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Debt and growth. Debt and growth. The basic exercise and key results
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Debt and growth • The basic exercise and key results Our analysis was based on newly compiled data on forty-four countries spanning about two hundred years. This amounts to 3,700 annual observations and covers a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. • The main findings of that study are: • First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP.1 Above the threshold of 90%, median growth rates fall by 1%, and average growth falls considerably more. The threshold for public debt is similar in advanced and emerging economies and applies for both the post World War II period and as far back as the data permit (often well into the 1800s). • Second, emerging markets face lower thresholds for total external debt (public and private) – which is usually denominated in a foreign currency. When total external debt reaches 60% of GDP, annual growth declines about 2%; 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 US, have experienced higher inflation when debt/GDP is high). The story is entirely different for emerging markets, where inflation rises sharply as debt increases. • - Carmen M ReinhartKenneth Rogoff
The Cost of Austerity • Suppose you slash spending equal to 1 percent of GDP • A weaker economy means less revenue. Assume that every dollar up or down in GDP means $0.25 in revenue, which is conservative. Then the fiscal austerity reduces revenue by 0.35 percent of GDP; the true saving is only 0.65 percent. • The government has to borrow those funds; let’s say the real interest rate is 3 percent The long run impact of the austerity on the fiscal position is to reduce real interest payments by 0.0195 percent of GDP. • What if there are long-run negative effects of a deeper slump on the economy? workers driven permanently out of the labor force. There’s also the negative effect of a depressed economy on business investment. • The real interest payments saved by a 1 percent of GDP austerity move are less than .02 percent of GDP; if the marginal tax effect of GDP is 0.25, that means that a reduction of future GDP by .08 percent is enough to swamp the alleged fiscal benefits. • Austerity fail even at the task of helping the budget balance
Bill Gross (PIMCO) • Both parties, in fact, are moving to anti-Keynesian policy orientations, which deny additional stimulus and make rather awkward and unsubstantiated claims that if you balance the budget, "they will come." It is envisioned that corporations or investors will somehow overnight be attracted to the revived competitiveness of the U.S. labor market: Politicians feel that fiscal conservatism equates to job growth. It's difficult to believe, however, that an American-based corporation, with profits as its primary focus, can somehow be wooed back to American soil with a feeble and historically unjustified assurance that Social Security will be now secure or that medical care inflation will disinflate. Admittedly, those are long-term requirements for a stable and healthy economy, but fiscal balance alone will not likely produce 20 million jobs over the next decade. The move towards it, in fact, if implemented too quickly, could stultify economic growth. Fed Chairman Bernanke has said as much, suggesting the urgency of a congressional medium-term plan to reduce the deficit but that immediate cuts are self-defeating if they were to undercut the still-fragile economy.
GIPSIs The horizontal axis shows gross debt as a percentage of GDP at the end of 2009; the vertical axis shows the budget deficit as a percentage of GDP in 2009. The US, UK, and (as you can’t see) Japan look similar enough to the crisis countries As of right now, the interest rates on 10-year bonds are 3.59% in the UK, 3.36% in the US, 1.29% in Japan. CDS spreads for Japan and the UK are only about a third of the level for Italy. All the crisis countries are in the eurozone
Greece/U.S. “The numbers on our federal debt are becoming frighteningly familiar. The debt is projected to equal 140 percent of gross domestic product within two decades. Add in the budget troubles of state governments, and the true shortfall grows even larger. Greece’s debt, by comparison, equals about 115 percent of its G.D.P. today.” -David Leonhardt (NYT)
“Britain is the next Greece!” • Britain ran a primary deficit — that is, a deficit not counting interest payments — of 9.5 percent of GDP last year. That’s larger than Greece’s 8.5 percent. • Britain had debt of 68 percent of GDP,
Speece and Grain • 7 fat years after the creation of the euro, experiencing large capital inflows and relatively high inflation. • Now the bubble has burstgovernment revenue has collapsed • Country must achieve relative deflation — reduce its costs and prices compared with Germany and France, regaining competitiveness. • With German inflation low, this means an extended period of deflation, with high costs in employment and output. It also means fiscal difficulties, requiring spending cuts and tax increases that deepen the slump. • The immediate crisis risk is that of a self-fulfilling loss of confidence by bond investors, who fear default and therefore demand interest rates so high that they force default, even if the country is willing and able to endure a lot of pain Hence the loan guarantees: by providing money at not-so-punitive rates, the idea is to buy time for adjustment. • By itself, however, this wasn’t enough for Greece: people looked at the program, saw that it would probably lead to rising, not falling, debt as a percentage of GDP, and concluded that it wasn’t any kind of solution. And the crisis rolled on, with contagion to Portugal and Spain. • Now: from the EU ministers a larger version of the failing Greek plan • Treating a solvency problem as if it were a liquidity problem.
Devalue? • Argument: since Greece’s debt is in euros, devaluing won’t relieve the debt burden — so it won’t help. • True, devaluation wouldn’t reduce the debt burden. But it would reduce costs of fiscal austerity. • Greece is running a huge primary deficit, so even if it were to stop paying any debt service it would be forced to slash spending and/or raise taxes, to the tune of 8 or 9 percent of GDP massively contractionary effect on the Greek economy, leading to a surge in unemployment and a further fall in revenues. • If Greece had its own currency offset contraction with an expansionary monetary policy — including a devaluation to gain export competitiveness. • A devaluation wouldn’t reduce the need for fiscal adjustment, but it would reduce the costs associated with fiscal adjustment.
Default and Austerity “The credit default swap (CDS) for the Icelandic state has now dropped to 200 points and has not been lower since many months before the banking collapse in October 2008. The CDS has been in constant decline since January and indicates growing faith in Iceland’s economy.” -Iceland Review • Meanwhile, the CDS spread for Ireland is 683 basis points.
Argentina • Austerity with a fixed exchange rate (because they’re on the euro) — imposes costs that are much greater than those needed simply to bring spending into line with income. • The austerity programs depress demand, leading to depressed economies, which not only magnifies the pain but even makes fiscal adjustment difficult thanks to reduced revenue.
From the WSJ: • From the WSJ: Greece's Budget Deficit Higher Than Expected • Greece's budget deficit in 2010 was 10.5% of gross domestic product, significantly larger than forecast ... Lower-than-expected government revenue was the main culprit behind the higher deficit number. ... The Greek government was targeting a 2010 deficit of 9.4% of GDP ...The missed target was "mainly the result of the deeper-than-anticipated recession of the Greek economy that affected tax revenue and social security contributions," the Greek government said in a statement after the Eurostatannouncement.More austerity coming - the beatings will continue until morale improves!The yield on Greece ten year bonds increased to 15.3% today and the two year yield is up to 24%. It seems like the markets expect a credit event soon.Here are the ten year yields for Ireland at 10.5%, Portugal up to a record 9.6%, and Spain at 5.5%. • (4/26/2011)
June 2010 • “The Irish approach to tackling the recent recession,” investment adviser Michael Johnston said, “was vastly different than the strategies implemented by the U.S. and much of the rest of the developed world. Most governments cranked the printing presses into high gear and began injecting round after round of capital into the global economy. Ireland went the opposite direction, imposing draconian budget cuts and reeling in government spending.” • The Irish approach worked in 1987-89 — and it’s working now. • This is a lesson that Washington should learn sooner rather than later. -Alan Reynolds is a senior fellow at the Cato Institute
