This article explores new research on the impact of large public debt burdens on economic growth. The study reveals that economic growth during such periods is typically more than 1% lower, and that on average they last 23 years. This suggests that the economic slump that plagues advanced economies could last another 18 years.
The new research paper, entitled ‘Debt Overhangs: Past and Present’, was written by the acclaimed authors of the book This Time Is Different: Eight Centuries of Financial Folly, Carmen Reinhart and Ken Rogoff, together with Vincent Reinhart who is Chief US Economist and Co-Head of Economic Research at Morgan Stanley.
Their study examines 26 episodes since the early 1800s in which advanced economies experienced a major public debt overhang. Countries were included in the study if they had “a prolonged period of exceptionally high public debt”, which they defined as a public debt over 90% of GDP for at least five years.
The trio used the latest research to examine the long-term growth consequences of these prolonged periods of high public debt and found that on average economic growth falls by 1.2% during such periods.
In addition the study found that, “the average duration of debt overhang episodes was 23 years, implying a massive cumulative output loss. Indeed, by the end of the median episode, the level of output is nearly a quarter below that predicted by the trend in lower-debt periods.”
The paper also helps reveal the scale of the debt problem we face. The chart below shows the trajectory of central government debt as a percent of GDP for both advanced and emerging market economies from 1860 to 2011.
Central government debt as a percent of GDP: 1860 to 2011
The next chart (below) shows the trajectory of gross public and private external debt as a percent of GDP for 22 advanced, and 25 emerging market economies from 1970 to 2011.
Public & private external debt as a percent of GDP: 1970 to 2011
Led by European countries, the surge in external debt since the early 2000s is unprecedented in history and dwarfs that of the late 1970s – early 1980s lending boom to emerging markets (shown in the inset). For Europe as a whole, public and private external debts are already more than double the 90% threshold used in the study and constitute a considerable source of anxiety.
The third chart (below) shows the trajectory of private domestic debt as a percent of GDP for 22 advanced, and 28 emerging market economies from 1950 to 2011.
Private domestic credit as a percent of GDP: 1950 to 2011
The paper concludes that, “The scope and magnitude of the debt overhang public, private, domestic and external facing the advanced economies as a group is in many dimensions without precedent. As such, it seems likely that our historical estimates of the association between high public debt and slow growth might, if anything, be understated when applied to projections going forward.”
The bottom line
Those of us living in advanced economies, in particular the UK, the US, Japan, and most of Europe, should be under no illusions that renewed prosperity is just around the corner. In fact, I see precious little evidence that our politicians are taking the required action to turn their economies around. Instead they continue to apply monetary stimulus in the vain hope that it will bring about a recovery.
The reality is that the economic slump that plagues advanced economies could last another 18 years.