Finance in the 21st Century
Debt and Delusion
Robert J. Shiller
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NEW HAVEN – Economists like to talk about thresholds that, if crossed, spell trouble. Usually there is an element of truth in what they say. But the public often overreacts to such talk.
Consider, for example, the debt-to-GDP ratio, much in the news nowadays in Europe and the United States. It is sometimes said, almost in the same breath, that Greece’s debt equals 153% of its annual GDP, and that Greece is insolvent. Couple these statements with recent television footage of Greeks rioting in the street. Now, what does that look like?
Here in the US, it might seem like an image of our future, as public debt comes perilously close to 100% of annual GDP and continues to rise. But maybe this image is just a bit too vivid in our imaginations. Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?
That would clearly be nonsense. After all, debt (which is measured in currency units) and GDP (which is measured in currency units per unit of time) yields a ratio in units of pure time. There is nothing special about using a year as that unit. A year is the time that it takes for the earth to orbit the sun, which, except for seasonal industries like agriculture, has no particular economic significance.
We should remember this from high school science: always pay attention to units of measurement. Get the units wrong and you are totally befuddled.
If economists did not habitually annualize quarterly GDP data and multiply quarterly GDP by four, Greece’s debt-to-GDP ratio would be four times higher than it is now. And if they habitually decadalized GDP, multiplying the quarterly GDP numbers by 40 instead of four, Greece’s debt burden would be 15%. From the standpoint of Greece’s ability to pay, such units would be more relevant, since it doesn’t have to pay off its debts fully in one year (unless the crisis makes it impossible to refinance current debt).
Some of Greece’s national debt is owed to Greeks, by the way. As such, the debt burden woefully understates the obligations that Greeks have to each other (largely in the form of family obligations). At any time in history, the debt-to-annual-GDP ratio (including informal debts) would vastly exceed 100%.
Most people never think about this when they react to the headline debt-to-GDP figure. Can they really be so stupid as to get mixed up by these ratios? Speaking from personal experience, I have to say that they can, because even I, a professional economist, have occasionally had to stop myself from making exactly the same error.
Economists who adhere to rational-expectations models of the world will never admit it, but a lot of what happens in markets is driven by pure stupidity – or, rather, inattention, misinformation about fundamentals, and an exaggerated focus on currently circulating stories.
What is really happening in Greece is the operation of a social-feedback mechanism. Something started to cause investors to fear that Greek debt had a slightly higher risk of eventual default. Lower demand for Greek debt caused its price to fall, meaning that its yield in terms of market interest rates rose. The higher rates made it more costly for Greece to refinance its debt, creating a fiscal crisis that has forced the government to impose severe austerity measures, leading to public unrest and an economic collapse that has fueled even greater investor skepticism about Greece’s ability to service its debt.
This feedback has nothing to do with the debt-to-annual-GDP ratio crossing some threshold, unless the people who contribute to the feedback believe in the ratio. To be sure, the ratio is a factor that would help us to assess risks of negative feedback, since the government must refinance short-term debt sooner, and, if the crisis pushes up interest rates, the authorities will face intense pressures for fiscal austerity sooner or later. But the ratio is not the cause of the feedback.
A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90% of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.
One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.
There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.
The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.
The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.
Robert J. Shiller is Professor of Economics at Yale University.
Copyright: Project Syndicate, 2011.
www.project-syndicate.org
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TheAmazingReset 06:44 22 Jul 11
Dr. Shiller you underling point is correct. Greece is not inslovent because its at 153% of GDP. It's also not insolvent because bond traders believe so. Its inslovent because no matter what "units" you use they can't pay the debt back because of limited growth prospects in a french/german controlled Union. In this global economy Greece has little to offer. They are in deep trouble because of basic economic principles. I invite you and other to join in a discusion on this at www.theamazingreset.blogspot.com I agree that there is no need for hysteria but this an issue that needs a serious "haircut." And its not one that will look good...
Donlast 11:00 22 Jul 11
Re: Debt and Delusion Multiplying nominal GDP by 40 is a huge unknown and unknowable. The 40 year debt commitments are well know and inescapable. The flow of interest payment obligations undertaken should be discounted back to current value and knocked off the incremental increase in nominal GDP. To describe that incremental rise in GDP as "economic growth" when it is solely due to the incremental rise in credit and debt is a gross fallacy. Economic growth comes from people, productivity, technology, market-oriented investment and risk taking. It never but never comes from credit and debt per se and it is a delusion to believe it so. It never has and it never will. When Keynes did his monumental work on the cause of sub-optimal employment he was concerned with two major aggregates, consumption and investment, which equates to savings - plus the external sector. Government , or "G" in today's standard and purely accounting equation, never came into it. Given the rigour of Keynes' intellect it never would have. He was concerned with analysis not with accounting labels which have little or no analytical or predictive value. Government spending financed by debt to tide over a period of investment deficiency was a TEMPORARY measure NEVER a permanent feature of his economic landscape. In Keynes landscape there was one inescapable fact that was immeasurable and could not be countered - uncertainty. I am sure he would have laughed Professor Shiller's debt delusion out of court.
viator 02:38 22 Jul 11
Got a terrible fever? Going to become critical ill or maybe expire? The cure is to break the thermometer. Then you'll be better.
Brynjo 04:07 22 Jul 11
You point about accounting for Debt/GDP in annual, quarterly, or decadal terms is useful, and does remind us that 100% is not a magic number, and there is nothing "mathematical" about a given debt to gdp ratio. Perhaps, given that we are not in a crisis right now, interest rates are low, inflation somewhat contained, there is no need for panic. However, you more than anyone else, have always said markets are not perfect, and the above metrics do not mean we can abandon all our experience, observation, and mathematical logic.
You did describe the Rogoff and Reinhardt results, which involved translating some of experience into quantifiable empirical presciptions. Kudos. However, we can also observe that in most emerging market countries, debt/gdp ratios start to become problematic when they exceed 40% or 50%. Developed countries are afforded more leeway, by convention, as well as due to confidence they pay lower interest rates so can support more debt. Maastrict, which was put together with ample input from intellectuals of all stripes (and few tea-partiers) strictly limited member state debt to gdp ratios to 60%. (Which was later abandoned, at their own peril!).
Lastly, though I'm a bit rusty on the particulars, my recollection is the the series of future debt to GDP ratios diverges (i.e. becomes untenable), if is it starts out at or above 100%, the interest rate on debt equals the nominal growth rate, and a nation does not want to be forced to run a primary budget surpluses.
carlson73 06:31 25 Jul 11
Professor Shiller, you are among the few economists who can deal with the fact that there is still as much your profession does not know as it does know about major economic course changes; your article "A People's Economics" was brilliant in stating what few economists, including the Fed Chairman, have publicly stated- almost the whole profession did not see the forest for the trees while at least a few serious investors did. (Neither did I, I saw the recession, but I had no clue Wall Street had completely gone to the dark side.)
Consequently, I do not see the purpose of an article essentially stating the ratio of Debt to GCP is meaningless, while offering nothing for the non-economist to use as a substitute measure of the state of our economy, and country's finances. Or even an alterantive vague theory. We are in a country where one party is scaring people with the short term, while the other scares it with the long-term. Citizens want someone to provide clarity to figure out who to support. Being told what data we can't use, with no substitute provided, by a profession that missed completely one of the great bubbles of the last century does not add to your professin's credibility or the public's confidence in your profession.
JerryLapell 11:19 03 Aug 11
Since, when debt rises, growth slows in ALL of the three categories Rogoff and Reinhart analyzed, then shouldn't voters and citizens ALWAYS scrutinize attempts to increase debt?
Increasing debt is even worse than I thought.
rienhuizer 12:59 04 Aug 11
Good to see a level headed post from a US economist!
AViirlaid 06:47 20 Aug 11
"Here in the US, it might seem like an image of our future, as public debt comes perilously close to 100% of annual GDP and continues to rise. But maybe this image is just a bit too vivid in our imaginations. Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?"
Maybe some lay-persons do, but I cannot think that Dr. Shiller is actually suggesting that any real investors do. If he is suggesting this, then like the term "Ricardian Equivalence" I predict that a new term "Shillerian Equivalence" will soon enter the economic lexicon.
The point of his article is valid. But still, as any nation's overall government debt goes higher (and concurrently therefore gets relatively riskier as per the sound evaluation of the financially-knowledgeable marketplace) the bond market does have a right to expect higher rates of return. Existing bonds will drop in price relative to the face value of their interest pay-outs. What is so surprising about that?
Bond yields of 6 percent (say for Italy or Spain) seem, relative to the recent historical European bond marketplace experience, to be inordinately high. But is this not just a case of having the borrowers be spoiled, at the cost of ripping off the savers who have made their savings available to those borrowers?
IMHO most of these rates (other than for Greece and Portugal) are yet not high ENOUGH to properly reward the Savers for the inflation risk they assume over the terms of these government bonds. In fact these rates are not high even relative to rates at certain times of incipient price inflation, or other economic system stress. Do America's 30-year Treasury-s at just over 3 % per annum really pay out enough to the Savers? No they don't, but that is a reflection of the nature of the Broken Money System we live in today.
The above sentiment is perhaps the better one to have written his article about --- namely, other than for Greece and Portugal, we have good reason to "cool it". Sure, all things equal, approaching 100% of GDP in a nation's federal debt is not sufficient reason for High Anxiety. But more importantly, paying out more return to Savers is only fair and rational.
Doomsday indeed for this reason alone, has not yet arrived. (Except for Greece and perhaps Portugal.
AViirlaid 07:01 20 Aug 11
"The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are."
NOT SO FAST. "Artificial"? "Irrelevant"...?
As to the "rational expectations" of the Bond Market, perhaps the market is not only looking at the Debt relative to the GDP, but also at the unfunded liabilities of some of these nations. Future Debt that will be auto-magically-added to a 100% Debt-to-GDP nation, with the prospect of low or no growth, would most certainly justify some of the fears of insolvency.
As intimated by 3 other posts (Donlast, viator,and Brynjo), Dr. Shiller did not mention that coming albatross in his article.
boryssoboliev 10:12 26 Aug 11
Dr.Shiller! Why the IMF since its' inception wanted client countries to keep public debt below 60% of GDP? I have heard these teachings from the IMF visiting staff since 1993 when Ukraine has joined the Bretton Woods agreements. Why you are teaching the guy like Larry Sommers who made us follow these rules?
Is it an umbiguity or gamble? How can the nation serve the debt over 100% GDP? By putting the burden on future generations?
Richard44 03:02 27 Aug 11
There is a big difference between household debt and government debt, particularly in the US: The government can take in more money by properly taxing the citizens. This might be the the functional equivalent of the individuals in the household taking on a second job, but my point is that it is possible to concieve of the problem (not just in the US) as a failure to tax properly, or wisely, rather than simply "excessive" (by some definition...) debt.
In the case of the US, it is obvious that income taxation was not properly considered in the Bush years, particularly considering that the "income" from housing refinances was absolutely untaxed, and that unearned income was a substitute for real economic growth. At present the argument about taxation in the US seems to involve some odd desire to destroy the govenment's ability to govern effectively. It also reflects the destructive effects of partisan politics.
Greece and less developed economies have a serious problem, because they have promised pensions and benefits to workers they simply cannot afford to pay. It reminds me of the bankruptcy facing various municipalities in the US caused buy excessive police and firemenn's pensions. It's not that we do not all have the highest regard to our policemen and the work they do, but we have done a lousy job of allocating our resources, and that error must be corrected. And the police and firement are not deserving of pensions much greater than other public workers.
Greece has the unfiortunate situation of looking more prosperous than it really is. It is possible that Greece simply cannot tax its citizens much more, so the only solution is to reduce benefits.
When I say properly taxing the citizens, I mean making sure that people pay according to fair and reasonable guidelines and that the taxes are progressive. People who make high incomes should not pay the same or lower tax rates than middle class individuals. It's that simple. If corporations are going to be taxed, then fairness has to be maintained in that area too.
At this point there has to be some analysis noyt just of the debt and GDP, but rather the taxation rates and the ability of the people to pay. If excessive government debt actually negatively affects economic growth, then proper taxation, that is, designed to deal with the issue, should not have a further negative impact. It might even be beneficial, not just by the mecahanical aspect of payment, but by the sense that the government actually has a plan and can perform its function.
Nichol 04:01 02 Oct 11
.. in the case of Greece: isn't that exactly an example of a country with a lot of up-side possibilities? If only they get a more efficient tax-collection system! If only they can improve their administration! If only they would do something about their corruption! If only they could sort out all their land-ownership issues, and map it! .. if only something happened to whip them up and get them motivated to actually make something out of their country. Oh.. could it be that this has just happened? Then isn't this exactly the moment for the EU to invest in this country? They do seem to have become a lot more serious about getting their government to actually work .. haven't they?
sooku 06:05 12 Oct 11
CONGRATULATIONS FOR USING THE CONCEPT OF FEEDBACK IN SOCIETY!
What about the economics-policy feedback loops? It's obviously a plurality of loops since it's a multi-input multi-output system. We need time-dependent dynamic models that include process coupling and feedback control, i.e. a method of deriving policy decisions directly from economic data. I would like to know why economists don't use the methods that have made technology so successful. There seems to be a fundamental missing link.
sooku 06:38 12 Oct 11
This is a response to viator 02:38 22 Jul 11
This is not about breaking the thermometer, it's about throwing out the ruler you were using in place of a thermometer.
RangerHondo 02:31 22 Jul 11
Lets look at debt to total gross wages & salaries of the private sector. After all government revenues are just a sub-set of the private sector wages & salaries. Stick a growth rate and a discount rate on that we can argue about and what's the NPV of the above?? What the government doesn't want you to know is that they have spent today and yesterday decades of your future wages & salaries.