Can We Recover from the Public Debt Crisis? Of Course We Can
June 9, 2015
by Laurence B. Siegel
Michael Mauboussin: Challenges and Opportunities in Active Management And Using BAIT #MICUS
“If something cannot go on forever, it will stop.” – attributed to Herbert Stein
Is the world facing a public-debt crisis, or is too much debt just another headache we will muddle through? How can investors distinguish between countries that are likely to default or otherwise injure debtholders, such as through high inflation, and those that will resolve their debt problems and emerge stronger? How can countries deal with high and rising levels of debt and return their finances to a sound footing?
In a recent article, “Dealing with Debt,”1 the husband-and-wife economic team of Carmen and Vincent Reinhart, along with Kenneth Rogoff, carefully studied the dynamics of high levels of public debt, and how governments have acted to reduce it. (Rogoff and Carmen Reinhart, who wrote the controversial and tremendously valuable book This Time is Different, are Harvard professors, and Vincent Reinhart works at the American Enterprise Institute.2)
Earlier, Stephen Sexauer, then at Allianz Global Investors, and Bart Van Ark of the Conference Board studied strategies by which countries can reduce their debt levels through economic growth.3
This article summarizes the findings of both of these teams and concludes with suggestions for investors.
Don’t we owe the debt to ourselves?
First, a word of caution: debt is not harmless, even if it’s all domestic (“we owe it to ourselves”). The U.S. has a lot of domestic debt, meaning that some Americans owe a lot of money to other Americans. The first group is taxpayers and the second group is bondholders – savers, pension beneficiaries, and so forth. Some people are in both groups but almost all are either net creditors (they are owed money) or net debtors (they have to pay). If there is a debt default or a burst of inflation that amounts to a default, the creditors become losers and the debtors become winners. These wins and losses affect wealth, spending, and investment in ways that slow growth and often lead to a worse crisis.
You cannot ignore domestic debt!
If some of the debt is owed to foreign lenders (bondholders), the situation is made a little more complicated, but not much. A default would increase domestic spending and decrease foreign spending, at least in the immediate run; longer-run consequences are harder to assess. But debt owed to foreigners is not economically all that different from debt owed to domestic bondholders.
Private debt is not harmless either. I worry less about private debt than about public debt because private agents – households and corporations – are subject to market discipline and have to weigh the cost of taking on debt against the benefit of holding the assets they use the debt to buy. (The 2008 mortgage fiasco shows that this mechanism does not work perfectly, to say the least.)
Governments, in contrast, can use debt proceeds to buy votes, a process that does not instill confidence in the quality of the decision to take on another unit of debt. But households have to service both piles of debt! They have to pay their taxes and their private debts. So one must add private to public debt when calculating the overall burden of debt in the economy.
When do governments increase their indebtedness? When do they reduce it, and how?
Reinhart, Reinhart, and Rogoff (henceforth “R3”) begin by observing that governments, at least in advanced countries, do not typically tolerate high levels of debt (more than 90% or 100% of GDP) for long.4 They run up debts during a war or depression and take steps to reduce the debt burden once the crisis is resolved. The R3 data are extensive and meticulously assembled, but the authors offer no economic theory as to why 90% or 100% is the cutoff. These levels have been suggested as a rule of thumb indicating the debt burden is so high that steps need to be taken, sometimes rapidly, to avoid a collapse and some form of default, but the real danger point depends on the specifics of each case.
R3 classify the steps taken to reduce debt into “orthodox” and “heterodox” categories. Orthodox steps include the “Boy Scout” method of raising economic growth rates above nominal interest rates, so that the debt burden reduces on its own. Of course, governments don’t fully control the growth rate, or we would all be rich. Limits to growth are set by the speed of innovation, the cost of inputs and competition from other countries. Governments can, however, maintain control of their own outlays such that the nominal growth rates are positive but below those of GDP and tax revenue. Sexauer and Van Ark show that this always works, mathematically, to decrease the debt-to-GDP ratio. Other orthodox methods are “austerity” (reductions in government spending) and selling government assets; this approach has a mixed track record (think Greece).5
- Reinhart, Carmen, and Kenneth Rogoff. 2009. This Time Is Different: Eight Centuries of Financial Folly. Princeton, NJ: Princeton University Press. The book made the case that beyond a public-debt-to-GDP ratio around 90%, economic growth is significantly impacted, making it difficult to reduce the debt level. Not long after, three authors (Herndon, Ash, and Pollin ) gleefully reported that Reinhart and Rogoff had made a math error, and the “debt hogs” – my name for people who believe that governments can borrow indefinitely without consequence – took the error as evidence for their cause. It’s not, and wherever you draw the tipping point, beyond which debt becomes significantly harder to repay, high levels of debt are not good. Debt service crowds out other uses of funds, high taxes discourage growth and investment, and savers suffer from negative real interest rates.
- Sexauer, Stephen C., and Bart Van Ark. 2010. “Escaping the Sovereign-Debt Crisis: Productivity-Driven Growth and Moderate Spending May Offer a Way Out.” Executive Action Series, Conference Board, New York.
- Emerging countries typically have less debt, at least partly because they “run into problems at lower public debt levels than do advanced economies” (R3, footnote 4 on page 8). But emerging countries also differ more from each other in their debt levels – Argentina is a case in point.
- I put the word “austerity” in scare quotes because it has become politically charged and has thus lost much of its meaning. See my comment on p. 1 of “The Tooth Fairy Economics of Jeff Madrick,” Advisor Perspectives, December 2, 2014.
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