Tag Archives: deficit

Does Debt Matter?

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“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:
          Yes, debt matters.   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 budget deficits during downturns.
          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. 


          [Comments on this blog can be posted at the Project Syndicate site.    For all 20 responses to the question, “Does Debt Matter?,” see the symposium in the spring 2013 issue of The International Economy.]
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McKinnon’s Claim that RMB-$ Appreciation Would Not Reduce Trade Imbalances

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The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?”   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

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