Wednesday, August 8, 2012

High Government Debt: A Bang or a Whimper?

Watching the travails of the euro area in the last few years, it seems as if the negative consequences of high government debt are likely manifest themselves with a bang: that is, a scenario in which investors fear that the debt will not be repaid, and thus begin demanding much higher interest rates for being willing to hold the debt, which then makes it impossible for the government to repay. Rounds of financial panic alternating with recrimination follow, while the economy of the country flounders. In a roundabout way, this scenario is oddly comforting for Americans, because there is no sign in the financial markets (and remember, financial markets look toward future interest rates, not just current rates ) that U.S. Treasury debt is anywhere near to experiencing a surge in its perceived riskiness.

But in the Summer 2012 issue of my own Journal of Economic Perspectives, Carmen M. Reinhart, Vincent R. Reinhart and Kenneth S. Rogoff offer a different scenario in "Public Debt Overhangs: Advanced-Economy Episodes since 1800." They argue that very high levels of government debt can also lead to a debt-without-drama situation in which interest rates rise little or not at all, and no deep financial crisis occurs--but the economy nonetheless suffers a prolonged slowdown in its long-term growth rate. 

They begin by collecting the available data on advanced economies from 1800 to 2011, and found 26 situations in which the ratio of gross government debt/GDP in a certain country exceeded 90% for at least five years. U.S. government debt passed the gross debt/GDP ratio in 2010, but because it has not remained in that zone for five years, the current U.S. debt experience is not included in their group of 26 examples. They point out many patterns in this data, but here, I would emphasize three:

  • When the government debt/GDP ratio climbs above 90%, it tends to remain there for awhile. They find only a few examples where the 90% ratio was reached that lasted less than five years--mainly cases of wartime debts that declined quickly after the war. As they note: "the 26 episodes of public debt overhang in our sample had an average duration of 23 years." Some countries had multiple lengthy episodes of high government debt. "For example, since 1848 (when the public debt data is available), Greece leads the way with 56 percent of the debt/GDP ratio observations above 90 percent."
  • "However, we find that countries with a public debt overhang by no means always experience either a sharp rise in real interest rates or difficulties in gaining access to capital markets. Indeed, in 11 of the 26 cases where public debt was above the 90 percent debt/GDP threshold, real interest rates were either lower, or about the same, as during the lower debt/GDP years."
  • "Consistent with a small but growing body of research, we find that the vast majority of high debt episodes—23 of the 26— coincide with substantially slower growth. On average across individual countries, debt/GDP levels above 90 percent are associated with an average annual growth rate 1.2 percent lower than in periods with debt below 90 percent debt; the average annual levels are 2.3 percent during the periods of exceptionally high debt versus 3.5 percent otherwise." The cases of high debt/GDP ratios and fast growth are typically cases of a bounceback from postwar rebuilding.
In discussing how government debt might lead to slower growth, there is a challenging problem of determining cause and effect. It is possible that high government debt leads to reduced growth, perhaps by leading to lower levels of domestic investment as government borrowing soaks up the available financial capital. (The authors do not have long-term data on investment levels to test this hypothesis.) But it is also possible that a country with slow economic growth might find it easier to build up excessive government debt and harder to muster the economic resources or political decision-making to reduce that debt. In all of these scenarios, high government debt and slow growth accompany each other--but which is the cause and which is the effect?

Reinhart, Reinhart, and Rogoff cite a number of studies using different groups of countries over different time frames, along with statistical approaches that seek to clarify the question of cause and effect (for example, instrumental variables, generalized method of moments estimation, measuring growth with five-year averages that are determined by other variables and thus not subject to feedback effects, fitting data to an endogenous growth model, and the like). They find:

 "We would not claim that the cause-and-effect problems involved in determining how public debt overhang affects economic growth have been definitively addressed. But the balance of the existing evidence certainly suggests that public debt above a certain threshold leads to a rate of economic growth that is perhaps 1 percentage point slower per year. In addition, the 26 episodes of public debt overhang in our sample had an average duration of 23 years, so the cumulative effect of annual growth being 1 percentage point slower would be a GDP that is roughly one-fourth lower at the end of the period. This debt-without-drama scenario is reminiscent for us of T.S. Eliot’s (1925) lines in “The Hollow Men”: “ This is the way the world ends/Not with a bang but a whimper.” Last but not least, those who are inclined to the belief that slow growth is more likely to be causing high debt, rather than vice versa, need to better reconcile their beliefs with the apparent nonlinearity of the relationship, in which correlation is relatively low at low levels of debt but rises markedly when debt/GDP ratios exceed the 90 percent threshold. Overall, the general thrust of the evidence is that the cumulative economic losses from a sustained public debt overhang can be extremely large compared with the level of output that would otherwise have occurred, even when these economic losses do not manifest themselves as a financial crisis or a recession. ..."

"This paper should not be interpreted as a manifesto for rapid public debt deleveraging exclusively via fiscal austerity in an environment of high unemployment. Our review of historical experience also highlights that, apart from outcomes of full or selective default on public debt, there are other strategies to address public debt overhang including debt restructuring and a plethora of debt conversions (voluntary and otherwise). The pathway to containing and reducing public debt will require a change that is sustained over the middle and the long term. However, the evidence, as we read it, casts doubt on the view that soaring government debt does not matter when markets (and official players, notably central banks) seem willing to absorb it at low interest rates—as is the case for now."