The Economic Effects of High Debt

Continuing our analysis of CBO's Long-Term Outlook, we looked yesterday at the policy assumptions under CBO's two budget paths and at spending and revenue projections in their analysis. Today, we will look at what CBO believes will happen to the economy as a result of our growing debt burden.

Under CBO's Alternative Fiscal Scenario, debt would exceed 100 percent of GDP in 2021, 200 percent in 2037, and theoretically hit 800 around 2080. Long before levels got this high -- and perhaps even in the next few years -- this could lead to a fiscal crisis. In such a crisis, CBO explains:

Investors become unwilling to finance all of a government’s borrowing needs unless they are compensated with very high interest rates; as a result, the interest rates on government debt rise suddenly and sharply relative to rates of return on other assets... [This could force] policymakers either to immediately and substantially cut spending and increase taxes to reassure investors—or to renege on the terms of the country’s existing debt or increase the supply of money and boost inflation... Thus, such a crisis would confront policymakers with extremely difficult choices and probably have a very significant negative impact on the country.

Even if projected levels of debt could somehow be sustained without a crisis, the impact on the economy is not pretty. In making its long-term projections, CBO assumes the economy will essentially return to trend levels after 2021 -- which means about 2.2 percent annual growth in real GDP every year, after accounting for the smaller labor force they expect to see in the future. Unfortunately, CBO projects that continued accumulation of debt will tend to slow economic growth.

Under the Alternative Fiscal Scenario -- which is the closer representation of current policy -- CBO projects that the economy could be as much 3% smaller in 2025 and as much as 10% smaller in 2035. Looking out beyond 2035, as debt grows higher, these effects would surely grow substantially.

Under CBO's Extended Baseline Scenario -- which represents the continuation of current law without regard to political reality -- the economic effects are substantially smaller -- GDP would be up to 0.2% lower in 2025 and 1.3% in 2035. And this change results largely from changes to marginal rates rather than debt, since the Extended Baseline Scenario allows all the 2001/2003/2010 tax cuts to expire, ceases patching the Alternative Minimum Tax, and allows continued bracket creep into the indefinite future. 

Importantly, slower economic growth doesn't just mean a weaker economy -- it means a worsened debt. CBO finds that continuing current policy would result in both higher interest rates and slower growth, with the former mainly increasing spending and the latter mainly reducing revenue (and the denominator in the debt-to-GDP equation).  This causes a vicious cycle that leads to a worsening debt and in turn a weaker economy.

Whereas CBO projects debt to be about 190 percent of GDP in 2035, it could be as high as 250 percent after accounting for the dynamic effects of higher debt (assuming no fiscal crisis).

Clearly, the never-ending cycle between higher debt and lower growth can make our fiscal problems harder to solve. Making the necessary adjustments now, instead of waiting for years, will allow them to be less severe and prevent a high debt burden from weighing down our economy further.