Capital Market Impact

Does the national debt affect economic growth?

July 20, 2022

Irish playwright George Bernard Shaw once famously stated: “If all economists were laid end to end, they would not reach a conclusion.” When examining the relationship between the rising national debt of the U.S. and its impact on economic growth, George Bernard Shaw’s quote seems apropos. Undeniably, for decades, economists and deficit hawks alike have been debating the merits of rising national debt and weaker economic activity as a result. However, there’s no simple answer to the question; the causal nature between debt and weaker economic growth is highly debated among economists and always full of controversy when attempting to strike a political consensus on the appropriate debt ceiling limit.

Federal government spending’s impact on the economy is always a balance between near-term and long-term effects. Increased federal expenditures can boost current real GDP growth by adding more capital for consumers and businesses to spend and invest. An example of this was the federal government stimulus during the Covid-19 pandemic which boosted demand across the economy and contributed to the strong 5.7% growth rate for 2021. Depending upon the form of spending, added fiscal spending can add to medium to long-term growth too, usually centered on infrastructure investment, schooling, or systems that increase the future productive capacity of the economy.

Of course, all spending increases come with a cost. Many years of federal budget deficits have led to a large national debt in the U.S. Too high of a national debt level can reduce long-term economic growth as more of the government’s budget must be dedicated to paying off prior debts. The government can also squeeze out the private sector by flowing too many dollars into the economic system at a reduced cost. Economic theory suggests that once the level of national debt surpasses the level of GDP (i.e., 100 percent debt-to-GDP ratio), then the debt burden tends to slow the potential economic growth of a country. Moreover, it can become increasingly difficult for the government to find buyers of debt issuance, raising interest rates and costs across the economy. The U.S. is not at these levels yet, but the current projections from the Congressional Budget Office show that it could be within a decade under current law.

Some economists argue that no absolute threshold exists. Instead, many factors can influence why economic growth may moderate. On the other hand, many deficit hawks in the U.S. warn that once debt surpasses gross domestic product (GDP), a “debt Rubicon” is crossed and financial trouble awaits. Although the debate is complex and lacks an absolute economic relationship, research from the Federal Reserve provides some clarity: unrelenting debt loads can hinder economic growth by “crowding out” private investment and creating weaker investor sentiment towards owning U.S. debt.

For example, according to the Congressional Budget Office (CBO), net interest costs will account for almost 40% of federal revenues by 2052. Fewer federal resources will be available to invest in critical areas that promote economic growth, economic opportunities for workers, capital investments, and trust in fiscal policy. Furthermore, the CBO projects that “annual interest costs will rise from $399 billion in 2022 to $1.2 trillion in 2032. As a percentage of gross domestic product (GDP), those costs would double from 1.6% of GDP in 2022 to 3.3% in 2032, which would be the highest level ever recorded.” Some economists worry that such a high level of debt servicing could cause investors to lose faith in the government’s ability to properly manage fiscal policy, ultimately driving higher financing costs as investors grow skeptical.

The astute investor might be wondering if this is a sustainable path for the U.S., especially with high inflation, the Federal Reserve raising rates, and by any historical measure, massive debt levels that may reprice at potentially higher interest rates. For example, according to the Committee for a Responsible Federal Budget, interest costs would be even higher if interest rates rise faster than the CBO’s forecasts. Remember, higher interest rates mean more debt servicing costs and ultimately force the government to decide which policy tradeoffs and consequences are acceptable.

Nevertheless, the U.S. enjoys a unique position in the global economy due to its reserve currency status, enabling the U.S. to hold more debt at a lower cost than other countries. Some economists argue that the U.S. is facing a potential debt trap, while other economists say that the U.S. can afford more debt. As the debate continues, most investors would agree that less debt servicing costs and protecting our unique reserve currency status in the global economy is a prudent strategy that can ensure economic growth for generations to come.

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