Till debt do render us free

Only major league economic statistics make it to our headlines (inflation is rising, GDP has fallen and so on). But this last summer, the debt/GDP ratio has been doing the rounds in our newspaper reports, particularly the financial press.

Two converging strains of macroeconomic realities have led this statistic to matter more. On one hand, the large governmental governmental bailout in the developed markets (DM) of public and private financial institutions has been orchestrated by the creation of more public debt. Secondly, countries with extravagant spending patterns (and who were propped up by an exuberant global bond market during the good times) found that when the crisis hit, the cost of their debt ballooned.

The first group includes the US, the UK, etc., the second group includes, most prominently, Greece. Then there are countries that belong in both groups like Spain.

In essence, a whole range of macroeconomic anomalies have been reduced to understanding the dynamics of the levels of debt to the levels of possible tax revenues in the economy. Further, it is not the levels that have alone been the issue but the rate of growth of debt and GDP.

Like any ratio, there are two components to it. The numerator is the level of public debt. Some argue, private debt ought to be included in such calculations since it affects private consumption levels, which affects the GDP growth and tax revenues. The denominator is the level of GDP, which measures the entirety of an economy's output.

Predictably, there are three ways to influence this number. Change the numerator, the denominator or some combination of both. This debate over debt-to-GDP ratio can thus be reduced to individual movements of these variables; but as any student of history knows, economic variables rarely move on their own. This property where variable A influences another variable B, which in turn influences variable A is called endogeniety. And endogeniety is what makes much of economics so difficult. This exercise is no different.

Options

Faced with economic decline, one of the politically attractive options is to increase the levels of fiscal stimuli provided to the economy. By fiscal stimuli one usually refers to governmental programmes that generate (at least temporarily) employment, which would hopefully jump-start the economy. This is usually done by the governmental agencies borrowing money from the bond market with the promise of repaying it back in the future.

So, such programmes end up doing is increasing the GDP (at least temporarily), but they also increase the debt. This would be "okay" if the employment generated is long lasting; but understandably, targeted employment generation programmes don't have the best of reputations. Hence, much scepticism.

Thus, we have a diversity of opinion on if this is the best policy recourse. For eg, Guillermo Calvo at Columbia University argues that governments must phase out expenditure programmes.

In contrast, Francesco Giavazzi at Bocconi University argues that government expenditure programmes must continue, notwithstanding the financial pressures.

An in-between stance is advocated by Giancarlo Corsetti at the European University, who argues that precaution is needed while managing finances but that with each such move, the consequences are likely to worsen.

In this context, Kenneth Rogoff at Harvard and Carment Reinhart at University of Maryland have brought to bear historical data that argues against raising Debt-to-GDP ratio through fiscal expansion. They demonstrate that once the debt-to-GDP ratio goes up to 90 per cent, economic growth starts to slow down alarmingly, which affects the ability to repay debt.

In contrast, some like Paul Krugman have questioned the underlying data itself and that the 90 per cent cut-off is a line drawn in sand.

To make matters more complicated — the dollar, argue many, is the de-facto currency of the world. So, unlike say Portugal or Spain, the US can continue to raise levels of debt because the demand for dollar-denominated debt is high.

Wall Street however has increasingly argued that this is all a false debate. Morgan Stanley, for e.g., has increasingly argued that conventional measures of debt don't include contractual liabilities like commitments to pensions.

So, the real obligation is even higher. And that GDP is the wrong measure, because governmental revenues are what matter — not aggregate productive capacity. In essence, they believe that the situation is worse than we probably realise. And they have begun to hedge by gradually buying emerging markets debt. From the days of the Asian Currency Crises in 1998 — the world seems to have come a full circle. The irony of it all is inescapable!

The columnist works for a major European investment bank in New York City. You can follow his tweets at http://twitter.com/ks1729