The Burden of Public Debt
The overall public-debt burden of the world’s most advanced countries is approaching levels not seen since the Second World War—levels that could damage their future growth prospects. According to International Monetary Fund (IMF) estimates (here and here), the average ratio of public debt to GDP among the advanced economies—their debt burden—will approach 111 percent this year, but then rise significantly above that percentage at least through 2017. The United States’ public debt level is headed for the wrong side of that average. After breaching 107 percent of GDP this year, the U.S. public-debt burden will settle at 114 percent after 2015, according to the IMF’s best guess. While much of the debt buildup stemmed from the ongoing global economic malaise, contingent liabilities associated with aging populations will keep pressure on many advanced countries’ budgets. The outlook is still cloudy, but this much seems clear: To the extent that public debts absorb private savings that otherwise would support private investment, long-term economic growth will suffer.
To be sure, with the global economic recovery lagging and with accommodative monetary policies keeping interest rates unusually low, public and private borrowers are not currently squaring off over a scarce pool of funds. But as economic activity gains momentum and approaches its potential growth path, central banks will begin to back-peddle on monetary stimulus. Then, rising debt burdens will crowd out private investment and crimp economic growth. According to the IMF, countries that have high and increasing debt-to-GDP ratios experience significantly lower GDP growth rates than countries with low debt-to-GDP ratios or even those countries with high, but declining debt-to-GDP ratios. What constitutes a high ratio? Certainly debt burdens above 100 percent, but maybe those as low as 85 percent and possibly even as low as 40 percent, according to the IMF.
Government budget deficits affect economic growth because they reduce the amount of private domestic and foreign savings available to support private investment. We outline the process here as a step-by-step progression, but the events that we describe unfold simultaneously: When a government issues debt to domestic households, businesses, and banks, it diminishes the amount of private savings available to finance private investment. Real—or inflation-adjusted—interest rates rise and might coax individuals to save a bit more, but, on balance, higher real interest rates will discourage businesses from investing in capital goods, which are crucial for economic growth. As domestic interest rates increase above interest rates elsewhere in the world, foreigners will likely channel more of their savings into the high-debt-burden country. This financial inflow will tend to mitigate the upward pressure on domestic interest rates. It will allow domestic investment to exceed domestic savings—the level that investment would obtain in the absence of globalized financial markets.
Still, while foreign financial flows might ease upward pressures on domestic interest rates, they come with other consequences. For one thing, the inflow of foreign funds will encourage an appreciation of the high-debt-burden country’s currency. So while lower interest rates might encourage some investment in interest-sensitive sectors of the economy, a currency appreciation might place domestic businesses that compete in global markets at a competitive disadvantage. One sector gains while another loses. In addition, foreign savings are not free. Even if the inflow of foreign funds were to completely offset the domestic-interest-rate rise, the foreign savings must eventually be repaid with interest. While economic growth might rise, the consumption that is enjoyed from that growth will be lessened by the amount that must be repaid to the rest of the world.
In the current environment, however, this global, debt-finance stop-gap might not work so smoothly. With advanced economies around the globe competing for domestic and foreign savings to finance their public debts, foreign financial inflows are likely to require substantially higher interest rate differentials to cross borders. Smaller financial inflows at high interest rates spell less domestic investment. Likewise, they are likely to initiate bigger exchange-rate movements.
The anticipated high public-debt burdens could also complicate central-bank efforts to reduce their balance sheets. High interest rates raise the costs of funding public debt. Their impact on government debt burdens can become profound if crowding out simultaneously slows economic growth. Under such circumstances, governments, intent on financing their debts at low costs, might exert pressures on central banks to keep monetary policy relatively easy. Inflation would then rise. The beneficial budget impacts, however, would only be transient because savvy financial markets would quickly demand interest rates to compensate for higher anticipated inflation. Nominal interest rates would eventually rise, leaving the real interest cost of financing the debt unchanged.
The IMF, like many economists, views the advanced world’s fiscal prospects as “sobering.” To be sure, countries—including the United States—have reduced heavy debt burdens successfully in the past. They did so by shifting the noninterest portions of their budgets to surpluses while maintaining relatively strong economic growth. Repeating such efforts while coming off of the worse economic collapse since the 1930s and facing adverse demographic trends does seem sobering—to say the least.