Monday, May 7, 2012

Reinghart and Rogoff, And Our Debt Overhang

In a recent NBER paper, Ken Rogoff and Vince and Carmen Reinhart address the long-lasting consequences of high public debt loads. The authors findings are shocking to many - especially those who choose to look at 10Y Treasury rates as an indication of stress (as opposed to our earlier note on the stresses beginning to occur in the less financially repressed USA sovereign CDS market). Across 50 countries, they find 26 periods of public debt overhangs where the government has pushed gross public debt to GDP over 90% and held it there for at least five years. The stunning reality of their empirical work is four-fold: 1) the median duration of these overhang periods in 23 years (that's a lot of can-kicking); 2) real GDP growth averages 1.2% lower than trend during these overhangs; 3) real GDP drops by on average around 25% at the end of the deleveraging episode; and 4) most critically, "waiting for markets to signal a problem may be waiting too long because governments have the ability to suppress market signals." So while all the chatter of renewed growth in Europe has us ebullient with an unchanged US equity market today, the longer-term reality is - unless this time is different, there's a long and painful road ahead.

From Vince Reinhart's Morgan Stanley note:
Some Observations

Nations rarely move into a region where gross public debt is greater than 90 percent. Across 22 advanced economies since the early 1800s, there have been 26 such episodes lasting five years or more. When they get there, they stay there a long time. The median duration is 23 years.

The neighborhood is scary, in that economic growth averages 1.2 percentage points less relative to the years outside of debt overhang episodes. The duration and growth differential of those episodes compounds: In the typical experience, the level of real GDP is about 25 percent lower at the end of an episode than the experience outside the episode would have predicted.

The reason for this subpar economic performance is not always the force of market discipline pushing up real interest rates. Rather, high government debt induces some other form of crowding out of the private sector. This might include a reliance on distorting taxes to pay the interest service on the debt or more direct restrictions on finance that creates a captive market for government debt. The former concerns the dead-weight loss from taxation, and the latter is sometimes known as “financial repression”. Financial repression includes directed lending by captive domestic audiences, explicit or implicit caps on interest rates, regulation of cross-border capital movements, high reserve and capital requirements, and moral suasion applied to regulated entities.
In such circumstances, waiting for markets to signal a problem may be waiting too long because governments have the ability to suppress market signals. Despite the absence of market signals, or perhaps because of it, growth often suffers.