The new paper, from David Greenlaw, James D. Hamilton, Peter Hooper, and Frederic S. Mishkin, is the latest effort to quantify the “danger zone” that can put a nation in a bad place; it follows a similar effort by Carmen Reinhart and Kenneth Rogoff that found public debt above 90 percent tends to leave nations in a precarious position.
“Our nonlinear regression results imply that a country can quickly move from the group without problems to the group that faces nearly insurmountable problems if its debt rises significantly above 80 percent of GDP, particularly if it is running a large current-account deficit” the authors write, in a paper presented Friday morning at the University of Chicago-Booth School of Business monetary policy forum.
As it happens, by the measurement of net debt the authors use, the United States was at that 80 percent debt to GDP ratio that they view as a danger zone in 2011. In other words, the United States has worked itself into a place where it's already susceptible to a crisis.
“The obvious policy advice is to avoid getting into such a situation in the first place,” the authors write, which is true enough, but not particularly helpful for policymakers trying to decide what to do. And they acknowledge that once in this spot, simple budget cutting and tax increases to reduce deficits aren’t necessarily the answer. “Trying to deal with the problem purely by fiscal reform can put the country on a slippery slope,” they write. “Dramatic cuts in planned spending or increases in tax rates are contractionary and will lead to a drop in GDP. This in turn aggravates the country’s fiscal challenges.”
Considering that the paper was presented at a monetary policy conference, and that its authors include a former Federal Reserve governor (Mishkin), it seems not to grapple enough with the crucial difference between the United States and many of the countries that are among the nations included in the historical analysis the paper is based on. Almost all of the countries that have experienced major financial crises in the recent past have in some way lacked control over their currency. For Greece and Ireland, that is because they use the euro, whose value is determined by the European Central Bank, the value of which is better suited for Germany and France than for those troubled peripheral European economies. In the East Asian crisis of the late 1990s, much of the damage came about because the countries involved had borrowed money in dollars, so when the value of their domestic currencies fell they suddenly had more onerous debt burdens than they had expected.
So for the U.S. fiscal picture to be as dangerous as the paper suggests, one needs a story of how a crisis of confidence in U.S. debt leads to an outflow of capital and no offsetting effort by the Fed to ease policy, simultaneously strengthening growth and making interest rates lower. This paper doesn’t do that.
As Eric Rosengren, the president of the Federal Reserve Bank of Boston, put it in his response to the paper, the model that the authors use is “parsiminous.” Read: It's awfully simple, even simplistic, omitting a numer of important variables that determine whether a country is at great risk of crisis. Rosengren mentions financial strength of the banking sector in a country and its political system.
“While this paper provides a good discussion of tipping points, the coefficients and simulations should be viewed as indicative of a more general point – that policymakers should consider how a variety of public policies, including fiscal policies, can influence tipping points,” said Rosengren.
And as Fed governor Jerome Powell put it in a second response, the tipping points that the authors found "are driven to a great extent by the experience of smaller eurozone nations that, of course, borrow in euros. The United States borrows in its own currency--the world's primary reserve currency. That difference is crucial for investors." He notes that the United Kingdom and Japan, both, like the U.S., large countries with their own currencies, show no detectable rate increases. "These countries present a serious problem for the authors' case," Powell said.
The paper also has extensive analysis of potential future losses that the Fed could face from its large holdings of bonds acquired in recent years; more on that later today.