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Last year, when Congress was debating the stimulus/relief packages, one Senator made a comment about the debt-to-GDP ratio and how we are approaching a point in that ratio that will have some major negative effects.

What are these supposed effects? Is there a threshold we can pass in terms of debt-to-GDP that will cause a runaway sort of effect? Is there anything that we should expect in terms of markets, inflation, etc. if that does happen?

(NOTE: I am talking about government debts, not private debt)

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  • $\begingroup$ Doesn't this depend completely on the interest rate? $\endgroup$
    – user13736
    Jul 27 at 12:41
  • $\begingroup$ If interested in any additional commentary on the whole threshold matter, I would look up the Fiscal Theory of the Price Level (FTPL). The FTPL promotes the idea that targeting a level is misguided. Instead - it is the management/credibility of debt (and in fact the prudent management of the fiscal authority) which matters for the credibility of the debt/rather than a threshold level. $\endgroup$
    – EB3112
    Jul 27 at 15:46
  • $\begingroup$ the short answer is no, the long answer is that there's a lot of anti-debt propaganda that makes no sense for the U.S. economy (but certainly could make sense for other countries). $\endgroup$
    – PatrickT
    Jul 28 at 11:54
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Is there a threshold we can pass in terms of debt-to-GDP that will cause a runaway sort of effect?

No there is no threshold or magic number (at least not one we know of). Few years ago there was an influential research claiming that there is a threshold at about 90% debt-to-GDP ratio published by Reinhart and Rogoff where debt was supposed to start having strong negative effects on growth, but that research was discredited later on when it was discovered it was based on several mistakes in their calculations (see Herndon et al 2014).

As the literature currently stands, there are no arguments for some 'magic' number. Debt can start being a problem for a country at 30-50% debt-to-GDP, but it might be no problem at all even at 300% of debt-to-GDP. It all depends on the structure of debt (e.g. who holds the debt?), how the debt is denominated (i.e. does country borrow in its own currency or foreign one?), and also what is the long term debt trajectory (e.g. see Pescatori et al 2014). The debt trajectory is very important because even country with large debt can out-grow it since debt-to-GDP ratio is literally ratio of $\frac{\text{debt}}{GDP}$ and thus you can reduce it both by reducing debt, or by keeping debt constant and growing GDP or just making sure debt does not grow as fast as GDP.

However, while there is no magic threshold for debt crisis/overhang high debt can have serious negative effects at some point (although for US it is likely quite high so you should not necessarily worry about scaremongering of some politicians. Japan that is somewhat similar (high income, industrial and aging country), is able to sustain debt-to-GDP in excess of 250% - see Statista data here).

What are these supposed effects?

This will depend on the nature of debt crisis once it is triggered. Although the Reinhart and Rogoff work on debt threshold was discredited, rest of their work which describes negative effects of debt crises is actually still quite solid. Reinhart and Rogoff show that debt crises are often having following negative effects:

  • high inflation (especially when we talk about external default on debt denominated in their own currency), in worst case scenario it can lead to currency collapse and currency substitution
  • banking crisis
  • capital flight
  • facing higher interest rates in the aftermath
  • lower economic growth
  • being forced to reduce some fiscal spending

However, note not all countries will suffer from all of the above problems. Some of the above problems are policy choices, others depend on exact structure of debt. Its difficult to say what would happen to the US so I won't speculate on that.

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    $\begingroup$ @user253751 yes but primarily caused by aging population the biggest issue with Japanese debt is that it reduces fiscal space, but question asks about major negative effects, sure Japan would probably have easier time with lower debt-to-GDP but as of now it does not suffer major negative effects from it $\endgroup$
    – 1muflon1
    Jul 27 at 9:49
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    $\begingroup$ @1muflon1 but then look at why the population is aging, and you start to read things like: everyone is too busy working to have children. Why do they have to work so hard? That's an economic problem. $\endgroup$
    – user253751
    Jul 27 at 9:57
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    $\begingroup$ @user253751 I never said aging is not an economic problem. However, it is not problem caused by debt, and in literature aging is primary connected to shift in mating strategies from many low quality offspring's to few offspring's that people invest in greatly. Also aging is problem even in EU and even in countries that do not have such strict working ethic. In fact if you would exclude immigration most developed countries are dying out. Additionally, the question is about debt so this off topic anyway. I pretty sure the reason why the Japanese people work so hard is not that they want to $\endgroup$
    – 1muflon1
    Jul 27 at 10:04
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    $\begingroup$ @user253751 no Japan has much smaller effective average tax rates than France where people do not have such high work ethic and it has just 0.3% higher than the Greek one, also their marginal effective rates are low. They were even much lower before some hikes post 2010. So this does not explain it $\endgroup$
    – 1muflon1
    Jul 27 at 11:43
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    $\begingroup$ @user253751 just to chime in - Japan's work ethic is so high compared to other countries because they almost all believe whole heartedly in "the way" - probably a terrible way to describe it to a native of Japan, but the idea is there is a best way to do anything and everything, and one must strive to perfect this best way. This includes the best way to be a productive member of their society. As far as I know this is relatively ubiquitous across all of Japan $\endgroup$
    – TCooper
    Jul 27 at 21:41

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