On predicting fiscal doomsday

From Free exchange
February 25, 2013 - 2:59pm

IT SURE seems like high public debt levels ought to represent a looming economic problem. Why, then, is it so difficult to demonstrate, conclusively, that they are? It could be due to the econometric challenges posed by any macroeconomic issue: sample sizes are small and the possibility of any number of statistical biases throwing things off is large. Or it could be that debt levels simply aren't, in many cases, as bad as everyone seems to think. A new paper illustrates the trouble economists have when they try to show that debt is scary. In a paper prepared the US Monetary Policy Forum, economists David Greenlaw, James Hamilton, Peter Hooper, and Frederic Mishkin conclude that "countries with debt above 80% of GDP and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of...tipping-point dynamics". But their work is remarkably unpersuasive.They begin by exploring an intuitive framework for debt tipping points. Markets, in deciding what interest rate to charge sovereigns wishing to borrow, weigh the probability that explicit or implicit default will eventually rob them of expected earnings on their loans. Other things equal, a higher debt load translates into higher probability of default. If the outlook for growth deteriorates, or if political changes make sustainable fiscal policy less achievable, markets may again update their outlook. And if the current-account deficit is larger, suggesting that more of the debt is owed to foreigners, then the temptation to default is greater and the odds of default rise.The authors put together a model showing how a change in the above variables can lead markets to adjust their default expectations and raise the interest rate charged to the sovereign. But a higher rate worsens the fiscal outlook, leading markets to worry more and raise rates again. Under certain circumstances, expected sovereign borrowing can grow explosively, leading to a debt crisis.They then turn to a statistical exercise, and report their findings:The regression covers 20 countries for years t = 2000 − 2011 for a total of 240 observations. Interestingly, the coefficients on gross and net debt are both highly statistically significant. The regression suggests that if the country’s primary deficit increases by 1% of GDP (causing both gross and net debt to increase by one percentage point relative to GDP), the borrowing cost would increase by...4.5 basis points.How to parse this, though? I was immediately concerned by the data sample: 20 advanced economies over 12 years. What's particularly distressing is that just over half of the sample countries are members of the euro zone. In choosing to study advanced economies, the authors specifically note the problem of "original sin" in studies of emerging markets—that countries which borrow in foreign currencies are subject to different debt dynamics—only to then use a sample in which most of the chosen economies are unable to print their ow...

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