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How our national debt hurts our economy

(MoneyWatch) Perhaps the largest concern investors have coming out of the election relates to our debt burden. Well, you should be worried. It's why stocks weren't trading at historically high valuations even before the election. A recent study measures the negative impact a high debt-to-GDP ratio has historically had on world economies, and the results haven't been favorable.

Professors Carmen Reinhart and Kenneth S. Rogoff and economist Vincent Reinhart examined the debt-to-GDP ratios of advanced economies for the period from 1800 to 2011. Specifically, they looked at periods where debt-to-GDP exceeded 90 percent for at least five years, as prior studies have shown that to be the point when it starts to have a negative effect. (As a side note, the U.S. passed that point in 2010.)

Perhaps the biggest finding is that high levels of public debt have been associated with lower growth. The vast majority of the episodes -- 23 of the 26 -- coincided with substantially slower growth, and average annual growth was 1.2 percent lower during periods with debt-to-GDP levels above 90 percent (2.3 percent growth) than below 90 percent (3.5 percent growth).

Another issue is that these episodes tended to last a long time. The average duration was 23 years, and 20 of the 26 episodes lasted more than a decade. The long duration suggests that even if such episodes were originally caused by a traumatic event such as a war or financial crisis, they took on a self-propelling character. It also implies that the cumulative shortfall in output from debt overhang is potentially massive -- with an average duration of 23 years, the cumulative effect of annual growth being 1 percentage point slower is GDP that is roughly one-fourth lower at the end of the period.

Adding to the concerns is that today's high debt burdens don't include the actuarial debt implicit in underfunded old age pension and medical care programs. The authors note that the public debt overhang problem that already affects some advanced economies has the potential to affect many others including the United States sometime soon, with consequences possibly as large as the ones studied. The reason is that "public debt is projected over the next decade or two to rise from its already high levels in many advanced economies, as the contingent liabilities now built into old-age programs come to pass. At present, the momentum is for public debt to become substantially worse over time, even when or if more sustained and rapid economic growth resumes."

Why high debt burdens negatively impact economic growth

One reason the study's authors give is that the attention given to the debt tends to discourage private investment. Raising taxes or ramping up inflation to deal with the debt both have a negative impact on investors' willingness to invest. High levels of public debt also call into question whether the debt will be repaid in full. That can lead to a higher risk premium, and that's associated with higher long-term real interest rates, which in turn has negative implications for investment as well as for consumption of durables and other interest-sensitive sectors, such as housing.

There's an old saying "That which cannot continue, will not." Ultimately, governments will be required to change policies as current fiscal policies can't be sustained over the long term. However, the evidence shows that soaring government debt has resulted in slower economic growth. It also suggests that we should be very wary of arguments for any further short-term fiscal stimulus, as the long-term secular costs of high debt service could easily outweigh any potential short-term benefits.

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