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February 27, 2013

Debt is a Real Drag in Any Season

By

Like snow during a long stretch of miserable winter weather, the U.S. has been piling up debt year after year. Being “snowed under” in this way is profoundly depressing, fiscally as well as mentally.

Economists have a term for this: “debt drag.” It occurs when national debt piles up so high that it becomes a drag on the economy, slowing long-term growth of GDP and wages.

With each additional year spending more money than it takes in, the federal government hoists more weight onto the existing debt drag. The government pays for its prodigality by having to devote more and more of its revenues to interest payments on ever-rising debt. The debt itself crowds out private investment, as money flows to low-risk government financial instruments like Treasury bills, leaving less capital available for riskier investment in private businesses. Slower growth in private investment capital means less opportunity for American workers: fewer new jobs, less efficient equipment and slower advancement in wages.

One recent study by economists at the International Monetary Fund found that the economies of high-debt nations (defined as those with debt above 90 percent of GDP) grew 1.3 percentage points slower than their low-debt counterparts (debt less than 30 percent of GDP). The adverse economic effects increase as debt grows, the researchers found.

Now 1.3 percent per year may not sound like much. But don’t forget the magic of compound interest or, in this case, compound depression. Over a decade, a 1.3 percentage point reduction in growth costs the economy $9 trillion. Divide that figure by the number of American families, and it suggests that, by the year 2023, debt-induced drag will leave the typical family $11,000 poorer that it would otherwise be. Who looks forward to an $11,000 pay cut?

The IMF study confirms a basic economic theory that many progressives like to ignore: When private savings are invested in government bonds, they cannot also be invested in the private sector. The key question, of course, is: How high can government debt rise before it starts taking so large a bite from the economy that it creates real hardship?

Another study, by economists at the Bank for International Settlements, estimates that the critical level is a debt load equaling 84 percent of GDP. Once debt hits the 84 percent mark, the drag starts to snowball quickly, tamping down private investment, workers’ salaries and labor productivity by truly significant margins.

Now, here’s the bad news: The U.S. has already blown through the cut-off point.

Using the IMF’s measure of the federal, state and local government debt, U.S. debt, which stood at only 48 percent of GDP in 2007, zoomed to the 84 percent level last year. Debt growth from 2009 to 2011 has already cost Americans $200 billion in lost opportunities. Combined with new debt projected to pile up over the next 10 years, it can be expected to depress GDP an additional $9 trillion, cumulatively.

As we stand at the 84 percent threshold for continuous economic slowing, it’s time for Congress to take a hard, long-term look at the effects high debt have when calculating the costs and benefits of government spending. Higher national debt can seriously slow an already stressed economy. And perpetually slow growth can be worse than a recession. Whereas a recession dampens income only temporarily, slow growth occasioned by an immovable mountain of debt produces a permanent drag on income.

Constraining federal spending through effective policy changes can allow our economy to continue moving forward and diminish our high debt levels. Low spending is the best cure for our debt drag blues.

-Salim Furth is a senior policy analyst in macroeconomics at the Heritage Foundation’s (heritage.org) Center for Data Analysis.

First appeared in The Washington Times.

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