Thursday, January 7, 2010

The Future Costs Of The Economic Bailout

It may be a generation before we know whether the government's massive spending was the right move, as the future costs of the debt remains uncertain. A new research paper by professors Carmen Reinhart and Kenneth Rogoff examines some of the potential effects to the future economy. See the following post from The Capital Spectator.

The monetary and fiscal stimulus dispensed by governments around the world was arguably effective in containing a recession and staving off depression. But if so, the question becomes: At what price?

Nothing is free in economics and so the world must grapple with the mountain of debt that now weighs on the global economy. In effect, policy makers have traded the acute for the chronic. Was it a worthwhile tradeoff? Perhaps, although the true answer won't be known for some time, perhaps as long as a generation.

Meanwhile, no one should underestimate the potential risks. A new research paper by professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard) bluntly lays out the stakes and the hazards that may be lurking. A working version of "Growth in a Time of Debt," forthcoming in American Economic Review, makes three key points. Quoting the paper, the authors advise:
  • The relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more.
  • Emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half.
  • There is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases.
Reinhart and Rogoff's recently published book—This Time Is Different: Eight Centuries of Financial Folly, which we reviewed here—made a timely statement with its arrival last year and this academic pair continues the tradition with their latest work. As their paper notes, the U.S. is among the nations with the biggest percentage increase in debt since 2007. A recent estimate of U.S. debt-to-GDP ratio is 84%, according to Reinhart and Rogoff--dangerously close to the 90% threshold, as illustrated in the following chart taken from the paper.

The bottom line: Bailouts are expensive, perhaps more expensive than generally realized. The worst of the financial crisis and Great Recession may be over, and perhaps that's due partly to the intervention of central banks and governments around the world. (The business cycle was a factor too.) But let's not celebrate just yet. The cleanup era has only just begun and it's not yet clear how much it's going to cost.

This post has been republished from James Picerno's blog, The Capital Spectator.


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