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CAMBRIDGE –Many, if not all, of the world’s most pressing macroeconomic problems relate tothe massive overhang of all forms of debt.In Europe, a toxic combination of public, bank, and external debt in theperiphery threatens to unhinge the eurozone.Across the Atlantic, a standoff between the Democrats, the Tea Party, and old-schoolRepublicans has produced extraordinary uncertainty about how the United Stateswill close its 8%-of-GDP government deficit over the long term. Japan,meanwhile is running a 10%-of-GDP budget deficit, even as growing cohorts of new retireesturn from buying Japanese bonds to selling them.
Aside from wringing their hands, what should governments bedoing? One extreme is the simplistic Keynesianremedy that assumes that government deficits don’t matter when the economy isin deep recession; indeed, the bigger the better. At the oppositeextreme are the debt-ceiling absolutists whowant governments to start balancing their budgets tomorrow (if not yesterday).Both are dangerously facile.
Thedebt-ceiling absolutists grosslyunderestimate the massive adjustment costs of a self-imposed “sudden stop” indebt finance. Such costs are precisely why impecuniouscountries such as Greece face massive social and economic displacement when financial markets loseconfidence and capital flows suddenly dry up.
Of course,there is an appealing logic to saying that governments should have to balancetheir budgets just like the rest of us; unfortunately, it is not so simple.Governments typically have myriad ongoingexpenditure commitments related to basic services such as national defense, infrastructureprojects, education, and health care, not tomention to retirees. No government can just walkaway from these responsibilities overnight.
When USPresident Ronald Reagan took office on January 20, 1981, he retroactively rescindedall civil-service job offers extended by the government during the two and ahalf months between his election and the inauguration. The signal that heintended to slow down government spending was a powerful one, but the immediateeffect on the budget was negligible. Of course, a government can also close abudget gap by raising taxes, but any suddenshift can significantly magnify thedistortions that taxes cause.
If thedebt-ceiling absolutists are naïve, so, too, are simplistic Keynesians. Theysee lingering post-financial-crisis unemployment as a compelling justificationfor much more aggressive fiscal expansion, even in countries already runningmassive deficits, such as the US and the United Kingdom. People who disagreewith them are said to favor “austerity” at a time when hyper-low interest ratesmean that governments can borrow for almost nothing.
But who isbeing naïve? It is quite right to argue that governments should aim only tobalance their budgets over the business cycle, running surpluses during boomsand deficits when economic activity is weak. But it is wrong to think thatmassive accumulation of debt is a free lunch.
In a series ofacademic papers with Carmen Reinhart – including, most recently, joint workwith Vincent Reinhart (“DebtOverhangs: Past and Present”) – we find that very high debt levelsof 90% of GDP are a long-term secular dragon economic growth that often lasts for two decades or more. The cumulativecosts can be stunning. The average high-debt episodes since 1800 last 23 yearsand are associated with a growth rate more than one percentage point below therate typical for periods of lower debt levels. That is, after a quarter-centuryof high debt, income can be 25% lower than it would have been at normal growthrates.
Of course,there is two-way feedback between debt and growth, but normal recessions lastonly a year and cannot explain a two-decade period of malaise.The drag on growth is more likely to come from the eventual need for thegovernment to raise taxes, as well as from lower investment spending. So, yes,government spending provides a short-term boost, but there is a trade-off withlong-run secular decline.
It is sobering to note that almost half of high-debtepisodes since 1800 are associated with low or normal real (inflation-adjusted)interest rates. Japan’s slow growth and low interest rates over the past twodecades are emblematic. Moreover, carrying ahuge debt burden runs the risk that global interest rates will rise in thefuture, even absent a Greek-style meltdown.This is particularly the case today, when, after sustained massive“quantitative easing” by major central banks, many governments haveexceptionally short maturity structures fortheir debt. Thus, they run the risk that a spikein interest rates would feed back relatively quickly into higher borrowingcosts.
With many oftoday’s advanced economies near or approaching the 90%-of-GDP level thatloosely marks high-debt periods, expanding today’s already large deficits is arisky proposition, not the cost-freestrategy that simplistic Keynesians advocate. I will focus in the coming monthson the related problems of high private debt and external debts, and I willalso return to the theme of why this is a time when elevatedinflation is not so naïve. Above all, voters and politicians must beware of seductivelysimple approaches to today’s debt problems.
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