Beyond the tipping point in debt
Yesterday, I wrote about what I called the “idiocy of the masses” and showed how it can be rational for investors to buy more and more government bonds of a country despite the mountain of debt increasing ever more. This is particularly true for the US because the US Dollar is the world’s reserve currency. The moral hazard that forces foreigners to invest in US Treasuries, no matter how high the debt burden, can provide a temptation for politicians to increase deficits in the hope that the increased cost of debt will not reduce GDP growth in the future. This assumption is at the heart of the Republican tax cuts of 2018, when the self-styled party of fiscal discipline opted to cut taxes and increase the debt burden of the US by $1tn over a decade in order to spur growth. It is also at the heart of the assumptions of the new darling of the Democratic Party, Modern Monetary Theory, when it assumes that rising deficits increase private sector wealth and triggers additional consumption and growth.
In the past, we used to believe that higher levels of public debt will lead to higher interest costs and lower growth. Recent research has shown that the relationship is not so straightforward. In fact, what matters is not so much the level of public debt to GDP but the size of public debt relative to private and household debt.
In an analysis of 29 developed countries between 1995 and 2014, Mehmet Caner and his colleagues have shown that the interaction between debt and GDP growth is complex and nonlinear. If debt levels are below a certain threshold, more debt (either private debt or public debt) leads to higher consumption and higher growth that outpaces the increase in costs for debt servicing. But once debt levels cross that threshold, the relationship between debt and growth becomes negative. For example, they show that once the ratio of household debt to public debt surpasses 36%, an increase of household debt or public debt will lead to lower GDP growth because the increase in debt costs will be so significant that it overwhelms any positive effects of additional consumption on growth.
Quantitatively, they show that an increase of public debt by 10% of GDP in a regime when household debt is more than 36% of public debt will lead to a decrease in GDP growth over the subsequent five years of 0.19% per year. The interaction between public debt and household debt (e.g. higher public debt leading to higher interest rates for government debt, which in turn increases interest costs for household debt) would reduce growth by another 0.04% per year. If the economy was growing at 2% per year before the increase in public debt, the additional debt would reduce growth to 1.77% per year. Of course, if the increase in debt is bigger, the reduction in growth would be stronger as well.
Similarly, if private debt (i.e. household and corporate debt) levels exceed 137% of public debt, the relationship between additional debt and economic growth switches sign from positive to negative and the authors find a similar drag on growth.
This explains why additional private debt (e.g. credit card debt or additional mortgage debt) used to stimulate the economy in the 1980s and 1990s just like additional public debt used to stimulate the economy back then. However, since the 2000s, this relationship has weakened. Unfortunately, today, the UK, just like the US and every major Eurozone country, exceeds either the private debt to public debt threshold or the household debt to public debt threshold, which means that piling up additional public debt through deficit spending is likely to reduce future growth. In the case of the US, Caner and his colleagues find that the additional debt accumulated in the private and public sector between 1995 and 2014 may have reduced growth by more than 1% per year on average, explaining why US growth used to be 3.5% or so per year until the 1990s and has been only a little above 2% over the least two decades.
If these results are correct, then adding to the deficit through lower taxes or additional deficit spending does not seem like a great idea after all.
Ratio of private to public debt 2018
Source: OECD, Fidante Capital.