At what point does the size of a country’s national debt begin to weigh down the growth potential of its economy?

Previously, the threshold at which that happened was believed to be when a country’s national debt reached 90% of its annual Gross Domestic Product (GDP), which is based on the historic research of Carmen Reinhart and Kenneth Rogoff.

However, new academic research just released by David Greenlaw, Jim Hamilton, Peter Hooper and Frederic Mishkin for the 2013 U.S. Monetary Policy Forum that incorporates more recent history into account suggests that the key threshold at which a nation’s economic growth potential will begin to suffer is passed once the publicly-held portion of its national debt exceeds 80% of the nation’s GDP, which especially applies to nations that continually run large trade deficits (or in their terms, “persistent current-account deficits”):

Countries with high debt loads are vulnerable to an adverse feedback loop in which doubts by lenders lead to higher sovereign interest rates which in turn make the debt problems more severe. We analyze the recent experience of advanced economies using both econometric methods and case studies and conclude that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics.

An adverse feedback loop is the academic name of what airplane pilots would call a “graveyard spiral” or more commonly, a “death spiral“. It describes an potentially fatal situation that begins slowly and almost unnoticeably, as the pilot misinterprets their true situation and continues to make the wrong decisions while flying an airplane, which actually works to amplify the level of risk they are facing.

That situation continues if the pilot persists in failing to recognize their growing level of jeopardy and take action to address the real cause of the situation. If they fail to recognize the danger for too long, the risk of a crash continues to escalate until a critical point is reached and the airplane’s controls start to become ineffective, limiting their ability to take corrective action even after they finally fully realize their true situation and react to recover from it.

In the worst case, the airplane becomes fully uncontrollable, after which even the best efforts of the pilot to correct the situation comes too late to do any good and their attempts to regain control fail.

So where does the United States fall in this measure?

As of February 21, 2013, the total public debt outstanding, which includes so-called “intragovernmental holdings”, which includes debt the U.S. federal government owes to Social Security’s trust fund and other government entities, is $16.608 trillion. The amount of debt directly held by the public (or non-U.S. government entities, which includes the Federal Reserve, banks, pension funds, insurance companies, U.S. individuals and foreign interests) adds up to $11.745 trillion, which is the portion of the national debt that applies to the economists’ analysis.

On January 30, 2013, the U.S. Bureau of Economic Analysis estimated that the size of the U.S. economy through the end of 2012 was $15.829 trillion.

That puts the current percentage of the publicly-held portion of the U.S. national debt at 74.2%. At the federal government’s expected pace of spending, the Congressional Budget Office projected on February 5, 2013 through its Budget and Economic Outlook: Fiscal Years 2013 to 2023 report that the size of the publicly-held portion of the U.S. national debt will exceed 80% of GDP as early as by the end of this year or early in 2014.

Meanwhile, the U.S. has chronically run large trade deficits since 1976.

Taking these basic conditions together, we should note that they don’t mean that a new economic crash is imminent. Instead, what they mean is that the U.S. can expect to have a lot lower economic growth going forward than what it experienced when it maintained its national debt at a much lower level. The recent evidence-backed 80% debt-to-GDP threshold means that situation will take root much sooner than previously had been expected.

That point about how the national debt weighs down the U.S.’ economic growth potential is underscored by another Congressional Budget Office analysis, which considers the long-run impact of President Obama’s 2009 American Recovery and Relief Act (ARRA), which is perhaps better known as the “Obama stimulus package”, which added nearly $1 trillion to the U.S. national debt in 2009 and 2010:

ARRA’s long-run impact on the economy will stem primarily from the resulting increase in government debt…. In the long run, each dollar of additional debt crowds out about a third of a dollar’s worth of private domestic capital, CBO estimates.

In other words, each additional dollar of debt reduces the potential for new economic growth in the private sector of the economy by one-third. So, instead of an economy that grows at an annual rate of 3% (the long-term average of real economic growth in the U.S.), which would double in size every 24 years, the economy would be expected to only grow by 2% on average each year, taking 36 years to double in size. As a tool for reducing the national debt burden of the U.S., economic growth would become much less effective – just like the controls of an airplane that has entered into a graveyard spiral.

And suddenly, because it can’t grow fast enough, it becomes that much harder to address the true cause of the situation behind the nation’s fiscal deterioration. All because the politicians at the controls don’t perceive reality as they should.

Featured Image: Source: Los Alamos National Laboratory