The Growing Threat Posed by the Federal Deficit
Our fiscal deficit, as measured by the debt-to-GDP ratio, has grown to levels that could impede growth, as predicted by financial theory and confirmed by empirical evidence. Moreover, new research shows that our burgeoning deficit could increase risk premiums for both stocks and bonds.
As the chief research officer of Buckingham Wealth Partners, I’ve been getting lots of calls from advisors concerned about the rapid growth in our debt-to-GDP ratio as well as the uncertainty over the future path of fiscal policy (including the underfunding of Social Security, Medicare and Medicaid). The concerns are based on not only the current level of debt, which reached a record $30 trillion in January 2022 (compared to the GDP of about $24 trillion), but also the fact that the ratio of federal debt held by the public to the GDP now stands at about 100%. Note that the total debt, which includes debt held by federal agencies – debt the government owes to itself and thus is netted out – is above 120%. A further concern is that inflation and the resulting rise in interest rates will exacerbate the debt problem. To answer the question of whether advisors and their clients should be concerned, we turn first to economic theory and then review the empirical research.
Why would a large federal debt have negative effects on the economy?
Economists have noted several reasons why high levels of debt-to-GDP can adversely impact medium- and long-run economic growth:
- High public debt can negatively affect capital stock accumulation and economic growth via heightened long-term interest rates, higher distortionary tax rates and inflation, and by placing future restraints on countercyclical fiscal policies that will be needed to fight the next recession (which may lead to increased volatility and lower growth rates).
- Large increases in the debt-to-GDP ratio could lead to not only much higher taxes, and thus lower future incomes, but also intergenerational inequity.
- Increased government borrowing competes for funds in capital markets, crowding out private investment by raising interest rates. Higher rates, along with higher taxes, increase the cost of capital and thus stifle innovation and productivity, reducing economic growth.
- If the government’s debt trajectory spirals upward persistently, investors may start to question the government’s ability to repay debt and may therefore demand even higher interest rates.
- Growing interest payments consume an increasing portion of the federal budget, leaving lesser amounts of public investment for research and development, infrastructure and education.
- During high-debt periods, a large stimulus plan faces resistance from fiscally conservative policymakers and is more difficult to pass. Consequently, fiscal policy fails to provide stimulus in time of need and leads to more risk and higher risk premia.
With that understanding, we turn to a review of the literature on the concerns about the potential for negatively impacting economic growth once debt-to-GDP approaches the level we are now at in the U.S.
To evaluate the claim that high government debt-to-GDP ratios had negative effects on the growth rate of an economy, Veronique de Rugy and Jack Salmon reviewed the literature (24 studies) on the relationship between government debt and economic growth in their 2020 paper, “Debt and Growth: A Decade of Studies.” They found that every study except two found a negative relationship between high levels of government debt and economic growth, with a large majority of studies finding a threshold somewhere between 75% and 100% of GDP. They concluded that the empirical evidence overwhelmingly supports the view that a large amount of government debt has a negative impact on economic growth potential, and in many cases that impact gets more pronounced as debt increases.
In 2021 the Cato Institute undertook a review of 40 studies published between 2010 and 2020: “The Impact of Public Debt on Economic Growth.” The authors found that “at low debt levels, increases in the debt ratio provide positive economic stimulus in line with conventional Keynesian multipliers.” However, “once the debt ratio reaches heightened levels (nonlinear threshold), further increases in the debt level as a percentage of GDP have a negative impact on economic growth.” In other words, “a nonlinear threshold could suggest that increased government borrowing competes for funds in the nation’s capital markets, which in turn raises interest rates and crowds out private investment, confirming the debt overhang theory.” Their findings where consistent with those of the 2011 study, “The Real Effects of Debt,” by the Bank for International Settlements. The authors concluded: “At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. … Beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems.” The authors estimated that after the threshold, an increase of 10% in the government debt-to-GDP ratio will lower annual economic growth by 0.17%-0.18% over the following five-year period. The authors of the 2012 study, “Is High Public Debt Always Harmful to Economic Growth?” found the same negative relationship, though their estimate of the threshold was somewhat higher, at 115% (a level the U.S. may reach in the near future).
Confirming evidence of the negative relationship between high levels of government debt-to-GDP and economic growth was provided by the authors of the 2013 study, “Does High Public Debt Consistently Stifle Economic Growth?,” who examined the relationship between public debt and GDP growth among 20 advanced economies in the post-war period. They found that growth in countries with a debt-to-GDP ratio between 60% and 90% was 3.2% but was 2.4% for countries with a ratio between 90% and 120% and fell to just 1.6% for countries with a ratio between 120% and 150%.
Further evidence was provided by the authors of the 2021 study, “Public Debt and Economic Growth: Panel Data Evidence for Asian Countries,” which analyzed whether rising public debt is harmful for growth in both the short run and long run in 14 Asian countries. These countries experienced two major crises during the 33-year period covered, 1980-2012 – the Asian financial crisis of 1998 and the global financial crisis of 2008 – which boosted their public debt-to-GDP ratios. The sample included very poor countries such as Bangladesh, Nepal and India, and wealthier countries such as Singapore and South Korea. Those countries provided an interesting test, as in 2010 only two had debt-to-GNP ratios in excess of 67% (Sri Lanka at 82% and Singapore at 101%), while six had ratios below 40%. Their findings led them to conclude: “Our results indicate that an increase in government debt is negatively associated with economic growth in both the short and long-run.” They added that “the idea that the negative effects of public debt kick in only at ratios of public debt to GDP of 90% or more may not apply to the Asian economies.”
Yang Liu, author of the May 2022 study, “Government Debt and Risk Premia,” examined the relationship between government debt-to-GDP and risk premia over a century of U.S. data and 50 years of data for 19 advanced economies. Following is a summary of his findings:
- Globally, higher debt-to-GDP ratios were associated with larger equity premia and larger credit risk premia – high debt levels implied high costs of capital for firms as uncertainty increased.
- Debt-to-GDP ratios positively predicted risk premia at short (one-quarter) and long (five years) horizons in the U.S. and other advanced economies. The predictability evidence was statistically and economically significant: The implied equity premium was 2.2% in periods of low debt and reached 13.4% in periods of high debt. Debt-to-GDP ratios produced predictive regression r-squareds of 11% at an annual horizon and 40% at a five-year horizon.
- A one percentage point increase in the debt-to-GDP ratio indicated a 34-basis point increase in expected excess equity return per annum and a 10-basis point decrease in the three-month real risk-free rate.
- Given the past debt level, the change in the debt ratio had stronger predictive power – the same 10% increase in the debt ratio from 10% to 20% or from 80% to 90% should have quite different implications for risk premia. Research has shown that at moderate levels, increases in debt can improve welfare and enhance growth, but increasing debt at high levels can be damaging.
- Higher debt was also associated with lower risk-free rates – the three-month real risk-free rates were negatively related to debt-to-GDP ratios when controlling for GDP growth, inflation and the price-dividend ratio. This finding is consistent with the risk premia result, as risk-free rates decrease with risk through precautionary saving.
- Increased risk premia provide compensation for higher fiscal risk – during periods of elevated debt, fiscal policy becomes less certain, less countercyclical and less effective, and can even lead to debt crises – while countercyclical fiscal stimulus would smooth the economic cycles, resulting in a more stable economy with lower volatility and risk premia. However, the limited fiscal capacity of a government constrains its ability to support the economy during times of need. Thus, in high-debt periods, government expenditures become acyclical and lose their benefit as stabilizers.
- The forecasting power of the debt-to-GDP ratio is not subsumed by other documented return predictors – dividend yields, price-earnings ratios, dividend-earnings ratios, stock return volatility, book-to-market ratios, net equity expansions, Treasury bill rates, long-term yields, long-term returns, term spreads, default yield spreads and inflation.
Liu’s findings led him to conclude: “During periods of high debt, the large risk premium is a significant cost to the economy that can impact corporate financing and reduce capital formation and economic growth.” (This could help explain the year-to-date negative performance of stock and corporate bond markets.) He added: “During periods of high debt, larger risk premia imply that fiscal policy is more uncertain, loses its stabilizer function, becomes counterproductive, and can lead to debt crises. Therefore, a high-debt level makes fiscal policy riskier and less desirable.”
Finally, the research team at Dimensional examined the relationship between equity returns and debt-to-GDP in developed markets (1975-2018) and in emerging markets (1995-2018). Their findings line up with those of Liu. For example, in developed markets, high-debt countries returned 8.14% while low-debt countries returned 6.6%, and in emerging markets high-debt countries returned 10.42% versus 8.68% for low-debt countries. That result should not be unexpected, as theory and the empirical research show that investors view countries with higher debt-to-GDP ratios as riskier and demand a risk premium.
The benefits of government debt are widely agreed upon, as government debt is crucial to smooth macroeconomic shocks and provides liquidity and a safe haven. As Liu noted, “A sustainable debt level leaves enough space for necessary fiscal expansion in the future. Debt reduction during normal times is desirable for macroeconomic stability and risk reduction.” Unfortunately, since 2000, across two Republican and two Democratic administrations, the U.S. has witnessed a dramatic increase in the level of the debt-to-GDP ratio to above the level at which empirical research has documented negative effects on impacted economic growth. Liu demonstrated that another concern exists: The high level of debt causes equity and bond investors to increase their risk premia, with negative impacts on valuations.
The empirical findings raise concerns about future U.S. economic growth, especially because we face an increasing debt-to-GDP ratio unless strong fiscal policy actions are taken to reverse the trend – actions that the last four administrations have demonstrated no desire or willingness to take. One only has to look to Japan, with a debt-to-GDP ratio in excess of 260% (and headed higher) and stuck in a 30-year period of weak economic growth (other problems, such as an aging population, have also contributed to Japan’s economic weakness), to raise concerns about our experiment in massive deficit spending at a time when our debt-to-GDP ratio is already in excess of 100%.
The takeaway for investors is that their financial plans should consider a negative impact on economic growth caused by rising debt, which could lead to lower equity returns if valuations move lower (to provide investors with a greater risk premium). Lower potential economic growth along with the risk of increased inflation, when combined with historically high valuations of U.S. stocks (as represented by the S&P 500) and historically low bond yields, should raise concerns. Prudent investors plan for these risks. For example, they adjust forecasts of future returns to reflect current valuations and yields (rather than relying on historical returns). They may also consider increasing allocations to fixed-income assets that are less susceptible to inflation shocks (such as TIPS and floating-rate debt).
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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