Arnold Kling  

Sovereign Debt Wonkery

The Housing-Oil Analogy... Brink Lindsey, Will Wilkinson...

I wrote Guessing the Trigger Point for a U.S. Debt Crisis for Mercatus. Don't assume that you understand it the first time you read it. This is a really difficult, subtle issue.

Think of the following as an analogy. A guy is paddling down a river without realizing that he is headed toward a waterfall. When is the last point that you can warn him in time so that he can paddle to safety? It depends on how fast the river is moving, how fast he can change direction, how strongly he can paddle, and so on.

The sovereign debt crisis trigger point is like this problem, only one level deeper. You don't win by guessing the last point at which the guy can make it to safety. Instead, imagine that you have a bunch of people standing next to the river placing bets on whether or not the guy makes it to safety. Your job is to pick the point at which the folks doing the betting will believe he can no longer make it to safety. That is what the trigger point for the sovereign debt crisis looks like. (For those of you familiar with Keynes' beauty contest analogy, there is something similar going on here.)

In any case, this an issue where academics generally fear to tread. Rogoff and Reinhart have taken a lot of grief for their magic number of 90 percent ratio of debt to GDP. And that is for a less striking prediction. They just want to predict the point at which you will see economic growth slow down, not the point at which you get a sovereign debt crisis. I'm trying to tackle the harder issue.

Comments and Sharing

CATEGORIES: Fiscal Policy

COMMENTS (12 to date)
Ted writes:

Trying to guess the debt crisis trigger point, when considering a self-fulfilling crisis like you are, is basically pointless since 2nd generation-like attacks aren't determined by fundamentals per-say. My guess is we actually won't see a fiscal crisis in the United States. I frankly don't believe even our politicians would allow it and my suspicion is most investors feel the same I do. The idea of the U.S. defaulting seems rather absurd and I think this is enough to prevent a self-fulfilling crisis. My guess is the most probable scenario is that our politicians will go through a war of attrition over the next decade or so and eventually we'll either see some type of fiscal reform (possibly one that just pushes back the day of reckoning further, but some type of reform). In terms of an actual economically harmful event in the near-term, my guess is that it wouldn't be a sovereign debt crisis. My guess would be stagflation. Again, let's assume that investors believe that the idea of the U.S. defaulting is absurd, like I believe. But if they also believe that the politicians won't enact reforms the most plausible outcome would seem to be the formation of expectations that central bank independence will be removed. If that happens, through the traditional expectations mechanism, inflation begins to rise. However, because this inflation is entirely expected by the private sector all this does is create "stagflation." Furthermore, if taxes are raised to help with the debt burden you could well witness a simultaneous aggregate supply shift that will create lower output.

As a side note, Reinhart & Rogoff have been rightly criticized. Their study is not rigorous - it's just a crude correlation. Another very simple explanation to explain the correlation is that countries are adverse to such high levels of debt and so debt levels are only that high either due to a some type of crisis that leads to low growth or the government imposes heavy taxes to bring the debt level down, which impedes growth. They make no attempt to establish causality, even in the slightest. And if you really dig into the historical record you'll find there story doesn't hold. Most of the examples they list the causality is going from low growth to high debt, not the other way around. And the other examples I saw the cases could either be explained by contractionary monetary policy or an overvalued exchange rate (the exchange rate was pegged too high, for example, to join the EMU). The only valid examples I can find of high debt leading to low growth is where the government imposes burdensome taxes in order to bring the growth rate down, but that says more about high taxes than debt per-say. And this final case is the biggest concern I have for the United States. Also, there study illustrates the problem of doing economic history without using any narrative record.

Dan Weber writes:
Japan’s high debt ratio may also be explained by captive lenders. To the extent that Japanese savers are confined to using savings institutions that invest in government debt, the Japanese government may, up to a point, be insulated from a shift in confidence.

Is this so? If so, a footnote explaining it would be awesome.

Stephan writes:

I admit due to time I had only a brief look. But the paper seems to start with a funny joke. Likening the federal government to a private sector household with a credit-card? Then the reference to the discredited RR paper. My first impression: this AK paper itself is a joke and any undergraduate would have serious problems to underwrite it.

Stephan writes:

Ahhh an before I forget it. I've learned from the New Yorker "Covert Operations" that the Koch Brothers pay you Mercatus guys big bucks to disseminate this sort of nonsense but I think you can try harder and be more subtle.

Rebecca Burlingame writes:

Reinhart and Rogoff's book about sovereign debt was really a good read. It also made me feel less silly about concentrating on what could potentially happen for the better, after falling off the waterfall.

Thucydides writes:

1)The CBO uses only debt held by the public, which may understate the problem. There is a large amount of debt held by the Social Security trust fund that when cashed in to pay benefits will result in additional Treasury borrowing. Why exclude it?

2)The CBO excludes some $5.6 trillion of Fannie and Freddie debt. What is the justification for not counting it? If you add back Fannie and Freddie and use total debt, not just that held by public, we are already at something like 130% of GDP.

3)CBO budget projections, even the alternative scenario, are ridiculously optimistic. Further, they use static estimates.

I believe this paper, which is most interesting, should point out that the true situation is probably much worse than CBO estimates.

John Thacker writes:
I frankly don't believe even our politicians would allow it and my suspicion is most investors feel the same I do. The idea of the U.S. defaulting seems rather absurd and I think this is enough to prevent a self-fulfilling crisis.

OTOH, if everyone believes that there's no way it would happen, then that can create a self-fulfilling crisis by discouraging people from agitating for and supporting the moves necessary to avoid the crisis. I'm not certain at which point the one danger outweighs the countervailing danger.

Quite a few people thought that the idea of the housing crisis, or Bear Stearns defaulting, or funds breaking the buck were "rather absurd" as well. If you're using the government response to that, TARP and everything else, as evidence for why things won't be that bad, well, that's a pretty scary silver lining.

Andy writes:

Ironic that the person most responsible for building the 2nd-gen models that Ted refers to is your old nemesis Olivier Blanchard.

Ted writes:


To my knowledge, the standard 2nd generation model was built by Maurice Obstfeld in the mid-1990s (based a lot on his earlier work in the mid-1980s).

In fact, to my knowledge, Olivier Blanchard has never written anything about currency crises.

8 writes:

It is a social phenomenon and therefore requires one to understand the crowd. What's the mood of the crowd, who makes up the crowd, what are their beliefs, etc.

Anecdotally, one thing I have been noticing is how some of the "strong dollar" people have been moving into the gold camp. It's at the fringe, but what happens to the "crowd" as marginal participants are positioned to profit from a sovereign debt crisis? It's like some of the strongest paddlers are climbing out of the boat and swimming to shore. Eventually, a sovereign debt crisis may be the transfer of wealth and power away from the current elite and to a new elite.

Jeremy, Alabama writes:

Guessing the trigger point is almost as hard after it has happened as before. All you know is that is happened, and there are then a hundred competing theories to allocate blame to one's favorite political enemies.

Trigger points for any major calamity is just as hard to identify. Try finding the "trigger point" for the War Between the States - was it really the firing upon Fort Sumter, or was it the US Army unit relocating to Fort Sumter, or was it the Missouri Compromise or the particulars about slavery in the Constitution?

I disagree with Ted that our country is run by people with the slightest pretense of statesmanship. Using Kling's analogy we are already over the cliff, but politicians don't care and neither does most of the electorate. The point of no return was FDR's social security programs or possibly Wickard v. Filburn, both of them a long time ago.

Ryan writes:

I think that the waterfall moment comes once the Japanese bond and currency markets collapse under the stress of too much debt, too little growth, and deteriorating demographics. Currently, Keynesians and those inclined to massive fiscal and monetary stimulus point to the example of Japan as to why the US does not need to worry about deficits and aggregate debt. Once this myth is debunked, the attitude of bond markets will be forever changed. Luckily for the US, we likely won't be first in line to be shot when attitudes shift.

Comments for this entry have been closed
Return to top