MANY of the world's most pressing macroeconomic problems relate to the large overhang of debt. In Europe, a toxic combination of public, bank and external debt in the periphery threatens to unhinge the euro zone. Across the Atlantic, a standoff between the Democrats, the Tea Party and old-school Republicans has produced extraordinary uncertainty about how the US will close its government deficit, which is 8% of gross domestic product (GDP), in the long term. Japan, meanwhile, is running a 10%-of-GDP budget deficit, even as growing cohorts of new retirees turn from buying Japanese bonds to selling them.
Apart from wringing their hands, what should governments be doing? One extreme is the simplistic Keynesian remedy that assumes that government deficits don't matter when the economy is in deep recession; indeed, the bigger the better. At the opposite extreme are the debt-ceiling absolutists, who want governments to balance their budgets tomorrow (if not yesterday). Both are dangerously facile.
The debt-ceiling absolutists underestimate the adjustment costs of a self-imposed "sudden stop" in debt finance. Such costs are precisely why impecunious countries such as Greece face social and economic displacement when financial markets lose confidence and capital flows suddenly dry up.
There is an appealing logic to saying governments should balance their budgets; unfortunately, it is not so simple. Governments typically have myriad commitments to basic services and cannot just walk away from these overnight.
When US p resident Ronald Reagan took office on January 20 1981, he retroactively rescinded all civil service job offers extended during the two-and-a-half months between his election and the inauguration. The signal that he intended to slow down government spending was a powerful one but the immediate effect on the budget was negligible. Of course, a government can also close a budget gap by raising taxes, but any sudden shift can magnify the distortions that taxes cause.
If the debt-ceiling absolutists are naive, so, too, are simplistic Keynesians. They see lingering post-financial-crisis unemployment as a justification for more aggressive fiscal expansion, even in countries already running huge deficits. People who disagree with them are said to favour "austerity" at a time when hyper-low interest rates mean governments can borrow for almost nothing.
But who is being naive? It is right to argue that governments should aim only to balance their budgets over the business cycle, running surpluses during booms and deficits when economic activity is weak. But it is wrong to think that a large accumulation of debt is a free lunch.
Very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more. The cumulative costs can be stunning. The average high-debt episodes since 1800 last 23 years and are associated with a growth rate more than one percentage point below the rate typical for periods of lower debt levels. After 25 years of high debt, income can be 25% lower than at normal growth rates.
Of course, there is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth comes from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline.
It is sobering to note that almost half of the high-debt episodes since 1800 are associated with low or normal real (inflation-adjusted) interest rates. Japan's slow growth and low interest rates over the past two decades are emblematic. Moreover, carrying a huge debt burden runs the risk that global interest rates will rise in the future, even absent a Greek-style meltdown. This is particularly the case today, when, after sustained "quantitative easing" by major central banks, many governments have exceptionally short maturity structures for their debt. Thus, they run the risk that a spike in interest rates would feed back relatively quickly into higher borrowing costs.
With many of today's advanced economies near or approaching the 90%-of-GDP level that loosely marks high-debt periods, expanding today's already large deficits is a risky proposition, not the cost-free strategy that simplistic Keynesians advocate. © Project Syndicate, 2012. www.project-syndicate.org
. Rogoff is professor of economics and public policy at Harvard University.