led Asteriou, Pilbeam and Pratiwi to conclude: "Our results indicate that an increase in government debt is negatively associated with economic growth in both the short and long-run." They added that "the idea that the negative effects of public debt kick in only at ratios of public debt to GDP of 90% or more may not apply to the Asian economies."
In light of the relatively lower level of debt-to-GDP ratios of the 14 Asian countries, these findings raise some interesting questions: Is the negative relationship because the increase in public debt is used to finance projects of little worth to future economic growth? Or because it crowds out productive private investment? Or is it because the increase in public debt has benefited a few elites at the expense of increasing the debt burden on the rest of the population? The answer may be a mixture of all three. The same questions apply to developed nations and raise concerns about future U.S. economic growth in light of our rising deficits. One only has to look to Japan, with a debt-to-GDP ratio well in excess of 250 percent (and headed higher) and stuck in a 30-year period of weak economic growth, to raise concerns about our experiment in massive deficit spending at a time when our debt-to-GDP ratio is already in excess of 100 percent.
The takeaway for investors is that their financial plans should at least consider that there might be a negative impact on economic growth caused by the rising debt and that it would likely lead to lower equity returns. Lower potential economic growth when combined with elevated valuations should at least raise concerns. Prudent investors plan for this possibility. Forewarned is forearmed.
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