I estimated the impact on GDP of the US’ recent and projected debt increase (in which the explosive growth of public spending on pensions and healthcare looms largest), using four alternative estimates of the effect of debt on growth: a smaller Reinhart/Rogoff estimate from a more recent paper; a widely used IMF study, which finds a larger impact (and which deals with the potential reverse-causality problem); a related CBO study; and a simple production function with government debt crowding out tangible capital. The results were quite similar: Unless entitlement costs are brought under control, the resulting rise in debt will cut US living standards by about 20 percent in a generation.
Corroborating statistical evidence shows that high deficits and debt increase long-run interest rates. The effect is greater when modest deficit and debt levels are exceeded and current-account deficits are large. The increased interest rates are likely to retard private investment, which lowers future growth in employment and wages.
Numerous studies show that government spending “multipliers,” even when large at the ZLB, shrink rapidly, then turn negative — and may even be negative during economic expansions and when households expect higher taxes beyond the ZLB period. Permanent tax cuts and those on marginal rates have proved more likely to increase growth than spending increases or temporary, infra-marginal tax rebates; successful fiscal consolidations have emphasized spending cuts over tax hikes by a ratio of five or six to one; and spending cuts have been less likely than tax increases to cause recessions in Organisation for Economic Co-operation and Development (OECD) countries.
Some argue that fiscal consolidation by gradual permanent reductions in spending would be expansionary for high-debt countries, as occurred in some historical episodes. Others maintain that a temporary increase in spending now would boost growth. Both could be expansionary — or not, depending on details and circumstances. Because many countries have been consolidating simultaneously, interest rates are already low; and, for the US, which accounts for more than 20 percent of the global economy and issues the global reserve currency, caution in generalizing from other fiscal episodes is highly advisable.
Nonetheless, the evidence clearly suggests that high debt/GDP ratios eventually impede long-term growth; fiscal consolidation should be phased in gradually as economies recover; and the consolidation needs to be primarily on the spending side of the budget. Finally, the notion that we can wait 10 or 15 years to start dealing with deficits and debt, as economist Paul Krugman has suggested, is beyond irresponsible.
Michael Boskin, professor of economics at Stanford University and senior fellow at the Hoover Institution, was chairman of former US president George H. W. Bush’s Council of Economic Advisers from 1989 to 1993.
Copyright: Project Syndicate