Counterparties: When debt becomes a problem

March 14, 2013

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If America’s debt is a problem — and both the GOP and Democratic budget plans, to varying degrees, say it is — just when should we start freaking out about it?

The recent econoblogspheric debate over this topic began with this paper by David Greenlaw and three co-authors. The paper’s findings in short: when a country’s gross debt-to-GDP ratio gets above 80%, and when it’s accompanied by persistent current account deficits, that country enters a debt “crunch time”. It becomes vulnerable to “rapid fiscal deterioration”, and suffers from “tipping-point dynamics” in the debt markets. This basically what happened to countries like Greece during the last few years — the market begins to worry about default, making it more expensive to borrow, which, in turn, makes the deficit worse. And so forth.

US gross debt stood at 103% of GDP in 2011, the paper says, so we’re already in the theoretical danger zone Greenlaw and his colleagues describe. But Paul Krugman and Matt O’Brien aren’t convinced, and argue that America won’t ever become Greece. O’Brien looked at the authors’ data and noticed one rather large exception to the rule: countries that can print their own currency don’t find themselves caught in a debt crunch. “There is no evidence of a debt tipping point for countries that borrow in money they can print.” If the market began panicking about US debt, the argument goes, the Fed could simply print more money.

Tim Duy argues that Japan is one big outlier to the “tipping point” theorem. Japan’s gross debt-to-GDP ratio was was 220% in 2011, it has recently started printing massive amounts of its own currency, and the cost of its debt has been steadily shrinking for the better part of a year. “Japan sticks out like a sore thumb that those preaching the unsustainability of government debt want to sweep under the rug,” Duy writes.

But James Hamilton, one of the co-authors of the paper, says that “printing money does not generate any magical resources with which to resolve a real fiscal shortfall”.

Sovereign debt markets can be irrational — a debt panic need not be related to anything particularly precise or fundamental. But cutting debt too quickly can make economic problems worse (we’re looking at you England!). Megan McArdle’s solution is sensible: back “slowly and cautiously” away from the debt precipice, even if it may not exist. — Ryan McCarthy

On to today’s links:

Ugh
Bad derivatives deals have left the near-bankrupt Detroit with a $350 million liability – Bloomberg

Big Brother
The US government will soon have unfettered access to your financial data – Reuters

Investigations
US regulators are looking into whether the gold market was manipulated – WSJ

Housing
Blackstone is going on a multi-billion dollar single-family home-buying spree – Bloomberg

JPMorgan
The London Whale is the “most dramatic recent example of poor internal controls” at JP Morgan – The Big Picture
The full Senate report on the London Whale – Senate Permanent Subcommittee on Investigations

Your Daily Outrage
Google decides it’s cool to be evil, kills beloved product because it can – Google Reader Blog
“Anyone who thinks social media is a valid replacement for an RSS reader, leave the room now” – YouTube

Servicey
Feedly has apparently cloned Google Reader – Feedly

Financial Arcana
Private equity finds a new way to drain cash from their portfolio companies – Dealbook

QTWTAIN
“Are there 40,000 exceptional hedge fund managers out there?” – Euromoney

Revealed
What the personal finance industry won’t tell you — a great conversation with Helaine Olen – Billfold

Wealth of Nations
By the end of the year, sovereign wealth funds will be even more wealthy – Reuters

Awesome
Brian Moynihan will help fix your credit score, if you email him nicely – Billfold

Depressing
The Iraq war has cost the US $2.2 trillion – Reuters
Migrating monarch butterflies are at their lowest level in at least 20 years – NYT

Wonks
Scott Sumner on flawed Keynesianism and blind faith in the 2009 stimulus – The Money Illusion

China
Despite decades of trying, China today “cannot build a globally competitive car” – Economist
Why “Django Unchained” made it past China’s state censors – Quartz

Alpha
Ackman: “The press is a necessary element of the strategy” – Advisor Perspectives

Fiscally Speaking
America’s fiscal problems in short: Unemployment today, deficits tomorrow – David Wessel

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