from Greenberg Center for Geoeconomic Studies

Debt Recovery: A Balancing Act

Early stimulus withdrawal would hurt the U.S. economy, but the U.S. Treasury needs to announce a debt-reducing strategy to buoy market confidence, says sovereign debt expert Carmen Reinhart.

March 18, 2010

To help readers better understand the nuances of foreign policy, CFR staff writers and Consulting Editor Bernard Gwertzman conduct in-depth interviews with a wide range of international experts, as well as newsmakers.

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Economic Crises

United States

The United States’ growing debt is being viewed with increasing alarm internationally, as countries like Greece and Iceland struggle with burgeoning deficits and civil unrest. In February, the Obama administration created a bipartisan debt commission to address a debt that could grow to 64 percent of GDP in 2010. But that hasn’t reassured credit rating agencies, which still question how long foreign lenders will continue offering favorable interest rates on U.S. debt, or lenders like China, which are concerned about continued U.S. government spending.

Carmen Reinhart--a research associate at the National Bureau of Economic Research and coauthor of This Time is Different: Eight Centuries of Financial Folly with Harvard Professor Kenneth Rogoff--says early withdrawal of fiscal stimulus would do more economic harm than good. Still, the Treasury department needs to announce a clear strategy for dealing with the debt to buoy market confidence, she says. While some economists suggest using moderate inflation to curb U.S. debt, Reinhart says "we have fiscal measures at hand that would do the job without resorting to inflation."

How well has the Obama administration balanced the competing needs to both address the U.S. recession and manage longer-term U.S. debt?

My view on that tradeoff between dealing with a financial crisis and a recession is that we should learn from the experience of the Great Depression and also from the experience of Japan. In both of those cases, the stimulus was withdrawn prematurely. It was declared a victory: that the recession was over, that the depression was over. The consequence of declaring an early victory was an early withdrawal of the stimulus. In both instances, the economy rolled over and died and wound up with the worst of two worlds, which was a very weak economy and rising debts, because the renewed weakness in the economy had adverse consequences for stimulus.

While the debt profile is a major source of concern, or should be, what is called for at this point is a well-articulated exit strategy.

My view has been one in which you deal with the recession first. While the debt profile is a major source of concern, or should be, what is called for at this point is a well-articulated exit strategy. You don’t need to implement it today, but you need to have it today. And that is to especially deal with confidence issues that are arising. The last thing that you want to portray is an image where things are, in the medium term, spinning out of control and there’s no sound, articulated plan to deal with it.

How should other immediate spending priorities--on healthcare, jobs, defense--be weighed against growing U.S. debt?

Some may feel we have a great luxury of time in correcting fiscal imbalances and worrying about debt ten years down the road. I think we should be concerned with debt implications of any fiscal action that is taken. We need a good sense that we are on a recovery path before withdrawing stimulus, but that doesn’t preclude us from having a plan in which all the fiscal actions--on the revenue side or on the expenditures side--are evaluated very much with the debt implications in mind. This is not an area where we can delay. Delaying would be a risky strategy, because market sentiment can turn very quickly, and what is seen as a fairly tame medium-term scenario can be viewed very negatively in short order. Those kinds of negative surprises, which make for interest rate increases and rises in risk premiums, we cannot take for granted. We cannot take for granted that we are going to be able to finance our debts and deficits with near zero interest rates.

Should the United States tighten fiscal policy before tightening monetary policy, as your colleague Kenneth Rogoff has suggested?

I don’t have a preset view on that, because I don’t forecast inflation, and inflation has not been an issue thus far. The real signal for [tightening] monetary policy is seeing a resumption of more normal economic activity first, which we haven’t yet seen conclusively. We have good reasons to believe we’re rebounding, but there are big question marks on the magnitude of that rebound. But whether fiscal has to tighten before or after monetary, that’s something we’re going to have to play by ear. However, the Fed has been more forthcoming in articulating an exit strategy. The Treasury has at this stage not put forth a comparable, convincing plan to curb the deficit and the debt over the medium term. It’s a very politically divided subject, and the Fed of course has the advantage that it can speak with one voice, much more concisely than the current administration can do so.

How do you expect the eventual pain of U.S. debt-reducing measures to compare to, say, Greece’s experience?

First of all, Greece has had a very high debt ratio for years, and the hardships associated with the global downturn have made it evident that, when you’ve already got very high debt, you can’t pile more on top of that. So they were in some important sense already on a different strata in terms of their debts. Also, Greece has a very patchy credit record. They have defaulted numerous times in the past since independence and have been in a state of default through the mid-1960s--that’s not ancient history. So, their credit-worthiness makes them more vulnerable. However, it doesn’t mean that even without taking the extreme Greek scenario, we wouldn’t face debt hardships of a different type. Let me point out something very concrete: We could be downgraded. Japan, which is a country that lends to the rest of the world, was downgraded several times after its banking crisis in 1992 and the collapse of its asset market. The prospect of a downgrade is not something to look forward to even if it doesn’t turn into something more dramatic than that.

In your March 2010 NBER paper with Rogoff, you note that economists tend to analyze financial crises based on debt and defaults going back only several decades, whereas you examine several centuries. How does that change the conclusions drawn about debt cycles?

It makes one more cognizant that when you look at long horizons, you find that countries’ histories are not as pristine as one would assume if one only focuses on the last ten to twenty years. Some advanced economies had quite a history of default and repeated, severe banking crises. So, the severity of the current crisis and the fact that the current crisis has hit the advanced economies particularly hard--that it’s been much more of an advanced economy phenomenon rather than emerging markets--that’s very pre-World War II. Since then, the severe banking crises and debt problems such as those Greece is facing--with a handful of exceptions--were largely in the domain of emerging markets. You have to go back to the thirties and before that to see what we’ve seen in the last couple years. So that longer horizon has helped us understand the current global advanced economy context of this crisis.

And that indicates that advanced economies are more at risk than we’ve assumed them to be?

I am more skeptical about inflation as a tool for reducing debt, especially if markets begin to anticipate that that will be the outcome.

Absolutely. If you go back to pre-2007, before all of this starts to unwind, it was very much the view that not only were such crises more in the domain of emerging markets, but there was a broad sense of complacency, a discussion of the "great moderation," where business cycles in the advanced economies--notably in the United States--had been tamed, that even recessions like those of the early 1980s were a thing of the past. This sense of complacency was bred upon focusing on a very narrow window of time.

Can you respond to Paul Krugman’s recent blog post, which questioned your and Rogoff’s conclusion that growth is negatively impacted when a country’s debt goes above 90 percent of GDP? He says many advanced countries have managed debt burdens as high as 250 percent of GDP and speculates that the reverse is true--that debt increases in the absence of growth.

Let me first say that in our work, and we made this very clear, we don’t do causation. We simply state that in periods of high debt, average to medium growth rates have been lower. And that that is true when we pooled the data from forty-four countries, and it is true for the longer period which for many countries goes back to the 1800s, and it is also true in the post-war. That encompasses a lot of variability. If you look at the periods of high indebtedness in Australia for example, it’s right after World War II, and they had pretty good growth, but you can’t extrapolate from a couple years.

The results we have, which show contemporaneously when debt is high, growth rates are lower, is a cross-country result. That is robust across sub-samples, and it is robust across advanced economies, and it is robust across emerging markets. Now what about causality, which we have not tested for and do not claim to test? What Paul is saying is in periods of low growth, you get higher debts. That goes without saying. If you look at the work we did on the aftermath of financial crisis, we state very clearly that in our sample, three years after the most severe banking crisis, public debt--real public debt--goes up by about 86 percent and, furthermore, the reason that debts surge is predominantly driven by the collapse in revenues. So it stands to reason that debt increases a lot when you have recessions, when you have negative growth outcomes. But that doesn’t imply that it goes in one direction.

Rogoff has recently suggested using a moderate level of inflation to temper U.S. debt. Do you think that’s a wise strategy, and has it been successful anywhere in the past?

Debts have been inflated away partially in both advanced economies and most notoriously in emerging markets. The most successful efforts to inflate away debt would be if it were a surprise. If people start to expect that debts are going to inflated away, you will start to see that in interest rates. So we are left with engineering inflation surprises, and we have fiscal measures at hand that would do the job without resorting to inflation. Not that those fiscal measures are exactly popular measures. When you talk about reduction in spending and benefits and increases in taxes, certainly you’re not going to win any popularity contest, but then again I don’t think people like high inflation either. So I am more skeptical about inflation as a tool for reducing debt, especially if markets begin to anticipate that that will be the outcome.