Newly minted Nobel Laureate Robert Shiller is on Project Syndicate talking about the debt to GDP ratio (excerpt):
NEW HAVEN – Economists like to talk about thresholds that, if crossed, spell trouble. Usually there is an element of truth in what they say. But the public often overreacts to such talk.
Consider, for example, the debt-to-GDP ratio, much in the news nowadays in Europe and the United States…Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?
That would clearly be nonsense. After all, debt (which is measured in currency units) and GDP (which is measured in currency units per unit of time) yields a ratio in units of pure time. There is nothing special about using a year as that unit. A year is the time that it takes for the earth to orbit the sun, which, except for seasonal industries like agriculture, has no particular economic significance.
We should remember this from high school science: always pay attention to units of measurement. Get the units wrong and you are totally befuddled...
...The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.
The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.
He goes on to diss Reinhart and Rogoff’s findings that the 90% threshold is significant (growth slows across the whole spectrum, not just at the higher end; the debt thresholds chosen were arbitrary), and notes that reverse causality is just as likely – high debt to GDP ratios might be caused by slower growth rather than the other way around.
Prof Shiller is sometimes hard to pin down – he’s obviously not a fresh water economist, but then neither is he a Keynesian. His background is behavioural economics, and his insights are fun to read even if they tend to be unorthodox. He was one of the few to correctly call the demise of the US housing bubble. He doesn’t pull any punches either - I absolutely love this line:
Economists who adhere to rational-expectations models of the world will never admit it, but a lot of what happens in markets is driven by pure stupidity – or, rather, inattention, misinformation about fundamentals, and an exaggerated focus on currently circulating stories.