On May 28, 2021, the Biden administration proposed its $6 billion budget. This is a level of federal spending that has not been seen since WWII years. As was widely expected, the expansion of the budget involves a significant expansion of the nation’s safety net programs. They are incorporated in Biden’s American Jobs Plan and American Families Plan. The budget proposal assumes that these social programs will be funded by new taxes on high, personal incomes and corporations.
Other elements involve spending on “infrastructure”, which the Administration has defined so broadly that it is not clear exactly what spending in this area will comprise. It includes conventional notions of infrastructure, such as roads and other transportation capital expenditures, but also includes such programs as child care, universal pre-school education, free community college and national, paid leave programs. His administration has already embraced subsidizing the purchase of electric vehicles, expanding broadband internet coverage, building a network of EV charging stations, and subsidizing other climate-change initiatives.
Some of Biden’s advisors embrace the tenets of the controversial Modern Monetary Theory (MMT). The MMT argues that a country with its own currency need not concern itself with excessive deficit spending and accumulation of debt. Rather, it argues that by issuing debt in its own currency, there is little to worry about. The associated expenditures will grow the economy fast enough to be able to afford the cost of carrying this debt. Few economists subscribe to the notion that one can grow an economy that is financed by debt alone.
There is no explicit mention of the adoption of the MMT notions in financing this budget. However, Biden's own budget proposal assumes that approximately $14.5 trillion in additional debt will be accumulated in the first decade alone. Thus, it is important to know what the effect of increased debt will be.
The amount of debt is conventionally measured as the debt-to-GDP ratio to account for a country's borrowing capacity. In the figure below, I have plotted the OECD’s measure of the ratio of debt to GDP for 33 OECD countries. To avoid potential distorting effects of the Covid-19 pandemic, I use the 2018 measure of the debt measure. In 2018, the US debt-to-GDP ratio was 136.2 percent. I have plotted the cross section of these ratios against the corresponding, compound annual growth rate of each of the countries’ economies.
Figure 1. Excessive Debt Slows Economic Growth
The data and the exponential trend line fit to the data reveal a strong negative relationship between higher debt-to-GDP ratios and the growth rate of the economy. (The simple trend explains almost 70 percent of the variation among the countries.) If this statistical link between the debt measure and GDP growth is accurate, the US economy will be slowed by the addition of $1.4 trillion in debt each year for the next decade.
Specifically, if the market perceives that the $14.5 trillion in additional debt were added all at once (or to an economy growing slowly) the result would be a reduction in the GDP growth rate that is lower than current growth by 3.7 percent of today's growth rate. As the Japanese case illustrates, even an economy that has a 250 debt-to-GDP ratio ekes out some growth. However, the addition of too much indebtedness can start a vicious cycle whereby the higher debt handicaps economic growth which, in turn, amplifies the burden of debt. In this scenario the US, like Japan, could suffer a long period of weak or zero real growth.
Data source:
OECD (2021), Gross domestic product (GDP) indicator. doi: 10.1787/dc2f7aec-en (Accessed on 25 May 2021)
