Diminishing quality of fiscal institutions in the United States and European Union.

• Author: Grennes, Thomas
• Position: Report

The value of government debt relative to the size of the economy has become a serious problem, and the problem is likely to grow in the future. Total debt of the U.S. government relative to gross domestic product increased substantially since the financial crisis and the Great Recession that began in 2007, but the debt ratio has been increasing since 2001. Cross debt relative to GDP increased from 55 percent in 9,001 to 67 percent in 2007 to 107 percent in 2012 Comparable figures for debt held by the public (net debt or gross debt minus debt held by various government agencies) were 80 percent in 2011 and 84 percent in May 2012 (IMF 2012). As a result, the debt ratio is now the highest in U.S. history, except for World War II, when it reached 125 percent of GDP (Bohn 2010). U.S. debt is also high relative to the debt of other high-income countries, and projections of future debt place the U.S. government among the world's largest debtors (IMF 2011, 2012; Evans et al. 9.012). Gross debt consists of all the bonds issued by the U.S. Treasury, but a broader measure that includes contingent debt results in a much larger debt (Cochrane 2011). Contingent debt includes unfunded obligations related to Social Security, Medicare, Medicaid, and loan guarantees to agencies such as Fannie Mac and Freddie Mac, and these obligations are so large that they have been described as a "debt explosion" (Evans et al. 2012). The sovereign debt crisis of the European Union has similarities to the U.S. debt problem, but it also has significant differences, as will be shown below. Interestingly, the poorer countries of the world that have frequently experienced debt problems in the past, have avoided major debt problems so far.

There is increasing recognition of the severity of the current and future U.S. debt problem, but the authorities responsible for fiscal policy have steadfastly refused to commit to reform. Various experts on sovereign debt have expressed the opinion that current U.S. debt is excessive, and that it is not on a sustainable path for the future. In an unprecedented act, Standard and Poor's downgraded U.S. government bonds in 2011, and fiscal authorities at the International Monetary Fund have repeatedly criticized the United States for excessive debt (Financial Times 2011, IMF 2011). The Simpson-Bowles Commission, appointed by President Obama, recognized the large U.S. debt to be a fundamental problem, and they offered detailed proposals that would first stabilize the debt ratio and eventually reduce it toward its historical level. Federal Reserve Chairman Ben Bernanke, in discussions of the interdependence of fiscal and monetary policy, has frequently advocated reform that would effectively limit federal debt. This article focuses on the adverse effect of government debt on economic growth when debt relative to the size of the economy exceeds a threshold. The possibility of default on government bonds is a more extreme problem that has been discussed elsewhere (Bi and Traum 2012). Other possible adverse effects of excessive debt include reducing the effectiveness of foreign policy (Zoellick 2012).

Adverse Impact of Excessive Government Debt on Economic Growth

Not all government borrowing is harmful, but there is increasing evidence that excessive government debt can decrease the rate of economic growth. Reinhart and Rogoff (2010) have assembled and analyzed extensive data across countries and over long periods that demonstrate the negative economic effects of excessive debt. They find that economic growth diminishes when government debt exceeds 90 percent of GDP. Several econometric studies (Caner et al. 2010, Kumar and Woo 2010, Cecchetti et al. 2011b, Checherita and Bother 2012, Furceri and Zdzienicka 2012, Baum et al. 2012, Greenridge et al. 2012) have estimated threshold levels for debt in the range of 70-90 percent of GDP. Beginning at debt levels below the threshold, small increases in debt have no negative effects on the rate of growth, but when debt ratios exceed the threshold and remain above it, the economy suffers from a lower growth rate. Furthermore, the reduction in the growth rate increases the farther a country is above the threshold. To isolate the effect of debt on growth, studies have controlled for other variables affecting growth, such as openness, investment, and the level of government spending (Gwartney et al. 1998). The studies have used samples from different countries and time periods and different estimation techniques, but a common result is that debt in excess of a threshold is harmful to economic growth.

An alternative approach to estimating sustainable levels of debt employs the concept of fiscal space (Ghosh et al. 2011a, 2011b). Estimates of fiscal space for a sample of 23 high income countries vary by country, but when debt ratios reach the neighborhood of 100 percent of GDP, it becomes increasingly difficult to generate primary budget surpluses to keep pace with higher interest payments on rising debt. In addition to the negative effect of excessive debt on long-term growth, there is 'also evidence that increased uncertainty about future fiscal policy (fiscal volatility) has an adverse effect on short-run output and employment (Baker et al. 2011, Fernandez-Villaverde et al. 2012, Taylor 2011a). A growing body of evidence using data from many countries indicates that excessive government debt can be harmful to growth.

If empirical evidence demonstrates that excessive debt reduces growth, what are the channels through which debt affects growth? Government debt could crowd out private investment by increasing interest rates. However, excessive government debt may also reduce growth without raising interest rates. In their study of debt overhang episodes over the last two centuries, Reinhart et al. (2012) found that in most eases real interest rates on government bonds were above their long-run average, but in nearly 40 percent of the episodes, real interest rates on government debt were below average. When debt is above a threshold level, interest payments on servicing the large debt may crowd out productive government investments that would otherwise contribute to growth. According to Evans et al. (2012), the underfunding of Social Security has reduced saving in the United States. The possibility of default on government bonds is a more extreme negative effect of excessive debt (Bi and Traum 2012) that Greece and other Eurozone countries have already experienced. What Has Led to Excessive U.S. Debt?

Since the United States became an independent country, the interaction between Congress and presidents has produced spending and tax policies that limited the size of debt relative to the size of the economy. For more than two centuries of U.S. economic history prior to 2001, the ratio of federal government debt to GDP has fluctuated without a trend (Bohn 2005). Debt increased during wartime and diminished during peacetime. The debt also fluctuated with business cycles, expanding during recessions and decreasing during booms. There was a presumption that higher than average debt during wars and recessions would be offset by lower than average debt during peacetime and business expansions. Fiscal institutions of the government provided an implicit "fiscal anchor" that limited sovereign debt and influenced private investors for most of U.S. history. The fiscal anchor operated through the political process and did not include an explicit legislative limit, except for a congressional limit on the nominal debt that was increased so frequently that it was hardly binding. Econometric evidence supports the hypothesis that fiscal authorities responded to excessive debt by increasing primary (net of interest payments) budget surpluses (Bohn 2010, Ghosh et al. 2011b). The recent decline in discipline on spending, taxation, and borrowing represents a decline in the quality of fiscal institutions in the United States, and it threatens to undermine economic growth.

In a given year, changes in government debt relative to CDP depend on the primary budget deficit (excluding interest payments), the real interest rate paid on outstanding government debt, and the growth rate of real GDP (Ghosh et al. 2011b). A combination of bigger budget deficits and slower economic growth has contributed to increases in the debt ratio since 2001. However, extraordinarily low interest rates on government bonds have kept the debt ratio lower than it would otherwise be. The recent departure from traditional debt policy follows three shocks to the U.S. economy since 2001: (1) increases in spending to counter perceived terrorist threats, (2) the Great Recession/financial crisis, and (3) demographic changes that increase government spending related to retirement and health. Following the terrorist attack of September 11, 2001, on New York and Washington, there was...