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Stimulating the Debt

Sharp analysis from Harvard's Kenneth Rogoff.

9:10 AM, Jul 21, 2010 • By MATTHEW CONTINETTI
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Kenneth Rogoff, coauthor of This Time is Different, in the FT:

The fact that the markets seem nowhere near forcing adjustment on most advanced economies can hardly be construed as proof that rising debts are riskless. Indeed, the evidence generally suggests that the response of interest rates to debt is highly non-linear. Thus, an apparently benign market environment can darken quite suddenly as a country approaches its debt ceiling. Even the US is likely to face a relatively sudden fiscal adjustment at some point if it does not put its fiscal house in order.

Some portray Japan, with nearly a 200 per cent government debt to income ratio, as a poster child for extremely indebted countries with low interest rates. Japan’s “success”, of course, has a lot to do with its government’s ability to sell debt domestically. How the country will handle its finances as saving by retirees shrinks and as its labour force rapidly shrinks, remains to be seen.

Similarly, the fact that postwar debts in the US and UK have exceeded 100 per cent of gross domestic product – a level that Ms Reinhart and I find to be above the threshold where growth might be affected – is hardly evidence not to worry about peace-time debt explosions. After a war, the natural phase-down in military expenditures combined with a surge of former soldiers into the workplace, makes it far easier to bring down debt-output ratios than after the kind of peace-time build-up we are now seeing. The risks of rising debt, while apparently far off, cannot be lightly dismissed.

At the same time, the stimulus benefits of massive fiscal deficits are not nearly so certain as proponents of a new surge of spending maintain. The academic evidence on Keynesian growth effects of fiscal deficits is thoroughly inconclusive. Ironically, a lot of the newfound conviction comes from the casual empiricism on the growth effects of the Bush tax cuts, evidence that few academics consider sufficient to outweigh the mass of previous results. Indeed, it will take researchers many years, perhaps decades, to sort out the effects of the massive fiscal stimulus that many countries undertook during the crisis. My guess is that scholars will ultimately decide that fiscal policy was far less important than monetary policy and measures to stabilise the banking system.

Buttonwood has more here.

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