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Last year, when Congress was debating the stimulus/relief packages, one Senator made a comment about the debt-to-GDP ratio and how we are approaching a point in that ratio that will have some major negative effects.

What are these supposed effects? Is there a threshold we can pass in terms of debt-to-GDP that will cause a runaway sort of effect? Is there anything that we should expect in terms of markets, inflation, etc. if that does happen?

(NOTE: I am talking about government debts, not private debt)

Jacob Jones
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  • Doesn't this depend completely on the interest rate? –  Jul 27 '21 at 12:41
  • If interested in any additional commentary on the whole threshold matter, I would look up the Fiscal Theory of the Price Level (FTPL). The FTPL promotes the idea that targeting a level is misguided. Instead - it is the management/credibility of debt (and in fact the prudent management of the fiscal authority) which matters for the credibility of the debt/rather than a threshold level. – EB3112 Jul 27 '21 at 15:46
  • the short answer is no, the long answer is that there's a lot of anti-debt propaganda that makes no sense for the U.S. economy (but certainly could make sense for other countries). – PatrickT Jul 28 '21 at 11:54

1 Answers1

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Is there a threshold we can pass in terms of debt-to-GDP that will cause a runaway sort of effect?

No there is no threshold or magic number (at least not one we know of). Few years ago there was an influential research claiming that there is a threshold at about 90% debt-to-GDP ratio published by Reinhart and Rogoff where debt was supposed to start having strong negative effects on growth, but that research was discredited later on when it was discovered it was based on several mistakes in their calculations (see Herndon et al 2014).

As the literature currently stands, there are no arguments for some 'magic' number. Debt can start being a problem for a country at 30-50% debt-to-GDP, but it might be no problem at all even at 300% of debt-to-GDP. It all depends on the structure of debt (e.g. who holds the debt?), how the debt is denominated (i.e. does country borrow in its own currency or foreign one?), and also what is the long term debt trajectory (e.g. see Pescatori et al 2014). The debt trajectory is very important because even country with large debt can out-grow it since debt-to-GDP ratio is literally ratio of $\frac{\text{debt}}{GDP}$ and thus you can reduce it both by reducing debt, or by keeping debt constant and growing GDP or just making sure debt does not grow as fast as GDP.

However, while there is no magic threshold for debt crisis/overhang high debt can have serious negative effects at some point (although for US it is likely quite high so you should not necessarily worry about scaremongering of some politicians. Japan that is somewhat similar (high income, industrial and aging country), is able to sustain debt-to-GDP in excess of 250% - see Statista data here).

What are these supposed effects?

This will depend on the nature of debt crisis once it is triggered. Although the Reinhart and Rogoff work on debt threshold was discredited, rest of their work which describes negative effects of debt crises is actually still quite solid. Reinhart and Rogoff show that debt crises are often having following negative effects:

  • high inflation (especially when we talk about external default on debt denominated in their own currency), in worst case scenario it can lead to currency collapse and currency substitution
  • banking crisis
  • capital flight
  • facing higher interest rates in the aftermath
  • lower economic growth
  • being forced to reduce some fiscal spending

However, note not all countries will suffer from all of the above problems. Some of the above problems are policy choices, others depend on exact structure of debt. Its difficult to say what would happen to the US so I won't speculate on that.

1muflon1
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  • This was extremely helpful, thank you. Accepted as the answer I was looking for. – Jacob Jones Jul 27 '21 at 02:18
  • Don't the people of Japan have some major economic problems to deal with, though? – user253751 Jul 27 '21 at 08:55
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    @user253751 yes but primarily caused by aging population the biggest issue with Japanese debt is that it reduces fiscal space, but question asks about major negative effects, sure Japan would probably have easier time with lower debt-to-GDP but as of now it does not suffer major negative effects from it – 1muflon1 Jul 27 '21 at 09:49
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    @1muflon1 but then look at why the population is aging, and you start to read things like: everyone is too busy working to have children. Why do they have to work so hard? That's an economic problem. – user253751 Jul 27 '21 at 09:57
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    @user253751 I never said aging is not an economic problem. However, it is not problem caused by debt, and in literature aging is primary connected to shift in mating strategies from many low quality offspring's to few offspring's that people invest in greatly. Also aging is problem even in EU and even in countries that do not have such strict working ethic. In fact if you would exclude immigration most developed countries are dying out. Additionally, the question is about debt so this off topic anyway. I pretty sure the reason why the Japanese people work so hard is not that they want to – 1muflon1 Jul 27 '21 at 10:04
  • save money and then out of goodness of their heart donate money to government for paying down national debt. – 1muflon1 Jul 27 '21 at 10:05
  • @1muflon1 perhaps they are taxed hard to pay down the national debt. Perhaps the national debt is partially paid off by investors in Japan who want to maximize their ROI by making people work hard. – user253751 Jul 27 '21 at 11:31
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    @user253751 no Japan has much smaller effective average tax rates than France where people do not have such high work ethic and it has just 0.3% higher than the Greek one, also their marginal effective rates are low. They were even much lower before some hikes post 2010. So this does not explain it – 1muflon1 Jul 27 '21 at 11:43
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    @user253751 just to chime in - Japan's work ethic is so high compared to other countries because they almost all believe whole heartedly in "the way" - probably a terrible way to describe it to a native of Japan, but the idea is there is a best way to do anything and everything, and one must strive to perfect this best way. This includes the best way to be a productive member of their society. As far as I know this is relatively ubiquitous across all of Japan – TCooper Jul 27 '21 at 21:41
  • @1muflon1 - Nice answer. I'm not a subject matter expert but you might also mention that GDP itself is a widely mushy thing that not everyone agrees on. If I understand that correctly. Mortgage-backed "securities" represent GDP growth, do they not? How you measure GDP itself changes it's size (and therefore the ratio). Thoughts on this? – Scott Prive Jul 27 '21 at 23:06
  • @ScottPrive no mortgage backed securities do not represent GDP growth. GDP is set statistical measure while there are different ways of measuring GDP (income approach, spending approach, output approach), they all measure the same thing and discrepancies are just due to measurement error. Perhaps you confuse that with concept of economic output which GDP wants to measure (although this would not depend on mortgage backed securities which are just transfers of money not new economic output). Economic output can be measured by various methods not just GDP and different methods would change the – 1muflon1 Jul 27 '21 at 23:18
  • ratio, but ultimately that does not really matter. If there is some research saying that let’s say 100% debt to GDP is a problem, then if you would use different measurement of output of economy like GNI, you would just rescale them 100% to some other percentage number without changing the message (e.g. if you are 2 meters tall nothing changes if you say you are 6.56 foot tall). Different methods might introduce some discrepancies but you would not expect overall conclusions from the research to change qualitatively – 1muflon1 Jul 27 '21 at 23:22
  • @1muflon1 re “the way”—TIL my father is Japanese. ;) Describes his outlook on life to a T. – KRyan Jul 28 '21 at 01:28
  • @1muflon1 isn't GDP a bad way to measure the 'weigh' of debt? Wouldn't governmental income be better? Or GDP increase compared to debt increase? – J_rite Jul 28 '21 at 12:40
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    @Jungkook no, ultimately the size of the economy is the size of a tax base from which government draws upon, so it makes more sense to compare it to national income rather than just government revenue (which actually is nothing else just a transfer of portion of national income to the government). In addition, comparing it to government revenue would give extremely misleading result. A country might have low tax rates lets say set at 1% of total output (let us assume it is 100) giving it a revenue of 1 and have a debt of 10, which would make debt to revenue 10/1=10, – 1muflon1 Jul 28 '21 at 15:10
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    but such country could easily hike taxes to 20% of total output (still way below OECD average) if it would feel pressure to repay the debt. On other hand you could have country where government taxes 90% of all output (let us assume in this second country output is 10) giving it 9 tax revenue and assuming debt of 10 it would have debt ration10/9= 1.11 which would look good but in fact this second country has much less ability to hike taxes more as it already takes almost everything from economy that it can. Calculating debt to GDP for both of the countries above would give us 0.1 or 10% for – 1muflon1 Jul 28 '21 at 15:13
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    first country and 1 or 100% for the second country, which is actually much much better representation of the actually trouble the two countries are in relatively to each other, clearly virtually any economist would agree that in the example above (all other omitted factors being equal) second country is much worse looking at the raw data and debt to GDP also conveys that, whereas debt to tax revenue is extremely misleading about the position of the two countries – 1muflon1 Jul 28 '21 at 15:15