The financial crisis has left many nations with mounting public debt, and Greece is just the tip of the iceberg. According to a recent study by the International Monetary Fund, the public debt to GDP ratio in developed countries will surge from 80% before the financial crisis to 120% within the next couple of years. Many investors and the broader public are worried. Are they right to be concerned?
Intuitively, the case against excessive public debt seems quite clear: It must be something bad as it would appear likely to depress growth and increase inflation pressures to boot. Moreover, there is no shortage of economic theories that back up our intuitive foreboding about excessive debt.
The "crowding out effect" states that the higher the public debt, the higher the pressures on interest rates to rise – thereby raising borrowing costs for the private sector, which in turn reduces private investment activity. Slower growth is the end result.
Yet another theory - the Ricardo equivalence theorem - stresses that the higher the public debt, the more likely households are to expect future tax increases. This leads households to save more and to consume less. This also depresses growth.
These effects are not limited to households – governments are not immune either. The higher the public debt, the more government resources must be devoted to service this debt and the less money governments have for discretionary and growth-enhancing spending.
Finally, the "unpleasant monetarist arithmetic assumption" speculates that government debt and money are equivalent. Hence, the higher the debt, the more implicit money is available and the higher the likelihood of inflation pressures.
Considering this large number of theories, it may surprise many that the empirical evidence relating public debt to growth or to inflation was rather unsatisfactory until recently. Most of the work in this area relied on case studies and few observations. This changed in 2009. Two US economists, Carmen Reinhart and Kenneth Rogoff, made the first thorough empirical study of financial crises - be they in banking, credit, exchange rates or sovereign debt. In their book ("This time it’s different – Eight centuries of financial follies") and in their subsequently published scientific articles, they explored an impressive database and came to several interesting conclusions, two of them addressing the macroeconomic impact of public debt.
According to their research, the relationship between public debt and growth is non-linear. This means that it doesn’t matter for growth whether you have a public debt to GDP ratio of 20% or of 60%. However, if you cross a certain threshold, which the two economists estimate to be around 90%, then the impact of public debt on growth becomes significantly negative. Currently several very large economies - the US, the UK and France - are on the verge of crossing this threshold. Hence, there is a risk that in the "new normal" of the post-financial crisis era we might see much lower trend growth rates for several important countries than the ones we were used to.
Reinhart and Rogoff also contend that there is no empirically significant relationship between public debt and inflation. While this might be puzzling at first glance, it will not surprise monetarists, who see inflation always and everywhere as a monetary phenomenon. According to this view, inflation should only occur with regard to public debt if this public debt is monetized, i.e. if the printing press is used to reimburse the debt. Given the current size of their debt problem, several countries, among them the US, might be tempted if the growth problem hurts too much to inflate their way out.
Summarizing all those findings, we must sadly conclude that yes, the size and evolution of the public debt are worrisome.
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