Interest Rates and Debt Ratios

Paul Krugman links us to a fascinating new report by the BOE (.pdf) which also presents some really really long time-series data on a hotly discussed issue over the past years, but also very much relevant for some of the discussions we’re having on this forum: the ability of governments to borrow and the limits to this borrowing. Below the relationship between long-term bond yields and debt-to-GDP ratios of the UK ranging all the way back to the 1700s.

The whole issue is of course strongly related to e.g. the 90% threshold level of debt-to-GDP ratio found (or not) after which economies abruptly start dying (again, or not) in the now infamous Reinhart-Rogoff paper (.pdf). Christoph, in his last guest post, also writes that “Empirical articles show that the higher the deficits and debts are, the higher is the probability of a country to experience a “sudden stop” of capital inflows”. As he points out in the comments, causality and correlation are indeed tricky to disentangle, yet the point seems to stand that a high debt-to-gdp ratio makes a country inherently a more risky investment. I, for one, am not sure why this should be the case. There are many things that might make a country a risky investment, and also many reasons that might lead to “sudden stops” in the willingness of investors to finance a country’s deficit. But, and as counter-intuitive as this might sound, the level of debt-to-GDP simply does not seem to be one of them, as the graph above but also the eperience of e.g. Spain in the current crisis and Japan over the past couple of decades, to name just three of the most obvious examples, show. This supposedly existent causal relationship – or indeed any meaningful relation at all – between debt levels and the ability of a country to finance itself seems not only wrong but utterly destructive. Spain (and Europe in general) has many huge problems it needs to tackle, but its debt level is not one of them (Greece, of course, is a different story).

As a final note, the authors in the paper note that “Increases in the public debt ratio resulting from military spending were often associated with increased government bond yields”. The most obvious exception to that is the second world war. The authors hint that the rise of interest rates in many past episodes of war “mainly reflected fluctuations in the fortunes of war”, but could this also be interpreted as representing the difference of fiscal spending that crowds out and that which crowds in? I don’t really know much about the other historical episodes but the spending undertaken that got us out of the Great Depression clearly would be a case of the latter, explaining why interest rates fell.

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3 thoughts on “Interest Rates and Debt Ratios

  1. I think this debate has to distinguish clearly beween “Net Foreign Liabilities” and the indebtedness of the public sector. The net foreign liabilities refer to the sum of public AND PRIVATE debts of a country. Indeed, Japan has a highly indebted public sector but also high private savings on the contrary. But I absolutely agree with you that there are several reasons that might lead to a “sudden stop”.

  2. one finak remark on Spain: Spains net foreign liabilities also amount to close to 100% of Spanish GDP, so there is a clear link between this number and the “sudden stop”. the ability of the government to refinance itself is of course a different story.

    • I just noticed I never responded to this – sorry. Thanks for making the point that it is the net foreign liabilities which we should look at, which I must admit I myself did not have fully in mind when writing the post. I am still not sure about the “clear” link between these liabilities and the sudden stops you are talking about. There is a clear correlation in many cases, no doubt, but does that tell us anything? Here is a list countries by total external debt:
      http://en.wikipedia.org/wiki/List_of_countries_by_external_debt
      The UK has an external debt of 406% of GDP, yet it did not experience a “sudden stop”. Germany has nearly the same level of net foreign liabilities as Spain. Clearly, the net liabilities might be part of the puzzle, but they are not what triggers anything, nor do they, by themselves, make a country necessarily more or less risky.

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