Do high levels of public debt reduce economic growth? Many economists asked that question after the financial crisis of 2007-09, when bank bail-outs and fiscal-stimulus programmes caused debt-to-GDP ratios to surge across developed countries. In 2010 two Harvard economists, Carmen Reinhart and Kenneth Rogoff, came up with an eye-catching answer. Taking data for 44 countries across two centuries they found that economic growth falls by roughly half when public debt exceeds 90% of GDP. Their results were cited by finance ministers in several countries to help justify austerity policies after 2010, though they then turned out to have been modestly inflated by a (now infamous) spreadsheet error. Ms Reinhart and Mr Rogoff stuck by their claim that high debt reduces growth. A decade on from the financial crisis, with debt-to-GDP levels rapidly rising again because of the covid-19 pandemic, should the impact of debt on growth be a concern once more?
Many historians suggest policymakers should not be too worried about high levels of debt in some advanced economies. Britain’s debt-to-GDP ratio, for instance, is set to rise from 84% last March to more than 100% this fiscal year. That is high by modern standards, but not unprecedented. By the end of the Napoleonic wars, in 1815, Britain’s national debt stood at nearly 200% of its GDP; it slid to 25% by 1914. After the second world war it reached 259%, and America’s 112%. After brief post-war recessions as arms production dipped, both countries enjoyed periods of strong growth. They also managed to reduce their debt burdens over time. America’s debt-to-GDP ratio fell as low as 31% in the early 1980s. Britain’s fell to about 25% by 1990.
This chimes with IMF research that suggests, in the long term, it is the direction of the debt-to-GDP ratio, rather than its level, that matters most for growth. The authors of one paper published in 2014 found, like Ms Reinhart and Mr Rogoff, that growth in GDP per person is slower in countries with debt-to-GDP ratios above 90%—if the data are looked at year-by-year. However, looking at average debt levels over 15-year periods, there is less convincing evidence that countries with debts above 90% of GDP grow more slowly. Even countries with debt ratios of more than 200%, such as post-war Britain, experienced solid medium-term growth. Instead, the IMF found that countries with a rising public-debt ratio suffer slower growth than those where it is falling—even if their accrued borrowings are already very high. This may be because large primary deficits (ie, excluding interest payments) make them more vulnerable to credit crunches in periods of economic difficulty.
How can countries reduce their debt-to-GDP ratios over the long term, as America and Britain have in the past? Whether the post-second world war experience can be repeated is questionable, as our recent briefing on public debt pointed out. Some 70% of the reduction in Britain’s debt-to-GDP ratio between 1946 and 2008 was because of inflation. This worked because it was paired with “financial repression”, a regulatory system which, using tools such as capital controls and credit-rationing, in effect forced people to lend to governments at artificially low interest rates while inflation eroded the real value of public debt. But this is a course of action increasingly unavailable to modern policymakers. Technological developments, such as the spread of cryptocurrencies, make it easier than it was for investors to sidestep restrictions on capital movement and lending.
In the long term governments may rely on economic growth—or, to be precise, growth that exceeds interest rates—to reduce their debt-to-GDP ratios. That would be similar to what happened in Britain after the Napoleonic wars. Britain did not inflate away its debts or run budget surpluses to pay them down (much of the debt was issued in the form of perpetual bonds finally repaid only in 2015). Instead, the compounding effect of real economic growth reduced the weight of the debt burden. As John Ramsey McCulloch, a Scottish economist, pointed out in 1845, “the stupendous inventions and discoveries of Watt, Arkwright, Crompton, Wedgwood and others have hitherto falsified all the predictions of those who anticipated national ruin and bankruptcy from the rapid increase of the public debt.” Those worried by today’s public debt may hope that latter-day Watts and Arkwrights will eventually save the day.
This article is from our Graphic detail section.