Four Economists Warn of Disaster: One Journalist Challenges Parametric Integrity and Statistical Significance
Econintersect: A paper presented at the U.S. Monetary Policy Forum, New York City, 22 February 2013 presents some grim warnings about tipping points for sovereign debt reaching sufficient levels to trigger negative feedback loops that would reinforce a rapid rise in interest rates as a substantial inflation risk premium would kick in. The study finds that there is a tipping point when debt reaches 80% of GDP. The conclusion of the paper is that the current environment in the U.S., with nominal sovereign debt at 103% of GDP, is at high risk of rapid fiscal deterioration.
The title of the paper is "Crunch Time: Fiscal Crises and the Role of Monetary Policy" and it attempts to focus, among other things, on difficulties for monetary policy when expanded central bank balance sheets are unwound. Negative feedback is reinforced when rising interest rates force the central bank to book capital losses for sale of assets of lower coupon when interest rates have risen. In the model negative feedbacks are aggravated perniciously for countries with current account deficits. Again the U.S. is "trapped" in that condition as well as the "excessive" debt to GDP ratio value.
One rough edge that shows in the analysis is found on page 52 of the paper:
...we used equation (18) only to predict the change in the interest rate premium, rather than its prediction for the overall level. One reason for this conservative approach is that our levels model would already be predicting an interest rate for the United States for 2012 that is higher than what we actually observed; the large-scale purchases by the Federal Reserve may be one factor that has helped keep interest rates down up to this point. For completeness, we display in Figure 3.15 the debt levels that would prevail if long-term yields were to rise immediately to the level predicted by our model as opposed to the CBO’s baseline assumptions and the gradual adjustment specified in our initial simulation.
The model had failed to correctly predict the interest rate for a year that was already over when the paper was presented.
Here is the conclusion from the Greenlaw et al paper, emphasis added by Econintersect:
In the aftermath of the global financial crisis, concerns about fiscal sustainability have come to the forefront in discussions of monetary policy. In this paper, we examined sovereign debt dynamics and concluded that countries with high debt relative to GDP should not be complacent, even if they currently face low sovereign interest rates. Such countries are always vulnerable to an adverse feedback loop in which high debt leads to higher interest rates and hence higher debt loads, culminating in a tipping point-- or fiscal crunch -- in which the interest rate shoots up.
Recent sovereign debt crises among advanced economies have provided a rich data base for empirical analysis of the sensitivity of sovereign yields to debt levels and other aspects of fiscal risk. Our empirical work used both econometric analysis and event studies, and suggests that countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics.
Current CBO projections for the U.S. assume constant borrowing rates as debt loads rise. If there is instead some feedback, as historical experience suggests there could well be, the problems facing the U.S. in the next decade could easily escalate into an unmanageable situation.
The dangers of a fiscal crisis raise issues about the appropriate response of monetary policy. Overly tight monetary policy may make fiscal consolidations harder to achieve, while unsustainable fiscal policy could lead to a situation of fiscal dominance in which the central bank is no longer able to keep inflation under control. A fiscal risk shock occurring within the next five years would complicate matters greatly for a Fed that will be in the process of exiting from its massive balance sheet expansion. Unsustainable fiscal policy could result in a large increase in the inflation risk premium for U.S. government debt, leading to possible substantial losses on the Fed’s balance sheet. This could further feed back into rising longer-term inflation expectations, raising the risk of an unwelcome surge in inflation.
If long-run fiscal policy were shifting in the right direction, consistent with a gradual decline in the debt burden, accommodative monetary policy would be the appropriate response to a weak economy. Unfortunately, such a shift in U.S. fiscal policy is still far from apparent, complicating significantly the choices for monetary policy makers.
An article critical of the Greenlaw et al paper has appeared in The Atlantic. Author Matthew O'Brien attacks the Greenlaw et al paper on primarly two grounds:
- Greenlaw et al failed to separately analyze data in two groups: One for countries sovereign in their own currency and the other for the rest.
- The Greenlaw analysis did not segregate debt owed domestically from debt owed to foreigners.
When O'Brien so segregates the data he finds that there is no evidence that the tipping point phenomenon exists for the U.S. or any other monetarily sovereign country. He says the evidince may not even exist for Eudrozone countries. From O'Brien:
There isn't any evidence that the U.S., or other countries that borrow in currencies they control, face some debt tipping point after which borrowing costs spiral out of control. There isn't even much evidence this is true of Europe's troubled economies. Borrowing costs fell for the PIIGS in 2012 (one year after Greenlaw & Co.'s sample ended), not because those countries reduced their debt burdens, but because the ECB promised to do "whatever it takes" to save the euro. A monetary backstop matters more than the amount of debt. Reducing debt isn't as empirically urgent as we hear.
Paul Krugman has said the Greenlaw et al paper "isn’t helpful at all; it ignores the key question in the whole debate." In an April 2011 paper, Paul de Grauwe discussed the very distinctions between Eurozone and monetarily sovereign EU members as a central issue in Eurozone governance. This paper was not referenced by Greenlaw et al. and this ommission was criticized by Krugman.
Note: James D. Hamilton, co-author of the Greenlaw et al paper, is a Global Economic Intersection contributor.
- Crunch Time: Fiscal Crises and the Role of Monetary Policy (David Greenlaw, James D. Hamilton, Peter Hooper, Frederic S. Mishkin, paper written for the U.S. Monetary Policy Forum, New York City, 22 February 2013)
- No, the United States Will Never, Ever Turn Into Greece (Matthew O'Brien, The Atlantic, 07 March 2013)
- Debt, Spreads, and Mysterious Omissions (Paul Krugman, The New York Times, 24 February 2013)
- The Governance of a Fragile Eurozone (Paul de Grauwe, University of Leuven and CEPS, April 2011)