This article originally appeared in a symposium of views on sovereign debt in The International Economy Magazine’s Spring 2013 issue.
Economic context is too important and widely varied between countries to universally quantify when public debt will prove harmful or likely spark a sovereign debt crisis. Differences in denomination of sovereign debt, ratios of domestic versus foreign holdings of debt, distinctions between countries with independent central banks versus those belonging to currency unions, reasons why debt has been incurred, and underlying economic health must be considered.
There is, however, an easily quantified rule for when sovereign debt accumulation is not harmful and, contrary to public perception, is instead quite productive. When a country with an independent central bank is in a liquidity trap, and that central bank’s policy rate is effectively maxed out at the zero lower bound of nominal interest rates, accumulating public debt is economically beneficial.
The United States has been in such a situation since 2008 and is currently in a depression, with economic output running $953 billion (5.6 percent) below noninflationary potential. Monetary policy has not and will not be capable of ameliorating this stark aggregate demand shortfall. In this context, the accumulation of public debt since 2008 has acted as a shock absorber for aggregate demand, preventing a much deeper depression. This benefit was underscored last year by concerns about the “fiscal cliff,” which reflected the reality that deficits shrinking too quickly, meaning public debt rising too slowly, would counterproductively push the economy back into recession.
Congress should not be prioritizing deficit reduction until the Federal Reserve starts raising interest rates to cool demand-side inflationary pressure, which will signal emergence from this liquidity trap. The Federal Open Market Committee has explicitly stated that rate tightening will not occur before unemployment falls below 6.5 percent or inflation expectations push above 2.5 percent, likely years away. Upon eventual return to normalcy, deficit reduction will lower market interest rates and thus “crowd in” private investment—a channel that has been totally blocked for years—offsetting decreased government demand. Similarly, fiscal multipliers are currently elevated but will shrink when full employment is restored, thus decreasing deficit reduction headwinds, and monetary policy loosening could once again offset fiscal tightening.
Conversely, if such a liquidity-trapped country undertakes austerity purportedly for debt reduction, they will effectively swap smaller structural budget deficits for larger cyclical budget deficits, and likely push near-term debt ratios higher. This has been the United Kingdom’s experience with the Cameron austerity budget. Best estimates suggest austerity in the United Kingdom and major Eurozone economies has, on average, counterproductively increased public debt ratios by roughly 5 percentage points as of 2013.
The housing bubble’s implosion was bound to markedly increase public debt—the appropriate policy question was how to revive the economy to best sustain this debt. Additional debt accumulated to rapidly restore full employment would also hedge against substantial, widely ignored downside economic and fiscal risks, notably economic scarring and persistent cyclical budget deficits.
This U.S. economic outlook remains unchanged, and more public debt should be incurred to fill the aggregate demand shortfall until the economy emerges from the liquidity trap.