Magazine article The International Economy

Debt Risk: The Real Problem Is the Dangerous Use of Semantics

Magazine article The International Economy

Debt Risk: The Real Problem Is the Dangerous Use of Semantics

Article excerpt

A government that does not tax sufficiently to cover its spending will eventually run into all manner of debt-generated trouble. Its nominal interest rates will rise as bondholders fear inflation. Its business leaders will hunker down and try to move their wealth out of the companies they run for fear of high future corporate taxes.

Moreover, real interest rates will rise, owing to policy uncertainty, rendering many investments that are truly socially productive unprofitable. And, when inflation takes hold, the division of labor will shrink. What once was a large web held together by thin monetary ties will fragment into very small networks solidified by thick bonds of personal trust and social obligation. And a small division of labor means low productivity.

All of this is bound to happen---eventually--if a government does not tax sufficiently to cover its spending. But can it happen as long as interest rates remain low, stock prices remain buoyant, and inflation remains subdued? I and other economists--including Larry Summers, Laura Tyson, Paul Krugman, and many more--believe that it cannot.

As long as stock prices are buoyant, business leaders are not scared of future taxes or of policy uncertainty. As long as interest rates remain low, there is no downward pressure on public investment. And as long as inflation remains low, the extra debt that a government issues is highly prized as a store of value, helps savers sleep more easily at night, and provides a boost to the economy, because it assists deleveraging and raises the velocity of spending.

Economists, in short, do not watch only quantities-the amount of debt that a government has issued--but prices as well. And, because people trade bonds for commodities, cash, and stocks, the prices of government debt are the rate of inflation, the nominal interest rate, and the level of the stock market. And all three of these prices are flashing green, signaling that markets would prefer government debt to grow at a faster pace than current forecasts indicate.

When Carmen Reinhart and Ken Rogoff wrote their influential study "Growth in a Time of Debt," they asked the following question: "Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long-run macroeconomic impact of higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?" Reinhart and Rogoff saw a public-debt "threshold of 90 percent of [annual] GDP," beyond which "growth rates fall.... in [both] advanced and emerging economies."

The principal mistake that Reinhart and Rogoff made in their analysis--indeed, the only significant mistake--was their use of the word "threshold. …

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