Why High Debt Doesn’t Imperil Growth

All over the world, governments’ huge fiscal responses to COVID-related fallout has debt dotting headlines. Based on recently released Q2 GDP numbers, America’s debt exceeded GDP sometime in late June. UK national debt crossed the £2 trillion threshold for the first time—also surpassing GDP. Some worry about the implications of these inauspicious milestones, arguing they store up future economic problems or will inevitably lead to crushing austerity. Others disagree, citing a concept called Modern Monetary Theory (MMT). We agree debt doesn’t become much more problematic when reaching a certain level, but MMT isn’t why.

One common—and somewhat sensible—thread running through coverage of US and UK debt is the comparison of debt to GDP. Scaling is the only way to make sense of huge-sounding numbers that otherwise lack context. However, we don’t think US and UK debt surpassing 100% of GDP is too telling. Going over that threshold tends to evoke comparisons to long-struggling economies like Greece, but that actually illustrates the fallacy. Governments don’t pay all debt at once. They pay interest and principal on maturing bonds, and they don’t pay it with GDP. Instead, they use tax revenues for interest and refinance maturing bonds by selling replacements. The inability to do that is what broke Greece.

We think the best way to gauge debt’s sustainability is to measure affordability—interest relative to tax revenues. For the US, interest payments comprised 10.8% of tax revenues in fiscal year 2019.^[i] That number likely rises based on recent issuance and revenue declines from the recession. Even so, US interest payments accounted for 15% – 18% of tax revenues for most of the 1980s – 1990s—a great period of economic growth. In the UK, interest payments were just 4.7% of tax revenues in 2019.^[ii] An increase from the lowest level over the past 20 years likely won’t prove onerous to the UK economy, either, particularly with newly issued debt carrying historically low interest rates—a strong indicator of creditworthiness. 

You might have noticed the above explanation differs from MMT, which holds that countries that have full control of their own currency and taxation can never go broke, because central banks can simply create more money to fund the government—and the government uses taxation to control inflation. Some point to quantitative easing (QE) as proof this can happen without dire consequences, citing low debt service costs. Supposedly, this is a direct counterpoint to the notion debt monetization must lead to runaway inflation (see Argentina in the 2010s or Germany in the 1930s).

But QE isn’t debt monetization—a crucial distinction. Debt monetization occurs when a central bank prints money to buy debt directly from the Treasury as it is issued—rapidly increasing the money supply. In this scenario, the higher inflation is seen as a fiscal benefit, as interest payments aren’t adjusted for inflation (the effect on households is an obvious problem). However, QE isn’t “money printing.” Rather, central banks exchange reserves for long-term debt, which they buy on the secondary market. Those reserves end up on bank balance sheets. New money doesn’t flow to the Treasury, which must continue selling all new bonds to banks and investors at issuance. For QE reserves to radically multiply broad money supply, banks must lend aggressively. Yet as we have written extensively, QE discourages banks from lending because it flattens the yield curve, which weighs on loan profitability. Without that incentive, banks have largely kept those reserves on deposit at the Fed.

Low interest rates coupled with low inflation aren’t a sign MMT works, but that in the here and now, Fed policy has squashed the yield curve, discouraging lending. Meanwhile, COVID restrictions prevented money from changing hands in spending and other transactions, quelling velocity. That could change in the future for a host of reasons, from economic reopenings allowing business to return to normal to a change in current Fed monetary policy. However, forecasting central bankers’ decisions is futile, in our view, and presently, inflation doesn’t look likely to gallop higher for the foreseeable future.

While the US discussion centers on MMT, many in the UK (and some in America) seem resigned to future spending cuts or tax hikes to make the debt manageable. Focus on future austerity seems premature, in our view. Importantly, carrying debt doesn’t stymie economic growth. US net public debt, which excludes government-owned debt, last exceeded 100% of GDP back in 1945 – 1946—reflecting the government’s borrowing for World War II. But the debt-to-GDP ratio fell in the following years even though the absolute level of net debt outstanding didn’t meaningfully dip. The reason: Rather than tank, the US postwar economy expanded robustly, outpacing outstanding debt.

Now, history buffs might point out that the Fed and Treasury had a wartime financing deal. However, the war still added about $192 billion to net debt. Some repayment and Treasury maneuvering reduced that total by about $27.5 billion, but the government never paid off the rest. Instead the Treasury rolled over the bonds, which are still on the books more than 70 years later. Carrying that debt didn’t prevent the US economy from becoming the world’s largest. Even if future growth isn’t as swift as it was in the postwar era, what matters more is slowing or ceasing—rather than materially shrinking—debt’s relative size to GDP. This doesn’t seem like a stretch to achieve, in our view, given the spike in government spending is likely a one-off response to the steep, COVID-driven contraction—which also skewed the denominator downward and seems poised to reverse.

Similarly, the UK shows a competitive economy can carry debt for centuries without hamstringing growth. In 2015, the UK government redeemed the last four undated bonds in its portfolio. These gilts were tied to financing going back as far as the 18^th century—with some related to government bailouts following the South Sea Bubble of 1720.^[iii] Carrying this debt for more than two-and-a-half centuries didn’t hinder growth because the dynamic UK economy kept expanding—shrinking debt’s relative burden on the country’s finances. Some point to austerity in the last economic cycle, but that was a political decision, not an economic one, and there wasn’t much evidence actual austerity ever happened.

Contrary to MMT proponents, we aren’t saying countries can continually take on debt without consequence. However, reality is a bit more complex than presuming a certain amount of debt will tip an economy into troubled waters.