Monday, July 16, 2012

What Happens When Public Debt Gets Too High

It doesn’t always result in a Greek tragedy, but high public debt (defined as exceeding 90% of GDP) results in a lower growth trajectory for, in most cases, over a decade (abstract, emphasis added):

Debt Overhangs: Past and Present
Carmen M. Reinhart, Vincent R. Reinhart, Kenneth S. Rogoff

We identify the major public debt overhang episodes in the advanced economies since the early 1800s, characterized by public debt to GDP levels exceeding 90% for at least five years. Consistent with Reinhart and Rogoff (2010) and other more recent research, we find that public debt overhang episodes are associated with growth over one percent lower than during other periods. Perhaps the most striking new finding here is the duration of the average debt overhang episode. Among the 26 episodes we identify, 20 lasted more than a decade. Five of the six shorter episodes were immediately after World Wars I and II. Across all 26 cases, the average duration in years is about 23 years. The long duration belies the view that the correlation is caused mainly by debt buildups during business cycle recessions. The long duration also implies that cumulative shortfall in output from debt overhang is potentially massive. We find that growth effects are significant even in the many episodes where debtor countries were able to secure continual access to capital markets at relatively low real interest rates. That is, growth-reducing effects of high public debt are apparently not transmitted exclusively through high real interest rates.

Bear in mind that we’re looking at significantly higher public debt ratios than we have locally, and that the growth effects themselves aren’t particularly controversial – high public spending does “crowd out” private expenditure when the level of economic activity is high relative to capacity.

But the length of time these effects last is uncomfortably long. Imagine entering the work force at 21 in such a country – 2/3rds of your career will have gone before economic growth resumes a more “normal” trajectory (barring any further shocks).

I’m not overly worried about Malaysia’s public debt levels as they stand; that’s not to say I’d be terribly happy to see the debt to GDP ratio continuing to rise. As things stand now, given the limits to debt accumulation, more aggressive fiscal consolidation seems warranted.

Credit growth is at decently high levels, unemployment is low, and capacity utilisation is around its long term mean. All these signal an economy with a small to negligible output gap. With public and private investment expected to boom over the next few quarters, maintaining a non-inflationary growth trajectory argues for a stronger pullback in overall public expenditure (though not necessarily a budget surplus) unless we’re prepared to see a deterioration in the trade balance or higher interest rates. The latter’s unlikely given BNM’s dovish stance, so look for an acceleration in imports over the coming months.

Technical Notes

Reinhart, Carmen M. and Vincent R. Reinhart & Kenneth S. Rogoff, "Debt Overhangs: Past and Present", NBER Working Paper No. 18015, April 2012


  1. Could you please explain the last bit about rising imports?

  2. @anon,

    An economy can be viewed as having a supply side (what is produced) and a demand side (what is bought). Aggregate demand in an economy can be further divided into two components - public and private.

    If total demand exceeds total supply, you get either demand-side inflation (in a closed economy with no trade), and/or higher imports (in an open economy).

    Viewing the role of fiscal policy as a macroeconomic tool, under those circumstances public demand (aka government spending) should be reduced to limit inflationary pressure and/or maintaining the trade balance.

    Otherwise, higher nominal demand "leaks" from the economy through higher prices or higher imports. Either or both restricts real incomes to no more than what the economy can produce in terms of real goods and services.

  3. Allow me a brief digression before I comment on this post.

    1.You may remember in your recent income inequality post, you nixed the idea that gains in agricultural prices accounted for the catch-up in Bumiputera income:

    Bank Negara data reveals that to be the case as there was a direct correlation between rising incomes and rising commodity prices. More on the Bumi factor in all this some other time......

    2. In the same vein, Total Factor Productivity in manufacturing declined substantially in post Asian Crisis era as established by World Bank Data, which thus accounted for the "stagnancy" in Chingk incomes in the 2002-present period.

    Well, we can exchange opinions on the above assertions when I provide the requisite links (dont have them in hand now).

    3.Regarding this post, the contention is something hardly surprising, given the simple equation "that leaving beyond one's means eventually catches up one day". In actuality, Rogoff et al's findings were predated by this :

    and affirmed here:

    4. Finally, what are your views about the absurdity or otherwise of Singapore's surpluses and its high public indebtedness of 98% of GDP granted most of the debt is presumed save as it is CPF "owned":

    The professor was later hacked but you can follow his thoughts at the links provided here:

    Warrior 231

    1. If Singapore's fiscal position is "absurd", then why does it have a "triple-A" credit rating and an "absurdly" strong currency (1Singapore Dollar = 2.51 Malaysian Ringgit")?

      Surely, the credit rating agencies would have marked any evidence of fiscal weakness by downgrading Singapore's credit ratings, wouldn't they?

      And the forex markets would have pounced like feeding piranhas to attack and weaken the Singapore Dollar at any perceived signs of weakness, much as they did to the Malaysian Ringgit during the Asian financial crisis.

      Have they held off because they fear the "big stick" potential of Singapore's Monetary Authority to defend the Singapore Dollar?

    2. I'm working on the numbers right now.

      The main reason for Singapore's AAA credit rating is that there's really zero threat of a default - all debt is domestic and held largely by residents, backed by forced savings such as represented by CPF and ample liquidity in the banking system (not to mention SGD150 billion in govt deposits).

      The interesting question posed by the Prof Balding is this - even considering that there's sufficient cash and liquid assets to pay off outstanding debt (and no one disputes this), there's still a very, very big hole relative to the investment returns claimed by Temasek and GIC.

      I can't as yet reconcile the numbers either - for the numbers to add up, it looks like Temasek (I can account for GIC) must make an average annual loss of over 25% per annum. Either that, or as claimed by Prof Balding, there's a lot of assets not accounted for under the SG government books.

    3. Spork is a con job about to go awry. International forex piranhas are being held back by the safety net of geopolitics. Triple A ratings are essentially mirages to buttress Spork's corny claim of being a fortress of fiscal responsibility and monetary stability.These are the very same agencies who rated the sub-prime junk bonds as investment grade paper worthy of accumulation.

      If that claim to being disciplined does not hold, capital flight would be the answer.Just like tax havens elsewhere, Spork is money launderer central for SEA. Open the world map and look at all the known tax havens from Hong Kong to the Caymans. They share some common genes:

      1. Geographical locations straddling the big economies to serve as the funnel and receptacle for kleptocrat dictators and white collar thieves in their midst.

      2. Low tax structures and opaque governance systems that pay lip service to enforcement and close one eye to the shenanigans of banks under their jurisdiction.

      3. Citation as money laundering centres of primary jurisdiction in factual evidence based reports like these:
      (the list on page 33 is self-explanatory)

      and picked elsewhere like here:

      Why in fact, one of the giant banks operating in Singapore admitted to money laundering via its branches in Europe and the US:
      (The BBC report is even more damning)

      Why would an entity awash in cash sell bonds to raise funds for its operating expenses?

      or maybe the absurd 17% claim is now taking a hit:

      Why even respectable economists are not taken in by the glitz, their ethnicity notwithstanding:

      It does not take a rocket scientist to figure out that these countries have sham economies that mask money laundering blackholes. The absurd discrepancy of being a frugal surplus generating junkie up to eyeball levels in debt cannot be reconciled as the data suggests.Sooner or later a lot of people have to give up the ghost of their illusions and accept the body of evidence as reality.

      Maddoff's undressed himself as a scumbag with his adroit money shuffling Ponzi schemes, he was the symbolic equivalent of individual greed and dishonesty gone awry. Soon we will see the sovereign equivalent. As to where it is, no prizes for guessing.

      Warrior 231

    4. Yes, why is Singapore AAA whilst Japan keeps getting downgraded. In both cases, almost all of their debt is domestically held and they control their own currencies.

    5. Because Singapore can retire nearly half its debt tomorrow - the government is sitting on a cash pile equivalent to 45% of the outstanding debt. Japan doesn't have that option. (Interesting side question: why are they doing this?)

      Also, unlike Singapore, Japan suffers from periodic bouts of deflation, which increases the real burden of debt.

      Japan's population is both ageing and shrinking, reducing the available tax base and limiting GDP growth.

      Japan's trade surplus has almost disappeared, suggesting fiscal deficits should be exchanged for fiscal consolidation. However, uncertain and unstable political leadership means that this isn't being done.

      Ratings themselves are subject to cross-country consistency checks, which don't take into account country specific characteristics (or economic theory). The surprise here is less that Japan has been downgraded, but that it continues to remain investment grade, irrespective of its ability to remain solvent.

      None of the above answer the interesting question of what happened to the money. By my count, Singapore's surpluses over the last 40 years amount to SGD550 billion. They have SGD150b in cash, some other portion placed with Temasek and some with GIC.

      If we take the investment returns claimed at face value, that puts an upper limit to the amounts invested via the SWFs. But where's the rest of the government's savings?

  4. @warrior 231,

    I'm working on an update to that post - I believe I actually said that commodity prices were a factor, but not entirely. Employment data appears to bear out the view that agriculture matters, but ownership data however says the opposite. The latter in fact also suggests that the decline of manufacturing has had a big impact on Chinese incomes either.

    With respect to this post, one of the functions of research is to corroborate findings in other research papers, using different methodologies and theoretical underpinnings.

    So no surprise that there are other research papers in the same vein. This particular Rogoff and Reinhart paper is in fact a follow up to a series of papers (and a book) the authors have published since the Great recession began, e.g.:

    I am not however of the view that "living beyond ones means" has much relevance to fiscal policy, looking at it from a government viewpoint alone.

    With respect to Singapore, I've harboured some of the same suspicions, though not to the extent of actually tracking down the numbers (the ratio of govt debt to GDP is still climbing, which doesn't make sense to me if its purely to develop the capital markets and provide "captured" income to CPF).

    I'm not sold on his numbers just yet, however, but I'm looking forward to browsing his articles. Thanks for the links.

    1. Sorry, in the first para it should be:

      "...the decline of manufacturing has not had a big impact on Chinese incomes either."