When Adam Smith said that “there is a great deal of ruin in a nation”, he was commenting on a military defeat, but economists tend to treat it as a more general truth about the durability of nations in the face of apparently overwhelming debt. And it is true that while over-indebted companies tend to be wiped out, countries such as Argentina keep bouncing back.
Emerging economies have to pay attention to what foreign investors think, because they typically have to borrow in dollars rather than their own currency. Life is different for countries such as the US and the UK, which have been borrowing enthusiastically in their own currencies with little sign of serious concern from the bond markets. For richer countries it is possible that Dick Cheney was right when (according to former treasury secretary Paul O’Neill) he said that “Reagan proved that deficits don’t matter.” If deficits don’t matter, one can only surmise that their natural consequence – public debt – doesn’t matter either.
We had better hope that both Cheney’s claim and Adam Smith’s rumination prove to be true, because many wealthy governments are building up debt very swiftly indeed.
According to the IMF, in the years leading up to the crisis, the gross debt to GDP ratio – which includes interest payments – was just over 40 per cent in the UK and 60 per cent in the US. This year it looks like it will exceed 80 per cent in the UK and 90 per cent in the US. By 2014, the IMF expects the UK ratio to be just under 100 per cent, and the US ratio to rise to nearly 110 per cent.
What are the likely consequences of issuing all these IOUs? A new study by Carmen Reinhart and the IMF’s former chief economist Kenneth Rogoff offers clues. Reinhart and Rogoff have been constructing an impressive database on public debt, covering 44 countries and stretching back two centuries. If the past is any guide to the future, they offer plenty of reason to be concerned.
Reinhart and Rogoff look at episodes of low, medium, high and very high indebtedness, drawing boundaries arbitrarily at public debt/GDP ratios of 30, 60 and 90 per cent. And up to a point, Dick Cheney and Adam Smith are right: there is little sign of trouble at any level of public debt up to 90 per cent of GDP. But once public debt strays into the “very high” category – which is where most rich countries are quickly heading – economic growth has tended to slump. For highly indebted rich countries, median economic growth is about 1 per cent lower than for less indebted rich countries, and mean growth is 4 per cent lower. The fact that mean growth is particularly weak indicates that for a minority of countries, high debt is a catastrophe.
The Reinhart-Rogoff study offers some cause for optimism. Most rich countries are still below the 90 per cent public debt/GDP threshold: so far, debt and deficits are a symptom of weakness, not its cause. And the high inflation feared by some commentators has not, historically, been a feature of high debt levels in rich countries.
Overall, though, the study is worrying. Although there are cases of highly indebted governments presiding over rapid growth – such as Australia and New Zealand immediately after the second world war – they look like deceptive parallels for today. High debt is to be expected after a major war, and as the economy moves to a peacetime footing, high growth is quite possible too.
But high debt in peacetime is suggestive of something rotten in the body politic. The UK government’s structural deficit is larger than the budget for the National Health Service. It will be a long slog from here.
Also published at ft.com.