Are sovereign debt crises inevitable?
What’s at stake: Historical experience – as shown in a new book by Carmen Reinhart and Ken Rogoff (“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”) – suggests that “balance sheet” crises driven by excessive private sector leverage lead to economic recoveries that are slow, anaemic and below trend for many […]
What’s at stake: Historical experience – as shown in a new book by Carmen Reinhart and Ken Rogoff (“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”) – suggests that “balance sheet” crises driven by excessive private sector leverage lead to economic recoveries that are slow, anaemic and below trend for many years and often lead, down the line, to serious sovereign debt problems given the massive re-leveraging of the public sector. They conclude that there is a “strong link” between banking crises and sovereign defaults. In fact, they state, banking crises can help predict sovereign debt crises. Carmen Reinhart has a new working paper out that’s an extremely valuable resource: more than 100 pages of charts showing the history of debt and banking crises in many countries.
Mohamed El-Erian writes that many metrics speak to the generalised nature of the disruption to public finances. His favourite comes from Willem Buiter, Citi’s chief economist. More than 40 per cent of global GDP now resides in jurisdictions (overwhelmingly in the advanced economies) running fiscal deficits of 10 per cent of GDP or more. For much of the past 30 years, this fluctuated in the 0-5 per cent range and was dominated by emerging economies.
Paul Krugman writes that it’s not so much that bad things happen to growth when debt is high; it’s that bad things happen to debt when growth is low. Krugman wonders about the Reinhart Rogoff result that bad things happen when debt goes above 90 percent of GDP, given the ability — documented in the new Reinhart paper — of some advanced countries to manage debt burdens as high as 250 percent of GDP. To him, the causal relationship seems to largely run from growth to debt rather than the other way around. This is definitely the case for the United States: the only period when debt was over 90 percent of GDP was in the early post-war years, when real GDP was falling, not because of debt problems, but because wartime mobilisation was winding down and Rosie the Riveter was becoming a suburban housewife. It’s also clearly true for Japan, where debt rose after growth slowed sharply in the 1990s. And European debt levels didn’t get high until after Eurosclerosis set in.
Andrew Scott argues that markets have financed much larger levels of debt than are currently predicted for the UK and US. Given the enormous financial shock these economies have experienced, they might actually be better off with high debt for a long period of time. Although economics is quiet on the issue of what it means for debt to be too high it does tell us that in the face of large temporary shocks the optimal response is for debt to show large and long lasting swings. If bond markets are incomplete then we know from Barro (1979) and Aiyagari et al (2002) that debt should act as a buffer to help the government respond to shocks. In other words, in response to large short term shocks government debt should show decade long shifts. These optimal swings may even appear unsustainable for significant periods of time – even though, by design, they are not.
The curious capitalist notes that a frequent contributor to those sovereign debt crises is “hidden debts” – for example, private debt that unexpectedly becomes public as a result of the crisis. Reinhart and Rogoff write that in a crisis, government debt burdens often come pouring of out the woodwork, exposing solvency issues about which the public seemed blissfully unaware. One important example is the way governments routinely guarantee the debt of quasi-government agencies that may be taking on a great deal of risk, most notably as was the case of the mortgage giants Fannie Mae and Freddie Mac in the United States. Indeed, in many economies, the range of implicit government guarantees is breathtaking. Nouriel Roubini outlines a related point and writes that the right solution to a debt problem is reduction – via default and restructuring – of excessive debts and their conversion into equity. If instead private debts are not reduced and converted into equity but rather, as happened, excessively socialised, the ensuing public debt accumulation may eventually lead to direct capital levies (default) or indirect ones (inflation). Thus, advanced economies will face in the next few years serious issues of public, private and foreign debt sustainability together with weakened economic growth.
Stephen Cicchetti, economic adviser at the BIS, argues that current estimates of public debt ignore the big problem: age-related expenditure. Long-run fiscal prospects, largely driven by ageing, are dire. Projecting forward Cicchetti finds that ratios of public debt to GDP could reach 250 per cent of GDP in Italy by 2050, 300 per cent in Germany, 400 per cent in France, 450 per cent in the US, 500 per cent in the UK and 600 per cent in Japan.
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