Deadbeat Uncle Sam: Bringing Down The Whole Family

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved. 
Ludwig von Mises

Fellow financial blogger and unabashed Money Monetary Theorist Cullen Roche opined on Seeking Alpha last fall that high levels of sovereign debt are beneficial to an economy during a balance sheet recession. With all due respect to my esteemed colleague, Mr. Roche is dead wrong.

In 2010 Carmen Reinhart and Kenneth Rogoff (of This Time Is Different fame) published an eye-opening National Bureau of Economic Research working paper in which they determined the effects of heavy sovereign debt on GDP. According to Reinhart and Rogoff, government debt inexorably becomes a drag on an economy after passing 90% of GDP.

Last year three economists from the Bank for International Settlements wrote a follow-up to the NBER piece which verified Reinhart and Rogoff’s conclusions. Using 20 years of data from 18 OECD countries, Stephen Cecchetti, M.S. Mohanty, and Fabrizio Zampolli found that, with debt-to-GDP ratios above 85%, GDP falls an average .1% for every 10% rise in aggregate sovereign debt. This is an important revelation, as the U.S. debt-to-GDP ratio since the financial crisis has blasted past 85% to over 100%.

Highly indebted nations, which hurt their own economies with profligate spending, often spend even more during times of economic duress. This is precisely what the U.S. has done, and this is a primary reason why the “recovery” has been so anemic. Using the formula outlined in the BIS paper, the current level of U.S. sovereign debt is decreasing quarterly GDP growth by .75%. That means that, if the government had tightened its belt at 85% debt-to-GDP, quarterly GDP growth would currently be hovering around the post-WWII average of 3.28%. In other words, we would be recovering instead of just treading water.

Our deadbeat Uncle Sam is bringing us down. In fact, the Peter G. Peterson Foundation suggests that, at the current level of growth, our dear uncle's debt will eventually pull us into perpetual recession.