Boskin on Debt and Growth

In light of the recent controversy over the findings from economists Carmen Reinhart and Ken Rogoff on the relationship between debt and growth, there has been much speculation about what the critiques of those findings mean for what we know about that correlation. Former Council of Economic Advisors chair Michael Boskin writes in Project Syndicate that the economic context of debt accumulation matters, but the longer-term risks of not paying attention to the debt are clear:

We should adopt policies that benefit the economy in the short run at reasonable long-run cost, and reject those that do not. That sounds simple, but it is a much higher hurdle than politicians in Europe and the US have set for themselves in recent years.

I estimated the impact on GDP of America’s recent and projected debt increase (in which the explosive growth of public spending on pensions and health care 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 International Monetary Fund 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 roughly 20% 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 OECD countries.

It is true that the design and timing of a comprehensive deficit reduction plan will matter a great deal in its economic benefit. But that is why working toward an agreement is so important. Putting debt on a sustainable path will be difficult, and it will take both parties to achieve a deal that will be better in both the short and long run for the economy than the sequester. Boskin agrees that we can't put the budget on the back-burner:

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 10-15 years to start dealing with deficits and debt, as economist Paul Krugman has suggested, is beyond irresponsible.

Click here to read to full op-ed.