Bond Market May Not Warn When Debt Crisis Strikes
One by one, European nations are letting their voices be heard, tossing out the party in power and voting in those who, in some cases, have a more radical agenda or, in others, are just willing to say “no” to the status quo. A bas l’austerite! Down with austerity! Up with growth!
If only it were that simple. That’s how the trade-off is being portrayed, and perhaps that’s what policy makers pushing the idea, and individuals on the receiving end, want to believe. With many euro-zone countries in recession, one can understand the appeal. Spend more, grow more and presto! The debt shrinks in relation to the economy and becomes more manageable.
“Wishful thinking,” said Carmen Reinhart, a senior fellow at the Peterson Institute for International Economics in Washington, who knows a thing or two about debt. “You seldom grow your way out of debt. The historic experience is very rare.”
Reinhart, along with husband Vincent R. Reinhart, chief U.S. economist at Morgan Stanley, and Harvard University economist Kenneth Rogoff offer some sobering advice for the struggling euro countries, as well as other nations, in an April working paper, “Debt Overhangs: Past and Present.”
To summarize the major findings: Forget about growing your way out of debt. Too much debt depresses growth, often for as long as two decades. Debt isn’t solely a cyclical phenomenon. Real interest rates may be as low during debt overhangs as they were before.
And one more point of note for the “What, me worry?” crowd: Just because bond markets in countries perceived as safe, such as the U.S., are blase about the debt load, it would be a mistake to ignore the lessons of history.
“Those waiting for financial markets to send the warning signal through higher interest rates that government policy will be detrimental to economic performance may be waiting a long time,” the authors wrote in their paper.
Now for some of the details, starting with a definition. The economists define a “debt overhang” as a five-year period when gross public debt exceeds 90 percent of gross domestic product. According to this metric, Italy, Greece and Japan are charter members of the club, with their most recent episodes beginning in 1988, 1993 and 1995, respectively. The U.S. isn’t in the debt doghouse just yet, given that it first breached the 90 percent threshold after the 2008 financial crisis. But it’s on the waiting list, along with Belgium, Iceland, Ireland and Portugal.
The economists’ study of prolonged periods of high debt, 26 cases in all, found that economic growth is 1.2 percentage points lower than in other periods. The average duration of debt-overhang episodes is 23 years, producing a “massive” shortfall in output that is almost one-quarter less, on average, than in low-debt periods.
In a challenge to German Chancellor Angela Merkel, the authors found that austerity isn’t a cure for excessive debt either. “High debt episodes involve all kinds of explicit or under-the-table restructuring,” Reinhart said in a telephone interview.
Under the table? Just call it debt forgiveness. Finland was the only country to repay its World War I debt to the U.S., Reinhart told me. By the time the Great Depression ended and World War II was under way, the countries were allies. And what’s $10 billion of unpaid debt between friends?
Restructuring is fraught with its own set of problems. “It’s disorderly, associated with growth shocks, but it’s part of a solution,” Reinhart said.
Then and Now
I was getting more depressed by the minute, trying to see a way out of the debt mess. After all, Greece has been in debtors’ prison for more than half of the last 160 years. Is this what the future holds for the rest of the debt bingers?
One of the 26 case studies in “Debt Overhangs” offered some hope: The U.S. made a complete recovery from the 1944-1949 episode. Maybe it could happen again. I called Reinhart back to ask her the secret formula.
“The U.S. did three things,” she said. “Balanced budgets, financial repression and robust growth in the 1950s and 1960s.”
The first is a pipe dream, with the federal deficit set to exceed $1 trillion in 2012 for the fourth consecutive year. World War II defense spending was easy to unwind once hostilities ended. Today’s necessary cuts to entitlement programs are a bigger challenge.
No. 3, robust growth, is probably not in the cards either. Transitioning from a wartime economy to a consumer-driven one, with returning soldiers eager to buy homes and cars, was a snap compared with today’s demographics.
The second, which I saved for last, is financial repression. That entails keeping nominal interest rates low, and real interest rates negative, and allowing a bit of inflation to reduce the real value of the debt. (Savers, be forewarned.) The Federal Reserve did just that during and after the war, pegging interest rates to help ease the government’s debt burden. It wasn’t until 1951, with the Treasury-Federal Reserve Accord, that the central bank won its independence.
One wonders if we are seeing a repeat of that complicit behavior today. The Fed has pledged to hold its benchmark interest rate near zero at least through late 2014. That would make it six full years of providing financial institutions with free money and prodding them to lend and take risk.
I used to think this was a case of academics finding a real-world application for rational expectations theory: If people expect something to happen, they will behave as if it already happened.
Now I’m not so sure. If Reinhart is correct, financial repression is an accepted part of rehab. What happens, then, when the treatment regimen produces adverse side effects?
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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