Book Review: A Decade of Debt
A Decade of Debt. 2011. Carmen M. Reinhart and Kenneth S. Rogoff.
Reviewed by Jerry H. Tempelman, CFA
In the wake of the global financial crisis, mainstream economists have begun to realize that financial markets need to be incorporated into their theoretical frameworks. The traditional view holds that asset prices ultimately reflect underlying economic activity. But it turns out that economic activity is, in turn, directly affected by asset prices, which is why the pathbreaking work of Carmen M. Reinhart and Kenneth S. Rogoff, economics professors at the University of Maryland and Harvard University, respectively, is so valuable. Their research offers a wealth of empirical data concerning the impact of debt on macroeconomic activity, as well as an analysis of the data. Because their analysis tends to be in the form of narration rather than econometric equations, it is highly accessible, even to nonspecialists.
A sequel of sorts to their acclaimed best-seller, This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009), A Decade of Debt is shorter and summarizes some of the authors’ research that has appeared in academic journals since the publication of This Time Is Different.
In A Decade of Debt, Reinhart and Rogoff document that the public and private debts of industrialized nations have grown to unprecedented levels relative to their GDPs. Historically, high public debt levels have been reduced not through higher macroeconomic growth but, rather, through a combination of austerity measures and default. Default can occur through repudiation and restructuring, which is how debt incurred during World War I and the Great Depression was typically unwound. Default can also occur through what has been called financial repression, which refers to such government-imposed measures as ceilings on interest rates, regulatory requirements that effectively create captive audiences that extend credit to the government, and direct governmental influence on the ownership or management of financial institutions.
Financial repression is how governments of advanced nations dealt with the debt they ran up during World War II. It is likely also — Reinhart and Rogoff hypothesize — how they will deal with the debt incurred in the effort to support national banking sectors during the recent financial crisis. Because historical episodes of delevering have tended to last as long as seven years, the authors suggest that we are currently in the middle of “a decade of debt,” extending from 2008 to 2017.
Empirically, it turns out that a large public debt burden lowers macroeconomic growth, even without explicit sovereign debt default. Specifically, in what the authors call their “main finding,” advanced economies tend to experience lower growth once their public debt begins to exceed 90 percent of GDP (emerging market economies reach this threshold at 60 percent). This finding is consistent with other research.
Reinhart and Rogoff note that spikes in public debt have historically come from issuance to finance war (e.g., World Wars I and II). During peacetime, sudden increases in public debt are typically in response to systemic financial crises, as governments effectively assume the credit risk of sizable amounts of private debt. Public debt due to fiscal profligacy tends to build up more slowly over time. Systemic financial crises, Reinhart and Rogoff find, are often the result of a large increase in private sector debt.
The authors point out that financial repression can occur via directed lending to government by such captive domestic audiences as national pension funds. In the United States, this claim finds support in the most recent annual report of the Social Security trust fund, whose trustees estimate the net present value of the program’s shortfall to be $17.9 trillion. Although this implicit debt is not yet included in the country’s debt-to-GDP ratio, it will morph into explicit debt over time. Barring some form of entitlement reform, the sheer magnitude of this number suggests that things will indeed be different in the future, albeit not for the better.