Does Debt Matter?

“Does Debt Matter?” is the question posed by The International Economy to 20 commentators: “The recent scrutiny of the popularized version of the Rogoff-Reinhart thesis (that growth plummets when debt exceeds 90 percent of GDP) makes clear there are no simple formulas for determining the risks in the level of a nation’s debt. …Can a realistic guide be fashioned for determining whether a nation’s debt has reached a danger zone? Or are countries from here on expected to pursue fiscal reforms only if and when a crisis sets in?”

My response is yes, debt matters.

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I don’t think I know of anyone who believes that a high level of debt is without adverse consequences for a country. There is no magic threshold in the ratio of debt to GDP, 90% or otherwise, above which the economy falls off a cliff. But if the debt/GDP ratio is high, and especially if the country’s interest rate is also high relative to its expected future growth rate, then the economy is at risk. One risk is that if interest rates rise or growth falls, the economy will slip onto an explosive debt path, where the debt/GDP ratio rises without limit. In the event of such a debt trap, the government may have no choice but to undertake a painful fiscal contraction, even though that will worsen the recession. (The resulting fall in output can even cause a further jump in the debt/output ratio, as it has in the periphery members of the eurozone over the last few years).

None of that means that austerity in the midst of a recession is a good idea. Reinhart and Rogoff never said it was, either in their research or in their policy advice. Rather, as Keynes said, the time for fiscal austerity is during the boom, not during the recession. Indeed, a good reason to reduce the debt/GDP ratio during a boom is precisely to create the space for fiscal stimulus during a downturn.

No, countries should not be told “to pursue fiscal reforms only if and when a crisis sets in.” Rather, high-debt countries should take advantage of periods of growth to eliminate budget deficits before a crisis sets in, so that they do not find themselves in a debt trap. The time to fix the hole in the roof is when the sun is shining. Most European countries failed to take advantage of the growth years 2002-2007, to strengthen their budgets, and are now paying the price. The Greeks spectacularly failed to do so, with the result that they have had to go up on the roof to attempt to fix the hole during a thunderstorm, a task that is unpleasant, difficult, dangerous – and probably impossible.

If you want to identify some research that has misled politicians, go for the papers suggesting that fiscal contraction is not contractionary and that it may even be expansionary. It is true that sometimes a country may have no alternative to fiscal contraction; but that does not mean it is expansionary, especially if the currency cannot be devalued to stimulate exports.

The United States also failed to take advantage of the growth years 2002-07 to run budget surpluses. But fortunately our situation is completely different from Greece’s: our creditors are happy to hold dollar bonds, even at rock-bottom interest rates. They are not imposing on us short-term recession-inducing fiscal austerity. We should not impose it on ourselves while the economy is still weak. Instead, we should take steps now that will restore fiscal discipline in the future.

For all 20 responses to the “Does Debt Matter?” question, see the symposium in the spring 2013 issue of The International Economy.