Debt's impact on growth: Latest study doesn't settle debate
By Jeanne Sahadi@CNNMoneyApril 17, 2013: 5:14 PM ET
NEW YORK (CNNMoney)
When a country's debt levels are very high, it's typically associated with slower economic growth compared to periods when a country's debt is lower.
That's what various research has shown over the past few years, and it still holds even after a new study released this week has called into question the best known analysis on the relationship between debt and economic growth.
The new working paper, from the University of Massachusetts Amherst, challenged a key finding from a 2010 study by Harvard economists Carmen Reinhart and Kenneth Rogoff.
The Reinhart/Rogoff research concluded that when a country's gross debt exceeds 90% of GDP, "median growth rates fall by one percent, and average growth falls considerably more."
That finding was flawed, according to UMass Amherst economists Thomas Herndon, Michael Ash and Robert Pollin.
But when they replicated the 2010 analysis after correcting for the alleged flaws, they too found that average economic growth was lower when countries' gross debt topped 90% of GDP -- just not as low as what Reinhart and Rogoff originally concluded. (The Amherst paper, which has not been reviewed or published, does not consider Reinhart and Rogoff's updated numbers from 2012.)
In response, Reinhart and Rogoff disputed two of the paper's three critiques concerning methodology. They conceded a third point, a "coding error," but argued it did not change the thrust of their findings.
So what's an average person to make of all this? Is high debt a problem or not? Does it really slow economic growth?
Research is not conclusive when it comes to cause and effect: Does high debt cause slower growth or does slower growth cause higher debt? There's reason to believe both may be true at different times.
And there is disagreement over the threshold at which high debt poses a risk to economic growth.
Two high-debt countries can have very different experiences with respect to growth, since so many factors play a role.
The United States and Greece, for example, both have debt levels topping the 90% threshold. But the United States is not Greece for many reasons. Among them: its diverse economy and the fact that it controls its own currency, which also happens to be the world's reserve currency.
However, when debt hits very high levels, here's how it could weigh on growth.
"Eventually the government has to devote a lot of resources to taxing people and spending money on debt service payments," said one budget expert. "Taxes will be higher than they otherwise would need to be or the government won't spend money on things they'd otherwise spend money on."
What's more, in a normally functioning economy, high debt levels can lead to higher deficits because of increased interest payments. And higher deficits can "crowd out" private investment, as the government consumes available funds.
But right now, the U.S. economy, though recovering, isn't back to normal yet.
And the United States still enjoys a reputation as a safe haven, which means it can borrow money at very low rates.
What's not clear is how long that advantage will last as the economy strengthens further.
What is clear, however, is that the United States will start to face growing deficits and debt in the coming decades due to the aging of the population and the growth in health costs -- all of which point to more spending on Medicare, Social Security and other entitlement programs.
The country's current tax policies, meanwhile, won't generate enough revenue to keep up with those spending increases.
That's why independent deficit hawks have consistently urged policymakers not to make drastic cuts to budgets in the short term, which could slow the economic recovery, but also to start making decisions about policy changes that can reduce the country's debt load over time.