The Size And Persistence Of U.S. Debt Are Unprecedented
The current (September 2015) gross public debt of the United States has risen to 105% of GDP. This is the highest peacetime debt relative to the size of the economy in the history of the country. The persistence of the high level of debt is also unprecedented. Reinhart et al (2012) have identified and charted all debt overhangs for advanced countries since 1800. They define an overhang as a period in which public debt exceeds 90% of GDP for at least five consecutive years. In the vast majority of cases, these periods have been associated with slower economic growth for the highly indebted countries. There have been 26 episodes of debt overhang since 1800, and in 23 of the episodes the highly indebted countries grew 1.2 percentage points more slowly with debt overhang than without it.
Until now, the US had only one debt overhang episode, and it was associated with World War II and its aftermath. However, the US recently entered its first peacetime debt overhang, a status it now shares with Greece, Italy, and Japan, chronic high debt countries. Not everyone is convinced that the current US debt constitutes a serious economic problem, and skeptics correctly point out that the US is not like Greece in facing imminent default on its bonds. However, it has become like Greece, Italy, and Japan and unlike all previous US governments in experiencing a persistent peacetime debt overhang. Is it possible that the slow recovery of the US economy from the Great Recession is related to its newly acquired debt overhang?
Historical Debt Crises
There is additional new evidence that US public debt has entered uncharted territory. Based on US data since 1800, D’Erasmo et al (2015) identified 5 debt crises, defined as debt ratios at least two standard deviations above the long-run average (8.15 percentage points above mean). There were 5 such crises: the Civil War, World Wars I and II, the Great Depression, and the 2008 crisis. The response to the most recent crisis has been significantly different from the fiscal responses to all previous crises. In the previous four crises, the government’s primary budget returned to a surplus within 4 years of the crisis. This traditional fiscal response treated the debt crisis as temporary, and it moved the debt back toward its pre-crisis level. However, since 2008, there has not been a similar adjustment. In 2015 the primary budget remains in deficit, and the Congressional Budget Office projects primary deficits for the next 10 years (Auerbach and Gale). Those responsible for US fiscal policy have been unwilling or unable to move the debt back to its pre-crisis level. The persistence of high debt has moved the US into uncharted territory.
This persistently high debt territory is uncharted for US government debt during peacetime, but not for other countries. They grew at 3.5% per year during periods without debt overhang, but only 2.3% per year during periods of debt overhang. The average US growth rate since 1946 was 3.25% (Bureau of Economic Analysis), and if debt reduced growth by 1.2 percentage points, US growth would be about 2%, which is close to what we have seen recently.
Why Does High Debt Reduce Growth?
What mechanism might have caused the persistently high debt to reduce the growth rate of real GDP? This is a bit of a puzzle, but it was not high real interest rates. The Fed has kept short-term money interest rates near zero since 2008, which has resulted in negative real rates for the US during this debt overhang episode. Reinhart et al have demonstrated that since 1800 most countries that experienced debt overhangs and slower growth have experienced low or negative real interest rates during the same periods.
What factors might explain why the United States government has produced and tolerated persistently high public debt in recent years. The aging of the population and the increased spending on Social Security and Medicare are likely factors. The debt overhang increases interest payments on the debt and aging of the population increases the portion of the government spending that is non-discretionary (much of this is for Social Security and Medicare). What remains for discretionary spending has been reduced to its lowest level since the data were first reported in 1962. According to the latest CBO projections, the share of government spending on Social Security and Medicare will increase continuously for at least the next ten years, and the non-discretionary share of government spending will drop for the next ten years (Auerbach and Gale 2015). The money cost of these entitlements is not limited, and this trend makes it increasingly difficult to spend on activities that are traditionally important for government: infrastructure, research and development, and education.
Debt and Growth in the European Union
How does the recent high debt experience of the US compare with the countries of the European Union? The Greek debt crisis is the most extreme. Greece has been in a debt overhang for many years, and its current debt ratio is 173%. Italy is also experiencing a persistent debt overhang, and its 2015 debt is 134%. These extremely high debt countries have had little or no economic growth. Germany (70% in 2015) has not had a debt overhang, in the sense of debt in excess of 90% of GDP, but it has had debt consistently above the Maastricht limit of 60%. France has 97% in 2015. In contrast to these high debt Eurozone countries, most Central European countries have had low debt ratios. Eurozone members Estonia (10%) Latvia (38%), Lithuania (38%), and Slovakia (54%), all have debt ratios below 60% today. Some EU members from Central Europe who are not currently EMU members also have low debt: Poland (49%), Czech Republic (42%). Hungary (75%) and Slovenia (80%) are a bit higher. This result could be related to their earlier experience with central planning in which governments could command real resources without having to borrow money to pay for them.
Conditional Debt Is Larger than Public Debt in the U.S.
The extraordinarily high public debt discussed above, consists only of bonds issued by the US government. The figures cited are for gross debt, which includes bonds issued by the Treasury but held by other government agencies. Because of limited data availability, gross debt is used in most international comparisons. Net debt excludes debt held by other government agencies. Net debt is necessarily smaller than gross debt, but it follows the same pattern. US gross debt for 2015 is 105% and net debt is 80%. A more serious aspect of the debt problem is the conditional or implicit debt associated with the unfunded debt from Social Security, Medicare, and other entitlements. The Congressional Budget Office estimated the unfunded portion of Social Security in 2011 to be more than twice the public debt, and the unfunded Medicare debt to be more than four times the public debt (Auerbach 2011).
The size and persistence of US public debt is in uncharted territory for the nation. History is not destiny, but countries with similar debt experience have suffered from slower economic growth. In the post-World War II period, Greece, Italy, and Japan have all experienced debt overhang and slower economic growth. The US now has the largest peacetime debt (relative to GDP) in its history, and Congress has so far failed to produce the budget surpluses necessary to move the extraordinarily high debt ratio back toward its long-run average. This fiscal response is a significant departure from the debt policies produced by Congresses for over 200 years of U.S. history (D’Erasmo et al). The simultaneous occurrence of the Financial Crisis of 2008 and the first Baby Boomers reaching retirement age made a Congressional response more difficult. Fiscal response was also constrained by the significant increase in polarization of the Congress, which is now at an all time high. A convincing explanation for a change in US fiscal policy remains elusive.
Auerbach, Alan. 2011. “Long-Term Fiscal Sustainability in Major Economies”. BIS Working Paper No. 361, November.
Auerbach, Alan, and William Gale. 2015. “The Fiscal Problem: Gone Today, Here Tomorrow.”, Working Paper, September
D’Erasmo, Pablo, Enrique Mendoza, and Jing Zhang. 2015. “What is a Sustainable Public Debt?” NBER Working Paper 21574, September.
Reinhart, Carmen, Vincent Reinhart, and Kenneth Rogoff. 2012. “Public Debt Overhang; Advanced Economy Episodes since 1800”. Journal of Economic Perspectives, 26(3).