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Debt – curse or blessing?

There are increasing calls for debt-financed stimulus packages. Is new debt likely to accelerate growth or could it risk derailing economic growth in the long run?

Growth is moderate and inflation expectations are low – despite ultra-loose central-bank policies. No wonder, then, that calls for debt-financed stimulus programs are getting louder. But there are dissenting voices, pointing, notably, to the work by Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff. According to estimates by these three economists, a ratio above 90% of government-debt to gross domestic product (GDP) tends to reduce economic growth.1

By contrast, Thomas Herndon, Michael Ash and Robert Pollin found some flaws in this analysis and doubt the mentioned mark of 90%.2 Moreover, it is doubtful whether simply focusing on public debt is enough. This only seems appropriate if governments were to spend borrowed money on one-off projects which will not boost longer-term growth – and perhaps even depress it. However, governments can also invest in infrastructure and education, thus improving the overall environment for corporate activities. This should eventually boost growth and tax revenues. Moreover, there is no reason to single out public sector debt.

The private sector, too, might go on a debt-fuelled consumption spree. Finally, debt-financed corporate investment does not necessarily induce growth. If investment is misguided, it is possible that no growth effects will be felt at all.

Cause and effect

Public debt is not the whole story, as a look back to the 1930s in the United States clearly shows. High indebtedness of the private sector was the main culprit for the high aggregate debt ratio. It is often argued that this high debt ratio eventually triggered the world depression, lasting from 1929 to 1933. However, debt ratios surged mainly after the onset of the crisis – the collapsing nominal GDP actually caused their enormous rise.

But even a view on debt in relation to GDP does not tell the whole story. The debt ratio must also be viewed in relation to per-capita GDP. After all, rising wealth also increases the capability of individuals and companies to bear higher debt in relation to GDP. Conversely, if per-capita GDP in a country hardly exceeds the poverty line, the low level of wealth will depress savings ratios, as well as debt sustainability.

So it is worthwhile to look at the development of debt ratios in relation to wealth – i.e. to real GDP per capita – in the United States. In 1928, the debt ratio in relation to wealth by far exceeded the long-term historic average. This suggests that the state of the U.S. economy was somewhat fragile. Slow reactions from monetary and fiscal policymakers turned the New York stock-market crash of 1929 into a worldwide recession.

It was not before 1933 when the New Deal enacted a series of social and economic reforms. Monetary policy became more expansive. As a result of these policy moves, the aggregate debt ratio in relation to wealth started to decline. World War II forced the U.S. administration into huge increases in public spending programs. The resulting boost to economic growth led to both the aggregate debt ratio and aggregate debt ratio in relation to wealth continuing their decline. This was further supported by interest rates which were statutorily fixed at a low level from 1942 to 1951. Although the debt ratio started to rise in the mid-1980s, debt sustainability only slightly fluctuated and remained on a low level thanks to growing per capita income.

Indicator of debt sustainability

This development suggests that the fear of higher debt inhibiting growth in the United States in the long run is somewhat overdone. The same is likely to hold true for other countries such as the United Kingdom or Germany where the relation of debt ratio to per-capita GDP is lower. This certainly provides scope for fiscal-stimulus measures – especially the sort of prudent and efficient spending that might boost longer-term growth.

Debt ratio on a high level

In 1928, debt in relation to GDP was rather high. The rise from 1930 onwards was due to contracting GDP. Today, the debt ratio has reached a similarly high level.

Debt ratio on a high level

Sources: Federal Reserve, Bureau of Economic Analyses,; as of 9/16/16

Debt ratio in relation to wealth

Between 1928 and 1945, this relation was rather high. In the mid-1970s it bottomed out and has trended sideways since.

Debt ratio in relation to wealth

Sources: Federal Reserve, Bureau of Economic Analyses,; as of 9/16/16

There are increasing calls for debt-financed stimulus packages. Is new debt likely to accelerate growth or rather derail economic development in the long run?


1 Carmen M. Reinhart, Vincent R. Reinhart, Kenneth S. Rogoff: Debt Overhangs: Past And Present. NBER Working Paper No. 18015, April 2012


2 Thomas Herdon, Michael Ash, Robert Pollin: Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff, April 2013

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