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The Perils of Debt Complacency

CAMBRIDGE – “What a government spends the public pays for. There is no such thing as an uncovered deficit.” So said John Maynard Keynes in A Tract on Monetary Reform.

But Robert Skidelsky, the author of a magisterial three-volume biography of Keynes, disagrees. In a recent commentary entitled “The Scarecrow of National Debt,”Skidelskyoffered a rather patronizing narrative, in a tone usually reserved for young children and pets, about his aged, old-fashioned, and financially illiterate friend’s baseless anxiety about the burden placed on future generations by the rising level of government debt.

If Skidelsky’s point had been that some economies, including the United States, would benefit from higher infrastructure spending, even at the cost of more debt, I would agree wholeheartedly. Compelling reasons for boosting US public investment include deteriorating infrastructure, tepid growth, low interest rates, and limited scope for further monetary stimulus. For the US, such an impetus might be especially welcome as the Federal Reserve raises interest rates (albeit gradually) while other countries ease further or hold rates steady and the dollar likely strengthens.

But that was not the route Skidelsky took. Instead, in his critique of a commentary by Kenneth Rogoff, he argued that it is silly and passé for a country that can issue debt in its own currency to fret over medium-term debt levels. Call me old-fashioned, but that argument smacks of complacency and is not supported by evidence. On this score, Skidelsky confuses two different papers on debt and growth, a 2012 paper of mine, in which there were some alleged data concerns, with one that I co-authored with Rogoff and Vincent Reinhart, in which there were none.

Coming from an author who knows Keynes so well, such complacency disappoints. I cannot read How to Pay For the Warand conclude that Keynes thought that high war debts were a “scarecrow” for the United Kingdom. In fact, the apparatus of the Bretton Woods arrangements that Keynes subsequently helped to craft were designed to ease a difficult transition out of debt.

The case for near-term fiscal stimulus, even if in the form of increased infrastructure outlays, cannot ignore the medium-term outlook for economies with already large debt obligations, major entitlement burdens, aging populations, and what appears to be a steady downward drift in potential output growth.

As Skidelsky notes, debts have risen significantly in the UK and the US (among others) since 2008, while interest rates have remained low or declined. Should we therefore conclude that high debt is not linked to low growth via high interest rates (which crowd out private spending)?

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Reading a little further into my study with Rogoff and Reinhart, one would find that there was ‘‘little to suggest a systematic mapping between the largest increases in average interest rates and the largest (negative) differences in growth during the individual debt overhang episodes.”

Our research considered 26 high-debt episodes between 1800 and 2011, looking both at growth rates and at levels of real (inflation-adjusted) interest rates. In 23 of these high-debt episodes, growth was lower, and in eight growth slowed even as real interest rates remained about the same or edged lower. Japan’s debt overhang (entirely domestic currency debt), which we trace back to 1995, illustrates this pattern.

Why do high debt and slow growth coexist, despite cheap financing? High debt levels can and do constrain a country’s abilities to cope with adverse events. For example, some of Italy’s largest banks have been diagnosed as approaching insolvency and requiring substantial recapitalization. Not surprisingly, the confidence of Italian households and firms has been shaken, and capital flight has ensued. If Italy’s debt were not already 130% of GDP, might its government have been better positioned to provide the resources to tackle decisively its lingering banking and confidence problems?

Our 2012 study identified three ongoing public-debt overhangs that began in the mid-1990s – Greece, Italy, and Japan. Relative to other advanced economies, these three economies are the worst growth performers (see chart). To be sure, a country’s economic performance depends on many factors. But the view that it is low growth that causes debt to rise, though important when assessing the cyclical feedback effects, can hardly explain the two-decade experience of these three countries.

It is difficult to imagine a sustained revival of Greek growth without another round of haircuts and debt forgiveness from Greece’s official creditors, which now hold most of its debt. Italy depends critically on the continued large-scale purchases of its bonds by the European Central Bank (its Target 2 balances have recently climbed, reflecting capital flight). The Bank of Japan is going to greater and greater lengths to orchestrate an increase in inflation expectations and price growth, which can help erode the value of outstanding debts. (“For inflation is a mighty tax-gatherer,” as Keynes observed.) Other countries, like Portugal, are also struggling with low growth and weak fiscal positions.

Concerns about debt levels (public and private) have now extended beyond the advanced economies to many emerging markets. I cannot recall an instance of a government that is concerned about having too low a level of debt. Perhaps, it is because the debt scarecrow has teeth.

Skidelsky needs no reminder of the historical record, but it bears noting that more than a dozen advanced economies received debt relief in one form or another during the depression of the 1930s. The approach to unwinding current debts is likely to vary considerably across countries, but it is time to place greater emphasis on debt restructuring (which comes with a menu of options) than on accumulating more debt.

Carmen Reinhart is Professor of the International Financial System at Harvard University’s Kennedy School of Government. Accompanying this commentary is a chart, which you can download here.

By Carmen M Reinhart

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