The insightful authors of "This Time It's Different" Carmen Reinhardt and Ken Rogoff are at it again, doing a simple yet crucial empirical analysis correlating sovereign debt (both government and external), and inflation (in some case) with GDP growth. It will come as no surprise to anyone that the more indebted a country is, with a government debt/GDP ratio of 0.9, and external debt/GDP of 0.6 being critical thresholds, the more GDP growth drops materially. Alas for the US, which is on the wrong side of this threshold, at the rate Geithner is issuing debt, the US economy will be able to grow organically, and not through stimulus after Keynesian stimulus, only after the administration manages to find a way to reduce its massive and growing debt load. In other words never.
The core findings of the paper:
First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies. Second, emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.
Why does debt soar? Based on Reinhart and Rogoff research this is the natural response to virtually every financial crisis:
Government debt has been soaring in the wake of the recent global financial maelstrom, especially in the epi-center countries. This might have been expected. Using a benchmark of 14 earlier severe post-World-War II financial crises, we demonstrated (one year ago) that central government debt rises, on average, by about 86 percent within three years after the crisis.
We don't need to know that precisely this is happening to the US right now: as the Fed assumes ever more private sector debt, and the administration pushes ever more problems into the future, both of these activities have to be financed, with the sad result being that every 1-2 weeks the US Treasury is forced to auction a staggering $80 billion + of new debt.
Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long run macroeconomic impact or higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?
Graphically, the relationships of economic growth and inflation to debt load can be seen in the graph below:
As the authors point out: "From the figure, it is evident that there is no obvious link between debt and growth until public debt reaches a threshold of 90 percent. The observations with debt to GDP over 90 percent have median growth roughly 1 percent lower than the lower debt burden groups and mean levels of growth almost 4 percent lower." And a little something for inflationists: "The line in Figure 2 plots the median inflation for the different debt groupings—which makes plain that there is no apparent pattern of simultaneous rising inflation and debt." Yet "There are exceptions to this inflation result, as Figure 3 makes plain for the Unites States, where debt levels over 90% of GDP are linked to significantly elevated inflation." And as the topic of analysis of every economic inquiry undoubtedly is the US, the relationship between inflation and debt load does not seem a definitive one.
A more granular look at the various debt load buckets reveals the following: "Over the past two centuries, debt in excess of 90 percent has typically been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), and compared with growth rates of over 3 percent for the two middle categories (debt between 30 and 90 percent of GDP). Of course, there is considerable variation across the countries, with some countries such as Australia and New Zealand experiencing no growth deterioration at very high debt levels. It is noteworthy, however, that those high-growth high-debt observations are clustered in the years following World War II."
A detailed look at the US alone is presented below:
It would be interesting to see the administration reconcile this empirical observation with the current plan of solving any and all economic problem by issuing more debt.
A more pronounced relationships between inflation and debt levels becomes apparent when mapping external debt and GDP growth, inflation:
As one can see, the growth thresholds for external debt are considerably lower than for the thresholds for total public debt. Growth deteriorates markedly at external debt levels over 60 percent, and further still when external debt levels exceed 90 percent, which record outright declines. In light of this, it is more understandable that over one half of all defaults on external debt in emerging markets since 1970 occurred at levels of debt that would have met the Maastricht criteria of 60 percent or less. Inflation becomes significantly higher only for the group of observations with external debt over 90 percent.
To see where the US falls in comparison to other countries when comparing changes in the debt-to-GDP ratio, the authors provide the following chart:
Lastly, and especially for the US, the authors also do a longitudinal analysis of private debt-to-GDP. The conclusion will not come as a surprise to deflationists: "Just as a rapid expansion in private credit fuels the boom phase of the cycle, so does serious deleveraging exacerbate the post-crisis downturn. This pattern is illustrated in Figure 7, which shows the ratio of private debt to GDP for the United States for 1916-2009. As the box in the figure illustrates, periods of sharp deleveraging tend to associated with much lower growth and higher unemployment. The magnitude of the current deleveraging episode in the United States has no counterpart in the post-war period. In varying degrees, the private sector (households and firms) in many other countries (notably both advanced and emerging Europe) are also unwinding the debt built up during the boom years. Thus, private deleveraging may be another legacy of the financial crisis that may dampen growth in the medium term."
The authors' conclusion should be very carefully considered, especially when the alternative is merely absorbing ludicrous amounts of hopium coming from the administration's TV actor for any given day:
"A general result of our “debt intolerance” analysis, highlights that as debt levels rise towards historical limits, risk premia begin to rise sharply, facing highly indebted governments with difficult tradeoffs. Even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia...[C]ountries that choose to rely excessively on short term borrowing to fund growing debt levels are particularly vulnerable to crises in confidence that can provoke very sudden and “unexpected” financial crises. Similar statements could be made about foreign versus domestic debt, as discussed. At the very minimum, this would suggest that traditional debt management issues should be at the forefront of public policy concerns...[W]e note that even aside from high and rising levels of public debt, many advanced countries, particularly in Europe, are presently saddled with extraordinarily high levels of total external debt, debt issued abroad by both the government and private entities. In the case Europe, the advanced country average exceeds 200 percent external debt to GDP. Although we do not have the long-dated time series needed to calculate advanced country external debt thresholds as we do for emerging markets, current high external debt burdens would also seem to be an important vulnerability to monitor."
With the US hell bent on testing every cautionary statement in the paper, with the debt to GDP ratio likely to surpass the 100% barrier within a year, we can't wait for the sequel to this paper in the near-future, in which the authors confirm that the U.S. experiment is an abject failure in every aspect of fiscal and monetary policy.