Comparing the macroeconomic and budgetary costs of debt

Over the past several decades, concerns about the sustainability of U.S. federal debt have been central to economic policy discussions. Federal debt as a share of GDP has grown significantly, reaching levels unseen since World War II, and the debt to GDP ratio is projected to continue rising in the absence of policy changes.

While the implications of this rising debt are often debated in budgetary terms—focusing on the tax increases or spending cuts necessary to stabilize debt—the real burden of debt on future generations stems from its macroeconomic consequences. High government debt can reduce capital accumulation by crowding out investment, leading to slower long-term economic growth and lower future consumption. It can also increase the foreign ownership of U.S. assets, which also reduces future consumption.

This paper uses a simple analytical framework to compare and link the two perspectives—budgetary and macroeconomic. It examines how persistent budget deficits affect the economy by reducing national saving and capital accumulation, thereby lowering future output and consumption. It also explores the fiscal consequences of debt accumulation, showing how rising debt levels necessitate future fiscal adjustments—whether through higher taxes, lower spending, or both. By linking these two approaches, the analysis provides insights into how the economic burden of debt compares to the direct fiscal costs of debt stabilization.

The model highlights key parameters that affect the comparison, including the marginal product of capital, the government’s borrowing rate, the responsiveness of consumption and saving behavior to fiscal policy, and the treatment of risk.

In particular, the paper conducts the following thought experiment: What if the government allows debt to continue rising for some time, and then decides to take steps to stabilize the debt to GDP ratio. The paper compares the increase in the debt to the change in the capital stock and examines how the tax and spending adjustments needed to stabilize debt compare to the reduction in consumption required to stabilize the capital-output ratio.

My conclusions are as follows:

• In a world without risk—where the government’s borrowing costs are equal to the marginal product of capital—the reduction in the capital stock from crowding out will likely be smaller than the rise in debt. Similarly, the reduction in consumption needed to stabilize the capital stock will likely be smaller than the increase in taxes/reductions in government spending necessary to stabilize the debt.
• In a world with risk, the expected decline in the capital stock from the experiment described above could be greater or smaller than the expected increase in debt. However, if the riskless return to debt is a reasonable measure of the certainty-equivalent expected return to capital, then the certainty-equivalent expected reduction in the capital stock will be smaller than the expected debt accumulation.
• In a small open economy, the certainty-equivalent reduction in U.S. asset ownership resulting from an increase in debt is equal to the marginal propensity to consume (MPC) out of the debt-increasing policies multiplied by the debt. If the MPC is 1, then the increase in debt is equal to the certainty-equivalent reduction in assets.
• If the types of policies that lead to higher debt are the same as those that are used to address the debt, then in a riskless open economy, stabilizing the debt will stabilize U.S. asset ownership. However, if the types of policies that are used to stabilize the debt lower private consumption by less than the types of policies that led to the debt (for example, if the debt increases because of high MPC policies like increases in Social Security and Medicare spending, but the debt is then stabilized with tax increases on high-income taxpayers), then stabilizing the debt may not be sufficient to stabilize asset ownership. More broadly, the macroeconomic effects of fiscal policy depend not just on changes in the deficit and debt, but also on the incentive effects, distributional consequences, and growth implications of the policies that drive them.
• In a closed economy, the relationship between debt and capital is slightly more complicated, because an increase in debt raises private income even if the MPC from the debt-reducing policies is 1. In a closed economy without risk (or in a certainty-equivalent world), the amount of crowding out will be equal to the accumulation of debt only if the MPC out of the debt-increasing policies is 1 and there is no increase in savings as a result of the higher private capital income. In other words, private consumption has to increase more than the primary deficit in order for the amount of crowding out to be as large as the debt.
• As in the small open economy, stabilizing the debt will be sufficient to stabilize the capital stock if the policies that stabilize the debt have the same effect on consumption as those that gave rise to it.
• The costs of debt are lower in a small open economy than in a closed economy because government borrowing does not raise interest rates or crowd out private investment.

Read the full paper here.