Limits to What We Know
Searching for a Policy Target
Once we get past the confusing issue of which definition people are using when they reference the “national debt”, we find that there is one key question that needs to be answered:
How high can we allow the debt to go before it reaches a tipping point for the economy when risks posed by the debt spiral beyond our control?
In 1992, businessman Ross Perot ran as independent candidate for President because he believed the rising national debt was a problem that needed to be nipped in the bud. At that time, the net debt was 48% of GDP – about 30% lower than the level we see today. However, the size of the debt had almost doubled in the twelve years leading up to the 1992 election – an unsustainable trend in the eyes of Perot and many others. Perot lost the election, but he succeeded in putting the debt issue near the center of public debate.
Despite decades in which the rising debt has sometimes served as a useful political weapon, the nation has apparently felt no ill effects from the debt as economists continue to struggle to define the tipping point at which the debt will affect economic growth. Without a clear breaking point, it is challenging to develop meaningful policies to manage the debt and its impact on the economy.
Thresholds Based on an Imperfect Science
Several general threshold numbers have been proposed. In 2010, the World Bank conducted a study that suggests that 77% is a useful average figure, but the study acknowledges that figure may be higher or lower depending on the specific circumstances of a given country. For the US, which boasts the largest economy in the world, that threshold would be well above the 77% mark.
Another famous study, also published in 2010, by Harvard University economics professors Carmen Reinhart and Kenneth Rogoff concluded that 90% is a useful threshold. Despite serious flaws, including the researchers’ use of gross debt rather than net debt, the 90% figure gained some traction in the debt debate. The Economist noted that subsequent studies, including one from the IMF, had also supported the 90% figure, or something close to it. The 2013 article concluded that the topic is highly charged politically and that further research requires the most “rigorous standards”.
In 2017, a team of economists published a new study based on the Reinhart-Rogoff dataset. Their findings suggested a threshold around 30%. The authors note, however, that the relationship between the debt threshold and economic growth is tenuous and in need of further research.
Modern Monetary Theory (MMT) takes a new approach that says budget deficits don’t matter, provided that the deficits are incurred through spending on line items like education, infrastructure, or research and development that all have potential future payoffs. MMT argues that revenue is not essential to cover budget overruns, since the federal government has the power to print more money and the capacity to control inflation.
This seemingly radical idea is, according to Forbes columnist Milton Ezrati and The Economist, deeply rooted in a nuanced understanding of Keynesian economics. Although MMT is touted in support of the progressive policy recommendations of Bernie Sanders and Alexandria Ocasio-Cortez, Wall Street veteran Ezrati notes that MMT is consistent with the Republicans’ interest in dynamic accounting, which recommends that budget effectiveness be evaluated on the economic response to policy and not solely on the surplus or deficit it generates. Ezrati likens MMT to a new version of supply side economics, while The Economist cites former treasury secretary Larry Summers, who called it the new “voodoo economics”.
Some reports suggest that Wall Street money managers are receptive to MMT ideas under certain circumstances. One of the chief ideas of MMT is that interest rates will remain low in periods of very high government debt. The NY Times reported that asset management firm Pimco relied on this idea as a critical part of its investment framework following the 2008 financial crisis. The Times cites Pimco’s former chief economist, Paul A. McCulley, who said that MMT contributed to Pimco’s ability to make good bets during this time that generated substantial returns.
Setting a Prudent Target
In lieu of hard scientific data connecting a clear debt threshold to economic growth or supporting MMT, a consensus has emerged around a net debt-to-GDP ratio of 60%. In 2012, Michael A. Peterson, CEO of the Peterson Foundation, cited the following reasons to support the 60% target:
- It is a target endorsed by “many budget experts and economists”;
- “It was the maximum allowable level of debt for countries originally seeking to join the Euro”; and
- Five ideologically diverse think tanks targeted 60% as their goal in fiscal plans submitted to the Peterson Foundation.
The Committee for a Responsible Federal Budget also advises a 60% target over the long-term. Given the scale of the debt problem, these organizations generally talk about the need to first stabilize the debt at its current level so that it is no longer rising, and then determine a strategy to reduce it to an acceptable target level.
No one disputes the potential negative impacts of a national debt that is too high, and most agree that the debt threshold varies based on the state of development of the national economy. For example, emerging markets may have a lower threshold than developed economies like those in the US and western Europe.
The decision to add to the debt also depends what the money is spent on. While it can make sense to borrow to invest in, for example, infrastructure that has some promise of economic return, it generally is not prudent to borrow funds to cover operating or ongoing expenses. The drag of debt should be weighed against the benefit of what’s being bought with the debt.