Monday, August 16, 2010

Criticizing the Notion of a Debt “Threshold”

John Irons and Josh Bivens are skeptical of the Reinhart and Rogoff conclusion that there exists a well-defined threshold (90%, in their estimation) of government debt relative to gross domestic product (GDP) above which economic growth is hindered. Read their paper here .


“While nobody would dispute that financial crises caused by excessive debt have inflicted large economic costs on many countries through time, these crises have generally not afflicted modern economies—like the United States’—that can borrow in their own currency and that have independent monetary and exchange rate policies. A review of the academic literature on sovereign debt defaults (Manasse and Roubini 2005) finds that it is exposure to currency risk that dominates the probability of debt default or financial crisis. This same review sets out a classification system to sort countries into those safe from debt crises versus those who are not safe—and the simple ratio of public debt to GDP is not found to be a useful predictor variable for this.

Lastly, given that the market for U.S. treasuries is the most liquid and transparent market in the financial world, interest rates in this market should be a barometer of investors’ expectations about the prospect of the U.S. government being unable to service its debt. Today, in- terest rates in these markets are at historic lows, reflecting the very large demand by global investors who want to hold U.S. debt. In short, we seem very far from facing a financial crisis triggered by the unwillingness of these investors to hold U.S. debt (for more on why these low interest rates are a normal part of a recessionary economy, see Bivens (2010) and Irons (2010)).[1]

[1] Bivens, Josh. 2010. “Budget deficits and interest rates.” Briefing Paper #262. Washington, D.C.: Economic Policy Institute.

Irons, John. 2010. “No crisis in confidence—Evidence shows U.S. creditors still think U.S. debt remains safest in world.” Issue Brief #276. Washington, D.C.: Economic Policy Institute.

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