Opinion

Felix Salmon

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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And, of course, there are many more links at Counterparties.

Comments
4 comments so far | RSS Comments RSS

So if the US has a lot of debt, and the EU has a lot of debt, and Britain has a lot of debt, and Japan has a lot of debt, and China (which probably has a lot of debt) doesn’t float its currency, how will any of those economies drive the value of the dollar down?

We’ve had huge budget deficits ever since W cut taxes and started wars, and the dollar only really started to lose value when the world became aware of just how little attention the reluctant regulators paid to borrowers’ ability to pay off loans, and were worried the US finance system was going to collapse. And ever since then, even with bigger deficits that were designed to help the economy recover from the credit crisis, the dollar has been on a steady, if bumpy, rise (the euro was worth about $1.55 five years ago; now it’s $1.30).

So really, if everybody else with a viable currency is borrowing, what problems does US borrowing cause now?

Posted by KenG_CA | Report as abusive
 

@KenG, if you’ll pardon the pun, all of modern economics is a confidence game. We trade paper and electronic chits that have no intrinsic value, and count ourselves “wealthy” when we accumulate large quantities of these in our electronic accounts. Yet this system is more than a scam, because people have confidence in it. If people lose confidence in the currency, in the artificial measure of wealthy, then it will begin to fall apart. And if people see it beginning to fall apart, that will feed the mass hysteria. No particular reason you can’t have a “bank run” on a currency, and that doesn’t require a viable alternative.

My guess is that we aren’t terribly near the “debt precipice”, but it will take at least a decade to turn this battleship around. As others have noted, attempts to abruptly cure deficits can (at least initially) worsen the situation rather than improving it.

I’m actually quite pleased that Obama got overridden on the sequester. That is only a small step towards fiscal sanity, but small steps are BETTER than large steps in this case. Combine that with a little job growth (as we are presently seeing) and we might not be as far from sustainability as it initially appeared we would be.

Now, can we prevent Congress from immediately giving back these gains?

Posted by TFF | Report as abusive
 

The problem with leverage is that it reduces the margin of error. Highly-levered companies go bankrupt more often because they have to pay the contractual debt service even if business conditions deteriorate. If global debt increases, the probability of a debt-deflation also increase. It is reasonable to be concerned about debt, at some point.

My problem with these analyses of US debt has to do with its measurement. According to Bloomberg, debt held by the public is $11.4 trillion, or 75% of GDP. There is no justification for counting “bonds” held by the Social Security Administration–whose liabilities are subject to statutory revision–as equivalent to those held by 82 year-old Aunt May. If our debt/GDP ratio is only 75%, we aren’t anywhere close to the “precipice.”

Posted by Publius | Report as abusive
 

If Japan is any indication, the US can probably go over 200% debt to GDP before the markets start to worry. Right now, the shortage is in a lack of safe harbor investments. As far as the free market is concerned the US just isn’t issuing enough IOUs.

Posted by Kaleberg | Report as abusive
 

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