Does Government Debt Really Weaken The Economy?

Jul 18, 2011

These days, many conservatives argue that slashing the nation's debt should be lawmakers' top priority as they try to revive the U.S. economy. Adding too much debt has eroded consumer confidence, they say, and paying it down would help jump-start growth.

But economists say the relationship between government debt and the weak economy isn't so clear.

Addressing the deficit has become a central focus of economic policy in Washington, and politicians like House Speaker John Boehner often talk about the deficit and unemployment in the same breath.

"I'm looking forward to more serious conversations about how we reduce the deficit and the debt and to get our economy going again and creating jobs," he has said.

But the relationship between government debt and growth is much more complicated than it appears.

Few economists dispute that the United States has a long-term debt problem. Not only is the deficit high now, but it's going to get a lot higher as baby boomers hit retirement and go on Medicare.

Economists say this is bad for two reasons. First there's the crowding-out effect.

Sun Won Sohn of California State University says when the government borrows too much, it competes with the private sector for capital and interest rates go up.

He says countries with high debt, like Japan, tend to have weak job growth.

"On the other hand, if you look at countries with a low debt, they have a pretty strong economic growth and job creation — a good example being Germany," he says.

Then there is the confidence issue. Kevin Hassett of the conservative American Enterprise Institute says when long-term deficits are growing, businesses start to worry that their taxes will eventually go up.

"The best explanation is that when times are very uncertain and deficits are large, then people and firms tend to get very cautious about their plans for the future and their purchases," he says.

Some members of Congress have used these concerns to press for big and immediate cuts in government spending. In fact, the emphasis on the deficit often seems to have eclipsed concern about unemployment in a way that drives liberal economists crazy.

Jared Bernstein of the nonpartisan Center on Budget and Policy Priorities says it's true that over time government borrowing can crowd out private sector capital.

"But interest rates are bumping along the bottom now so crowding out can't possibly be a problem," he says.

Bernstein, who served as economic adviser to Vice President Joe Biden, says it's also true that many businesses lack confidence in the economy and that's a problem.

But they're not worried about levels of government debt years down the road. They're worried about weak demand right now. Bernstein says cutting spending right now could be a disaster for the economy.

"This is an economy that cannot sustain spending cuts or tighter monetary policy or any of that sort of thing right now," he says. "If anything, that would raise the probability of moving us backwards."

Bernstein says cutting the deficit is important long term, but not right now. And that view seems to be shared by a fair number of economists. Hassett, of the American Enterprise Institute, says there's a delicate balance to cutting government spending and it may be risky to do it too soon.

"If you reduce government spending right now, then output is going to go down, almost surely, and so that's a negative," he says. "And given where the economy is, a big reduction in current spending by the government would be a somewhat treacherous strategy."

But Hassett also says research has shown that getting control of a country's finances can reap benefits over time and help build a better foundation for the economy. And a lot of people in Washington right now say they agree with him.

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