The Debt-Ratio Distraction

While a high public debt/GDP ratio can hamper a country’s growth prospects, the ratio itself is not the determining factor. The impact of debt on GDP growth depends on a country's economic volatility, its balance-sheet structure, and the likelihood that an adverse shock will cause borrowing costs and contingent liabilities to soar.

BEIJING – A 2010 paper by Kenneth Rogoff and Carmen Reinhart suggesting that a country’s economy will slow when public debt exceeds 90% of GDP has fueled heated debate worldwide. What is usually missing from such discussions, however, is an explanation of how too much debt leads to slower growth. Such an explanation is needed to decide whether crossing a particular threshold really is the determining factor in an economic slowdown.

In fact, it is not. While excessive debt can hamper a country’s growth prospects, it does so by inducing economic actors to behave differently, thereby generating financial-distress costs. Just as major stakeholders in a business generate such costs by changing their behavior when the firm’s balance sheet becomes too risky, an economy’s stakeholders respond to rising default risk in ways that reduce growth and, in a vicious feedback loop, increase financial fragility further.

This change can occur in many ways. Creditors raise their interest rates and shorten maturities, while businesses, worried about future tax hikes or expropriation, begin to disinvest. Workers organize to protect their jobs, while savers, concerned that inflationary policies will erode the value of their savings, withdraw their bank deposits. Policymakers shorten their time horizons.

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