Slow Growth and Rising Debt

From Carmen Reinhart and Kenneth Rogoff:

As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. Our research on the long history of financial crises suggests that choices are not easy, no matter how much one wants to believe the present illusion of normalcy in markets. Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis.

In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. The dynamic is hardly surprising, since public debt soars after a financial crisis, rising by an average of over 80 per cent within three years. Public debt burdens soar owing to bail-outs, fiscal stimulus and the collapse in tax revenues. Not every banking crisis ends in default, but whenever there is a huge international wave of crises as we have just seen, some governments choose this route.

We do not anticipate outright defaults in the largest crisis-hit countries, certainly nothing like the dramatic de facto defaults of the 1930s when the US and Britain abandoned the gold standard. Monetary institutions are more stable (assuming the US Congress leaves them that way). Fundamentally, the size of the shock is less. But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.

While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

ECONOMICS!!

From my inbox:

Dear Dr. Mankiw,

I've been using your introductory textbook for a couple years. I tell students that in five years if all they remember about economics is the first chapter, then their efforts will not be wasted. To help them remember, I created this acrostic device. It finally occurred to me that it might be useful to others. So if you like it, feel free to use it, in class or in the 6th edition. The acrostic is ECONOMICS!! The attached explains the connection to the ten principles.

BTW, I am a regular reader of your blog, and I appreciate your views and the wide scope of views you moderate on your blog. You have directed me to quite a few places and opened doors I wouldn't have found so easily.

Best regards,

Gordon Boronow
Assistant Professor
Nyack College

Thank you, Gordon, for sharing this.  Here it is:

Ten Key Principles in Economics

Everything has a cost. There is no free lunch. There is always a trade-off.

Cost is what you give up to get something. In particular, opportunity cost is cost of the tradeoff.

One More. Rational people make decisions on the basis of the cost of one more unit (of consumption, of investment, of labor hour, etc.).

iNcentives work. People respond to incentives.

Open for trade. Trade can make all parties better off.

Markets Rock! Usually, markets are the best way to allocate scarce resources between producers and consumers.

Intervention in free markets is sometimes needed. (But watch out for the law of unintended effects!)

Concentrate on productivity. A country’s standard of living depends on how productive its economy is.

Sloshing in money leads to higher prices. Inflation is caused by excessive money supply.

!! Caution: In the short run, falling prices may lead to unemployment, and rising employment may lead to inflation.

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