Tipping Point: Will debt constrain America’s economic growth?

Once a nation's public debt hits 77% of its Gross Domestic Product (GDP), it reaches a tipping point that hurts economic growth, conclude the authors of a World Bank research working paper, “Finding the Tipping Point–When Sovereign Debt Turns Bad.” Every percentage point increase in the debt/GDP ratio above the tipping point costs the economy 0.174 percentage points on average in annual average economic growth.

The authors, Mehmet Caner, Thomas Grennes and Fritzi  Koehler-Geib, based their analysis on a data set of covering 101 countries (75 developing and 26 developed) between 1980 and 2008. Their findings follow the highly publicized and extensively quoted work of Carmen Reinhardt and Kenneth Rogoff, who contend that economic growth declines when countries reach a debt/GDP ratio of 90%. The new paper's conclusions are important for at least two reasons: They confirm the thrust of Reinhardt and Rogoff's work using a different database and a different statistical methodology, and they more precisely define the relationship between higher debt and lost growth.

It is important to note that the 77% debt/GDP tipping point and the 0.174 percentage point loss of growth are average figures. Moreover, the effects are long-term in nature, the authors note. Temporary deviations from the average due to recession need not have negative effects on growth. “The existence of debt thresholds need not preclude short-term fiscal stabilization policy. If debt explosions move debt ratios above the threshold and keep them there for decades, however, economic growth is likely to suffer.”

What are the implications for the U.S. economy? Caner, Grennes and Kohler-Geib do not tackle that question. However, their findings should prove alarming to anyone concerned about the rapid accumulation of U.S. Treasury debt.

According to International Monetary Fund calculations, the U.S. debt/GDP ratio in 2009 was 83.2%, above the tipping point, and will climb to 109.7% by 2015. (See page 13 of “Fiscal Space.”) That implies that the U.S. is experiencing a small growth penalty today: about one-tenth of a percentage point yearly. By mid-decade, however, the growth penalty could swell to 0.56% yearly — more than a half percentage point.

Presumably, the Obama administration did not take the “tipping point” phenomenon into account when preparing the economic assumptions that go into its 10-year forecast. That projection assumes that the economic recovery will continue without interruption throughout the decade, slowing modestly in the late stages of the business cycle. A slower rate of economic growth along the lines highlighted by the World Bank paper would add tens of billions of dollars to the deficit each year, causing deficits to run up the national debt considerably faster than forecast.

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