Monday, February 1, 2010

When does the short run become the long run?

When debt reaches 90% of GDP (via Greg Mankiw):
As government debt levels explode in the aftermath of the financial crisis, there is  growing uncertainty about how quickly to exit from today’s extraordinary fiscal stimulus. ... Unless this time is different – which so far has not been the case – yesterday’s financial crisis could easily morph into tomorrow’s government debt crisis.
In previous cycles, international banking crises have often led to a wave of sovereign defaults a few years later. ...
We do not anticipate outright defaults in the largest crisis-hit countries, ...But debt burdens are racing to thresholds of (roughly) 90 per cent of gross domestic product and above. That level has historically been associated with notably lower growth.
While the exact mechanism is not certain, we presume that at some point, interest rate premia react to unchecked deficits, forcing governments to tighten fiscal policy. Higher taxes have an especially deleterious effect on growth. We suspect that growth also slows as governments turn to financial repression to place debts at sub-market interest rates.

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