Bond Bubble Watch
By Arnold Kling
at 5 percent of GDP below the debt limit, the government should be able to borrow at the risk-free rate; but as debt rises by a mere 5 percent of GDP more, the government loses market access and the marginal interest rate effectively becomes infinite. Although the analysis is more complicated with multiperiod debt, these orders of magnitude imply that market signals of rising interest rates will likely come very late (that is, just on the eve of a loss of market access).
Thanks to Peter Suderman for the pointer.
Their description of the dynamics of a debt crisis is similar to mine. The difference is that they try to use historical tendencies to arriave at an estimate of the typical rate at which high-debt countries adjust their fiscal policies to try to correct excessive debt. Instead, I merely characterize the maximum feasible adjustment as a variable (the “pain threshold”) and show what happens as your assumptions change about the pain threshold.
Perhaps the most striking point in their paper is the weak fiscal position of Japan. In my paper, I say that Japan can be ok as long as they have a high enough pain threshold–that is, the Japanese government will be able to call forth the sacrifices needed in order to get the debt on a sustainable path. In the IMF economists’ paper, the adjustment capacity is based on historical averages, and if you accept those, then Japan is already toast. The authors probably would not want me to be expressing it in such terms, but I read them as saying that Japan was toast even before the financial crisis hit, and it is really toast now. Again, if you believe my story that the Japanese have a high pain threshold, you don’t necessarily think that Japan is toast. However, if you think my story is just one of those things that investors tell one another in the midst of a bubble (like, “house prices never have declined nationwide”), then at some point…
How do you say “Have a nice day” in Japanese?