What Do High Debt Levels Do To Our Economy?

Politicians and economists have long talked about the negative effects of an accumulating national debt, but cannot always quantify their position. This week's report on the long-term budget outlook from the Congressional Budget Office (CBO) attempts to put some hard numbers behind the consequences of high debt. 

As we reported earlier this week, CBO found that debt will continue to climb over the coming decades, reaching 100 percent of GDP by 2038, and twice the size of our economy by 2076. But incorporating the negative effects of accumulating debt on our economy makes the picture worse.

CBO's standard estimates account for historical norms of economic growth, inflation, and other variables. They do not, however, incorporate the effects of changing levels of debt or different spending and tax policies on these economic variables, often called the “feedback effects” or “dynamic effects." 

CBO finds four major consequences of rising debt that are not directly incorporated into their standard assumptions:

  • Increased borrowing by the federal government would eventually reduce private investment in productive capital, because the portion of total savings used to buy government securities would not be available to finance private investment. The result would be a smaller stock of capital and lower output and income in the long run than would otherwise be the case [...]
  • Federal spending on interest payments would rise, thus requiring larger changes in tax and spending policies to achieve any chosen targets for budget deficits and debt.
  • The government would have less flexibility to use tax and spending policies to respond to unexpected challenges, such as economic downturns or wars.
  • The risk of a fiscal crisis—in which investors demanded very high interest rates to finance the government’s borrowing needs—would increase.

Because of these effects, CBO included alternative scenarios that account for the negative effects of rising debt, which makes the budget picture a little bleaker. The first scenario keeps the same baseline assumptions about the deficit, but includes economic feedback effects. This model shows the economy would be roughly 4 percent smaller in 2038, interest rates would be a half point higher, and the debt would increase to 108 percent of GDP by 2038, instead of 100 percent without feedback effects. 

Because it may not be realistic to assume no changes in law, CBO projected three more alternatives, all incorporating economic feedback effects. The first is an Alternative Fiscal Scenario with deficits roughly $2.4 trillion higher than current law over the next ten years. CBO also projected two scenarios in which spending is reduced and/or revenue is increased by $2 trillion and $4 trillion over the next ten years. These packages exclude interest spending, so the total figures would be higher.

If those same savings continue into the future, the budget picture dramatically changes.  It takes a savings package of $2 trillion to keep our debt near current levels, at 67 percent of GDP. On the other hand, if lawmakers spend an additional $2.4 trillion beyond current law, our debt could reach 190 percent of GDP by 2038.

Source: CBO, 2013 Long-term Budget Outlook

These different budget packages will also affect economic growth. A savings package of $2 trillion is needed just to keep the economy on its current course, roughly offsetting the negative impacts of including economic feedback. Under the Alternative Fiscal Scenario, annual economic growth is projected to be 0.35 percentage points lower than it would otherwise be, resulting in an economy nearly 7 percent smaller in 2038. The scenario with $4 trillion in additional savings would have the opposite effect, where annual growth is estimated to be 0.31 percentage points higher and the economy is 7 percent larger after 25 years.

Source: CBO, 2013 Long-term Budget Outlook