DEBT DIAGNOSIS

Peter­son Perspectives Inter­views on Cur­rent Top­ics The Shadow Cast by US Debt Car­men M. Rein­hart dis­cusses how his­tory teaches that large pub­lic and pri­vate debt impedes eco­nomic growth, a les­son that the United States must heed in the years ahead. Edited tran­script, recorded Feb­ru­ary 18, 2011. © Peter­son Insti­tute for Inter­na­tional Eco­nom­ics. Steve Weis­man: It’s bud­get sea­son, and Wash­ing­ton is deal­ing with steps to curb the Amer­i­can over­hang of debt. This is Steve Weis­man at the Peter­son Insti­tute for Inter­na­tional Eco­nom­ics and with plea­sure I wel­come Car­men Rein­hart, new senior fel­low here at the Insti­tute, for her first Peter­son Per­spec­tives inter­view. Thanks for join­ing me, Car­men. Car­men Rein­hart: Thank you for hav­ing me. Steve Weis­man: Car­men, there’s a lot of talk in Wash­ing­ton about the dan­gers of mount­ing US debt, espe­cially after the finan­cial cri­sis, but also dri­ven by the com­monly under­stood demo­graphic and spend­ing fac­tors. How would you char­ac­ter­ize how pre­car­i­ous the United States’ sit­u­a­tion is now? How are global mar­kets per­ceiv­ing it? Car­men Rein­hart: I think that there is ample rea­son to be con­cerned about the level of indebt­ed­ness in the United States, both pub­lic and pri­vate. Let me say some­thing as back­ground. Going into the cri­sis, pri­vate debts — notably that of house­holds and finan­cial firms — had sur­passed any his­toric mark­ers that we could point to, by a huge mar­gin. And sig­nif­i­cant debt over­hangs still exist notably in the house­hold sec­tor but also in the finan­cial indus­try. So right now the only sec­tor that isn’t weighed down by that over­hang is in finan­cial busi­nesses. Now the pub­lic debt, which has been the focal point of so much atten­tion since the bud­get was released, is at lev­els that we had not seen since the end of World War II. And the end of World War II were the all-time his­toric highs since 1790. So there are well-founded con­cerns about issues raised by this debt bur­den. By the way, when I say gov­ern­ment, this really means gov­ern­ment in its nar­row­est sense. It doesn’t take into account the con­tin­gent lia­bil­i­ties that we have accu­mu­lated in Social Secu­rity or the con­tin­gent lia­bil­i­ties that are still out there in the finan­cial indus­try. So I would divide the con­cerns into two parts which we can dis­cuss. One is the con­cern over an immi­nent Greek-style sov­er­eignty cri­sis and the other is just the more gen­eral con­cern that over­hangs have dark con­se­quences for growth. Steve Weis­man: Let’s talk about the sov­er­eignty issue first. You were in Davos. Obama Admin­is­tra­tion offi­cials, includ­ing Trea­sury Sec­re­tary Gei­th­ner, were some­what upbeat in say­ing that the United States was get­ting its arms around the prob­lem. What’s your reac­tion? Car­men Rein­hart: I think that, in praise for the bud­get that has come out, I will cer­tainly say that the bud­get is based on a real­is­tic sober assess­ment of eco­nomic prospects. It’s not fore­cast­ing a Pollyan­naish strong sus­tained recov­ery, espe­cially in employ­ment. So it’s pred­i­cated on fairly rea­son­able eco­nomic assump­tions. I’ll say more about that later. But in terms of really tack­ling the debt, it’s really quite mod­est. And say­ing that we are cap­ping net debt at around 77 per­cent GDP still leaves gross debt at his­toric highs. In my work with Ken Rogoff, we iden­ti­fied gross debt thresh­olds of around 90 per­cent as being asso­ci­ated his­tor­i­cally with lower growth out­comes. And we are past that already. And I would add that one area where the bud­get is very mod­est in its achieve­ments, to put it gen­tly, is in its spend­ing cuts, which are largely con­cen­trated on non-defense dis­cre­tionary spend­ing, which is about 12 per­cent of total spend­ing. Of course that leaves the big ques­tion, “What about the other 88 per­cent of spend­ing?” Steve Weis­man: You men­tioned that you thought the eco­nomic assump­tions were rea­son­able in the short term. Tell me a bit more about that. Car­men Rein­hart: For some time, mar­ket par­tic­i­pants by and large, and Admin­is­tra­tion and the Fed­eral Reserve, had been fore­cast­ing a more stan­dard recov­ery from the finan­cial cri­sis. In my work with Ken Rogoff on the after­math of finan­cial crises and also in the work that I did with Vin­cent Rein­hart for the Jack­son Hole Sym­po­sium, a big mes­sage that emerges is that reces­sions fol­low­ing severe finan­cial crises are deeper and more pro­tracted, notably in employ­ment recov­ery and also in the recov­ery — or more accu­rately lack thereof – in hous­ing mar­kets. In the Jack­son Hole work, it goes beyond say­ing that the imme­di­ate reces­sion after a cri­sis is more severe, more pro­tracted. It basi­cally con­cludes that the decade fol­low­ing a finan­cial cri­sis is char­ac­ter­ized by lower growth and a higher unem­ploy­ment rate – and this is advanced economies; this is not an emerg­ing mar­ket com­par­i­son – than the decade pre­ced­ing the cri­sis. A big rea­son for that sub-par per­for­mance is huge debt over­hangs, pub­lic and pri­vate. Steve Weis­man: So com­ing back to the Administration’s and Fed’s fore­casts, are they being overly opti­mistic? Car­men Rein­hart: I think they have grad­u­ally moved in the direc­tion that is more con­sis­tent with the less v-shaped, more grad­ual recov­ery in employ­ment. So I would say that right now the bud­get assump­tions are pred­i­cated on rea­son­able esti­mates of what could hap­pen. Steve Weis­man: Let me come back to the pri­vate sec­tor debt sit­u­a­tion, both com­mer­cial and house­hold. I thought that there were some signs that house­hold and com­mer­cial sec­tors were delever­ag­ing or reduc­ing their debt. Did I mis­un­der­stand? Car­men Rein­hart: No you didn’t; not at all. House­hold debts peaked in 2008. But let me say this about delever­ag­ing. You can mea­sure delever­ag­ing on a flow basis. That is, “Are they tak­ing on new cred­its? Are they tak­ing on new debts?” You can also look at the inher­ited stock of debt rel­a­tive to income. Now, we have a prob­lem with the inher­ited stock of debt in that for house­holds, for exam­ple, they have faced a hous­ing price decline in real terms of about 30 per­cent. But loans and debts on a wide­spread basis remain at book value. So that still leaves this unre­solved debt over­hang that is being resolved only very spo­rad­i­cally and grad­u­ally through fore­clo­sures. Like­wise, the finan­cial indus­try has been pre­sented with the gift of for­bear­ance, cou­pled with gov­ern­ment guar­an­tees and zero inter­est rates. So it’s not too bad to carry all those dead weight assets on their bal­ance sheets. But real­is­ti­cally, the mar­ket value of those debts is nowhere near what they appear to be. So these kinds of delays in write-downs of bad debts are part of the rea­son why recov­er­ies are more mea­ger and take so long after a finan­cial cri­sis. In effect, the delever­ag­ing process his­tor­i­cally for all the severe post-War crises — not all, but for a sub­stan­tial num­ber of the severe finan­cial crises — the delever­ag­ing process for the pri­vate sec­tor takes about seven years. Steve Weis­man: Car­men Rein­hart, thanks very much. Car­men Rein­hart: Thank you.   There is some­thing each of us can do to help our­selves, our chil­dren and their chil­dren along with help­ing the finan­cial state of the coun­try; Become your own banker. Call me today to find out how and why this will help.

1. garage says:

   June 4, 2011 at 5:57 am

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