Why U.S. Debt Must Continue To Rise

Debt is rising more quickly in the United States than most people would prefer. This is happening in part because the U.S. current account deficit and the country’s high level of income inequality distort the structure and amount of American savings.

Many Americans are worried about the seemingly inexorable rise in U.S. debt, whether government debt, household debt, or business debt. They are right to be concerned. Rapidly rising debt is a problem not just in the United States but in many other countries too, including China, parts of Europe, and most of the developing world. In today’s environment, it seems, reasonable levels of economic growth cannot be achieved unless boosted by even faster growth in debt.

With so much debt in the world, and with debt levels rising so quickly, people tend to think that economists have studied this issue deeply and fully understand it. But there continues to be a great deal of confusion about debt and about whether and why excessive debt levels can harm growth prospects. To try to address these issues, this blog post is divided into two parts. The first part discusses debt and some of the conditions under which it affects the prospects for economic growth.

The second part argues that at least two of the reasons that debt has been rising inexorably in the United States for several years are the country’s rising income inequality and its persistent trade deficit. Surprising as it may seem at first glance, these two conditions operate the same way: they distort the level and structure of American savings. As long as income inequality remains high and the United States runs large deficits, the resulting savings distortions will continue to mean that U.S. debt levels have to rise to prevent the economy from slowing and unemployment from rising.



To begin with, broadly speaking, debt can be divided into two types:

Self-liquidating debt is used to fund investment projects that increase economic productivity enough (after including all associated positive and negative externalities) to service the debt fully. In such cases, an increase in debt is used to create an equal or greater increase in assets. While this usually leaves the overall economy better off, there could still be an argument about whether it is best to fund a particular project with debt (versus equity), about the best (or least risky) way of structuring the borrowing, and about how the debt and its subsequent repayment affects income distribution.

All other debt funds household consumption, nonproductive government activities (such as military spending, welfare programs, and other kinds of consumption on behalf of households), and nonproductive investment by either the government or businesses. In some cases, this debt can have a positive impact on economic welfare, such as when debt is used to smooth out consumption over a person’s life cycle. In other cases, it can be positive or negative for economic well-being or for overall economic growth depending on how it affects the way income is distributed. (Indeed, this is one of its least understood but most important functions.)

Self-liquidating debt adds to the total debt in the economy, but rather than heighten the economy’s debt burden it usually reduces the burden by increasing the wealth or productive capacity created by the project by more than the cost of the project. The most common form this debt takes is business investment or government investment in infrastructure. I say that this type of debt usually reduces a country’s debt burden, rather than saying it always does, because this may not be the case if the debt is badly structured; (if, for instance, debt servicing costs are severely mismatched relative to a project’s net increase in production), such a project can raise uncertainty in ways that adversely affect the rest of the economy.

But, except in cases of very badly structured, highly inverted debt, self-liquidating debt is ultimately sustainable because it allows economic actors to service the rise in debt by more than the associated debt-servicing costs. In principle, this means that the debt can be repaid fully out of the additional value created, leaving everyone better off in the aggregate. That said, it is possible in some instances that certain sectors of the economy would benefit disproportionately and other sectors would be worse off, with the winners exceeding the losers.

Debt that is not self-liquidating increases the total debt in the economy and, because it doesn’t improve debt-servicing capacity, usually adds to the economy’s debt burden. Again, I say usually rather than always because, in some cases, this second kind of debt leaves the economy’s debt burden no worse off (if the debt is used for consumption smoothing, for instance); in other cases, such debt can even reduce the debt burden if the debt redistributes wealth in ways that increase the economy’s wealth-producing capacity.1

Debt that isn’t self-liquidating is necessarily serviced only through implicit or explicit transfers from one economic sector to another. In such cases, the borrower can service the debt by appropriating income from other projects, including taxes if the borrower is the government. If the borrower defaults, on the other hand, the debt-servicing cost is transferred to the creditors.

There are other ways that governments, in particular, can service such debt by effectively transferring the cost. The debt can be eroded by inflation, in which case the debt-servicing cost is effectively forced onto those who are long monetary assets, mainly households that save in the form of bonds, bank deposits, and other interest-sensitive assets. If wages are forced down to make it easier for businesses or governments to service their debts, the debt-servicing cost is forced onto workers. If government debt is serviced by expropriation, the debt-servicing cost is forced onto the rich or onto foreigners. One way or another, in other words, this kind of debt is serviced by explicitly assigning or implicitly allocating the costs by way of a transfer of wealth.


Unfortunately, few economists seem able to explain coherently why a heavy debt burden can be harmful to the economy. This statement may seem surprising, but ask any economist why an economy would suffer from having too much debt, and he or she almost always responds that too much debt is a problem because it might cause a debt crisis or undermine confidence in the economy. (Not only that but how much debt is considered too much seems to be an even harder question to answer.)2

But this is clearly a circular argument. Excessive debt wouldn’t cause a debt crisis unless it undermined economic growth for some other reason. Saying that too much debt is harmful for an economy because it might cause a crisis is (at best) a kind of truism, as intelligible as saying that too much debt is harmful for an economy because it might be harmful for the economy.

What is more, this sentiment isn’t even correct as a truism. Admittedly, countries with too much debt can certainly suffer debt crises, and these events are unquestionably harmful. But as British economist John Stuart Mill explained in an 1867 paper for the Manchester Statistical Society, “Panics do not destroy capital; they merely reveal the extent to which it has been previously destroyed by its betrayal into hopelessly unproductive works.” While a crisis can magnify an existing problem, the point Mills makes is that a crisis mostly recognizes the harm that has already been done.

Yet, paradoxically, too much debt doesn’t always lead to a crisis. Historical precedents clearly demonstrate that what sets off a debt crisis is not excessive debt but rather severe balance sheet mismatches. For that reason, countries with too much debt don’t suffer debt crises if they can successfully manage these balance sheet mismatches through a forced restructuring of liabilities. China’s balance sheets, for example, may seem horribly mismatched on paper, but I have long argued that China is unlikely to suffer a debt crisis, even though Chinese debt has been excessively high for years and has been rising rapidly, as long as the country’s banking system is largely closed and its regulators continue to be powerful and highly credible. With a closed banking system and powerful regulators, Beijing can restructure liabilities at will.

Contrary to conventional wisdom, however, even if a country can avoid a crisis, this doesn’t mean that it will manage to avoid paying the costs of having too much debt. In fact, the cost may be worse: excessively indebted countries that do not suffer debt crises seem inevitably to end up suffering from lost decades of economic stagnation; these periods, in the medium to long term, have much more harmful economic effects than debt crises do (although such stagnation can be much less politically harmful and sometimes less socially harmful). Debt crises, in other words, are simply one way that excessive debt can be resolved; while they are usually more costly in political and social terms, they tend to be less costly in economic terms.


So why is excessive debt a bad thing? I am addressing this topic in a future book. To put it briefly, there are at least five reasons why too much debt eventually causes economic growth to drop sharply, through either a debt crisis or lost decades of economic stagnation:

  • First, an increase in debt that does not generate additional debt-servicing capacity isn’t sustainable. However, while such debt does not generate real wealth creation (or productive capacity or debt-servicing capacity, which ultimately amount to the same thing), it does generate economic activity and the illusion of wealth creation. Because there are limits to a country’s debt capacity, once the economy has reached those limits, debt creation and the associated economic activity both must decline. To the degree that a country relies on an accelerating debt burden to generate economic activity and GDP growth, in other words, once it reaches debt capacity limits and credit creation slows, so does the country’s GDP growth and economic activity.
  • Second, and more importantly, an excessively indebted economy creates uncertainty about how debt-servicing costs are to be allocated in the future. As a consequence, all economic agents must change their behavior in ways that undermine economic activity and increase balance sheet fragility (see endnote 2). This process, which is analogous to financial distress costs in corporate finance theory, is heavily self-reinforcing.
  • Some countries—China is probably the leading example—have a high debt burden that is the result of the systematic misallocation of investment into nonproductive projects. In these countries, it is rare for these investment misallocations or the associated debt to be correctly written down. If such a country did correctly write down bad debt, it would not be able to report the high GDP growth numbers that it typically does. As a result, there is a systematic overstatement of GDP growth and of reported assets: wealth is overstated by the failure to write down bad debt. Once debt can no longer rise quickly enough to roll over existing bad debt, the debt is directly or indirectly amortized, and the overstatement of wealth is explicitly assigned or implicitly allocated to a specific economic sector. This causes the growth of GDP and economic activity to understate the real growth in wealth creation by the same amount by which it was previously overstated.
  • Insofar as the excess debt is owed to foreigners, its servicing costs represent a real transfer of resources outside the economy.
  • To the extent that the excess debt is domestic, its servicing costs usually represent a real transfer of resources from economic sectors that are more likely to use these resources for consumption or investment to sectors that are much less likely to use these resources for consumption or investment. In such cases, the intra-country transfer of resources represented by debt-servicing will reduce aggregate demand in the economy and consequently slow economic activity.
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