Does Debt Act as a Brake on Economic Growth?

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Most Americans know what debt is, how to get into debt (easy) and how to get out of debt (hard.) And most would agree with the general statement that debt does indeed act as a brake or as least decelerate on someones economic growth and well-being. After all, it’s very difficult to feel prosperous and wealthy when you are weighed down with a mortgage, a car payment and that VISA bill.

But does government debt act as a brake on economic growth for an individual country? Before that question is answered, lets look at little known fact. Since the 2007 economic crash, has the combined debt of the worlds countries gone up or gone down? If you answered “up”, you would be correct. A whopping $57 TRILLION dollars to be exact! So the answer that almost every economically developed country took in response to the worst economic downturn in world history since 1929 was – to go more into debt.

Chart courtesy of McKinsey Global Institute.
Chart courtesy of McKinsey Global Institute.

The chart above indicates that almost every country continues to “leverage” up (take on more debt) with their economies than those that are de-leveraging. A few interesting countries adding sizable amounts of debt since 2007 are Greece and Spain (part of the Euro Group), as well as the very large countries of Japan and China. 

We know from personal experience that heavy loads of debt does hamper an individual’s and businesses ability to grow and prosper. But does that apply to a government – and therefore a nation, as well?

One of the world’s preeminent economists, John Maynard Keynes (1883 – 1946), is widely attributed with the creation of an economic philosophy called “Keynesian economics.” One of the basic tenants of Keynesian economics is that when a nation slips into a recession, people (consumers) stop buying things. As a result, Keynes suggested that the government should then step in and spend money instead. And how does a government spend money? One way is by public works projects such as the building of roads and infrastructure. This also has the added benefit of the employment of individuals, who might otherwise become unemployed.

Another Keynesian method of the government stimulating the economy (in lieu of businesses or consumers doing the deed) is by lowering the interest rate for new debt. Though how they do this is rather complicated, convoluted and somewhat controversial.  The main point here is that by a lowering the interest rate, more debt is created.  And by lower interest rates for all, this should encourage consumers and businesses to borrow, then buy and spend.

For a great example of this, think home mortgages. The housing crisis of the mid to late 2000’s in the U.S. was mitigated and turned around by the lowest mortgage rates in history. In many cases, one could buy a house with a mortgage as low as 2 – 3% for a 30 year mortgage! Talk about (almost) free money.

As the economic theory goes, as a country adds more debt – attempting to stimulate its economy, consumer and business demand for goods, products or services should increase, thus lifting the nation out of recession. And if all goes well, that economic increase will then become greater than the increase in the debt – resulting in a decrease in the debt to GDP ratio. But as the chart above shows us, debt continues to rise faster than economic growth in almost all countries of the world.

Is rising debt the cause of the worlds slow and anemic growth? Or is the rising debt keeping the world from entering into yet another economic morass? Economists are divided on the answer. This amount of debt has never happened on such a global scale in the history of the modern world, so there are no lessons from which to draw.

So the answer to the question of how debt affects growth, is still largely unanswered. However, it is this writers opinion that after a certain level of debt has been reached, the incremental benefits of the debt are no longer useful – and actually cause greater harm. Below is a bell-curve of concept of debt diminishing returns:

Debt vs. Growth