Monday, January 12, 2009
Massive government spending is afoot. Banking crises are usually very expensive, and for the major post-War episodes worldwide, average real government debt soared by 86%. Interestingly, the rise in debt is usually the result of a precipitous decline in tax revenues – driven by a severe recession, or a 9% average loss in output – rather than costs to stem the banking crisis. Accordingly, the government response to this banking crisis is different: the government is spending on two bears: (1) a recession, and (2) a fire in the financial system.
Fiscal deficits occur during recessions: tax revenues decline and spending rises
But this time, government debt is set to soar
The chart illustrates the U.S. debt held by the public (all federal debt held by individuals, corporations, state or local governments, foreign governments, and other entities outside the United States Government less Federal Financing Bank securities) as a percentage of GDP through 2008 Q3, and forecasted through 2009. With already announced (or in place) spending on the financial bailout and the oncoming stimulus package, public debt held in 2008 Q4 (using Q3 nominal GDP and current Q4 public debt) will be roughly 44%, and over the nexxt, it will surge to 58%. New debt in 2009 Q4 includes the Congressional Budget Office’s projected $1.2 trillion deficit in 2009 plus an $800 billion stimulus package.
So does this mean that U.S. government debt will rise by the average banking crisis' 86%, given that it has already allocated a significant amount of resources toward the banking crisis?
- Loans to AIG, JP Morgan, Citigroup
- $700 billion TARP
- The Federal Reserve’s various lending programs has cut their Treasury holdings by $252 billion, putting the taxpayer on the hook if losses are made on the corresponding collateral.
This time, the new debt is different because the U.S. government is spending to stem the financial crisis AND to mitigate a recession (the stimulus package). Rogoff and Reinhart argue that new debt incurred during and following a banking crisis (a large one like this) is on average due to the recession alone (via reduced tax revenues). Since the government is allocating massive resources in an effort to stem the financial crisis, some could argue that the average banking crisis recession, 9% output loss and severe loss in tax revenues, may be averted. Therefore, the actual debt load will not surge 86%.
Can the government handle such a massive debt load?
Kenneth Rogoff says yes in this interview (hat tip, Mark Thoma):
THE LONG-TERM CONSEQUENCES OF DEBT
Region: Well, let's talk about the U.S. debt and its long-term consequences, in the context of the current economic crisis. The Stabilization Act authorizes $700 billion, some of which will contribute to the growth of national debt. Economists such as NYU Professor Nouriel Roubini suggest $2 trillion …
Rogoff: I have, as well, suggested $1 trillion to $2 trillion.
Region: Yes, I think up to $2 trillion "to fix the system" are your words.
Rogoff: That is because the bailout process is just at the beginning. Look at history. Carmen and I have a paper coming out—it's another chapter from our book—looking at the aftermath of banking crises. We argue that it is highly misleading to look at reported ex post fiscal costs because these are subject to a great deal of accounting manipulation and typically do not reflect true economic costs. If, instead, one looks at things that are less manipulable, like the run-up in public debt, it's clear that the costs of a financial crisis are just staggering.
For example, even though this interview won't be published for a couple of months, I think it's safe to say there'll be a huge stimulus package, some of it surely dissipative. We'll probably bail out the mortgage holders before this is over, some large class of them. Auto companies, municipalities and so on.
Perhaps the costs will be less. But I doubt it.
Region: And the long-term growth consequences of that additional debt?
Rogoff: Fortunately, adding a trillion dollars in debt is quite manageable for the United States. Of course, it is not a fun way to spend money, bailing out the financial system. We'd rather spend it on health, education, infrastructure or the environment. (That is, if the expenditures are well crafted and packaged with policy changes and structural improvements.) The fact is that for all the railing against the Bush deficits, the United States grew decently until recently, so that our debt/GDP burden is still modest by European or Japanese standards.
The rising debt burden will have some effect on growth. But I'm more concerned about what happens to our financial sector at the end of this, what's left of it. I just don't know what's going to emerge after the political system works it over. I hope that we do not throw out the baby with the bathwater. If we rebuild a very statist and inefficient financial sector—as I fear we will—it's hard to imagine that growth won't suffer for years.
Yes, the financial sector needs to shrink. In fact, there's a nice 2007 paper by Thomas Philippon (at NYU) which actually forecast this happening. So some retrenchment is desirable. But I worry we are going to turn back the clock altogether too far. What are needed are (much) greater capital requirements and more transparency, not regulatory strangulation.
But as Greg Ip argues, this time Congress must pay down the debt when the U.S. attains potential growth again (the rest of the article is worth a read) in order to avoid a sovereign default situation:
So what's the moral of the story? The Obama administration should not focus on debt reduction now, which could actually undermine the prospects for a recovery in the real economy. With households and businesses trying to spend less and save more, the federal government must spend more and save less -- that is, borrow more -- in order to prevent a self-feeding downward spiral in economic activity. Once the recession is over, getting our debt burdens down will hinge on Obama's and Congress's willingness to confront the looming cost of Social Security and Medicare benefits for the aging U.S. population.
RW: I tend to think that Congress will pass the massive stimulus, and argue that the new debt will be paid down when the U.S. economy recovers completely; this time is different. But my understanding of Congress is that it can be quite shortsighted, and by the time the U.S. economy is back at potential growth, will probably not pay down the debt until forced to. Case study: the U.S. consumer! So unless there is a specific trigger to pay down debt built into Obama's bill (to my knowledge, the TARP bill doesn't contain such a trigger), I am both skeptical and slightly nervous.