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Noted for February 26, 2013

Economists Looking Under the Lamppost for Fiscal Doomsday

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Ryan Avent:

Debt crises: On predicting fiscal doomsday | The Economist: IT SURE seems like high public debt levels ought to represent a looming economic problem…

They do--but there are other, more serious economic problems we have now, to which government deficits can be an answer.\

Ryan goes on:

Why, then, is it so difficult to demonstrate, conclusively, that they are?… A new paper illustrates the trouble economists have when they try to show that debt is scary…. David Greenlaw, James Hamilton, Peter Hooper, and Frederic Mishkin conclude that "countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of… tipping-point dynamics". But their work is remarkably unpersuasive…. The regression covers 20 countries for years t = 2000 − 2011 for a total of 240 observations…. [I]f the country’s primary deficit increases by 1% of GDP (causing both gross and net debt to increase by one percentage point relative to GDP), the borrowing cost would increase by...4.5 basis points…. In choosing to study advanced economies, the authors specifically note the problem of "original sin" in studies of emerging markets—that countries which borrow in foreign currencies are subject to different debt dynamics—only to then use a sample in which most of the chosen economies are unable to print their own money. With that understood, the possibilities of spurious findings are clear…. [S]everal of the sampled economies did experience soaring debts and skyrocketing borrowing costs. Troublingly… yields reversed after the ECB effectively broke the link between banking system solvency and sovereign obligations, even though total debt stocks have continued to grow…. [T]he largest increases [in debt-to-GDP] occurred (in order) in Ireland, Greece, Spain, Japan, Portugal, Britain, and America. Yields over that time frame soared in Ireland, Greece, Spain, and Portugal, of course. But they fell, sharply, in Japan, Britain, and America. We can draw a lot of important macroeconomic lessons from the sample the authors consider, but I'm not sure that the universal danger of a debt stock above 80% of GDP is one of the top ones.

That is, I think, the takeaway.

Ryan goes on:

Does that mean that Japan, Britain, and America can relax? Not necessarily…. By 2020, the government will be dealing with the substantial fiscal demands of the Boomer generation. These factors might all push rates higher than they otherwise would be, thereby worsening the long-run debt outlook and pushing America toward a tipping point. Given these threats, why aren't American yields already soaring?… [Because] there are at least as many ways a bet on an American debt crisis could go wrong as there are ways it could go right. That's not an argument for complete fiscal irresponsibility in Washington. It does suggest that issues other than long-run fiscal sustainability may deserve a higher priority at the moment. And… there are good reasons to think that markets will continue to favour American debt in the short run…. [S]hort-run austerity may be counterproductive, leading to slower growth and a more dire fiscal position. The most fiscally responsible thing to do, in the short run, is to focus on growth….

[T]his paper seems to me to be another case in which the flimsiness of the empirics are the real story. If it is this hard to come up with convincing data showing that when the typical rich country with its own currency accumulates enough debt, nasty consequences and crises ensue, then maybe we should reflect on that a bit and re-examine the stories we're trying to tell.