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    Recessions caused by financial crises are different from typical recessions, economists meeting told (photo: Frances Roberts/Newscom)

    Recessions caused by financial crises are different from typical recessions, economists meeting told (photo: Frances Roberts/Newscom)

    AMERICAN ECONOMIC ASSOCIATION MEETING

    High Government Debt Threatens Growth Prospects

    IMF Survey

    January 8, 2013

    • Crisis recovery major topic of discussion
    • Financial crises trigger spike in debt
    • Uncertainty compounded by use of new tools

    Policymakers in advanced economies will have to resolve the problem of high government debt or they may face low growth prospects, a panel of economists said.

    A session at the annual American Economic Association conference in San Diego January 4–6 heard that debt levels have exploded across the advanced economies since the financial crisis, and are now at unprecedentedly high levels. High debt levels are a potential drag on growth, the session was told.

    At the conference, economists from the IMF, academia, and a broad range of other institutions acknowledged that, five years after the start of the Great Recession, economists are still struggling to find solutions to the mounting debt and high unemployment the crisis has triggered.

    Recessions caused by financial crises are a different animal from typical recessions, said Kenneth Rogoff of Harvard University, and growth does not usually bounce back quickly following a downturn of this type.

    Several presenters at the meeting noted that the current uncertainty is compounded by the use of new tools, and that in some ways—for example, with U.S. interest rates at the zero lower bound—economists are now in uncharted territory.

    “The past few years have highlighted how little we actually know,” stressed Donald Kohn, a former Vice Chair of the U.S. Federal Reserve who is currently at the Brookings Institution.

    With the advanced economies mired in crisis, policymakers should look to the past for insights, but in light of the global economy’s new complexity, they should also learn and adapt as they go, the conference heard.

    Dealing with debt

    At a session on sovereign debt crises, IMF Chief Economist Olivier Blanchard asked the panelists—who included Rogoff, Simon Johnson of the Massachusetts Institute of Technology, and 2011 Nobel laureate Thomas Sargent of New York University—to consider three questions.

    How does one decide when debt restructuring becomes needed? What is the cost of not doing anything about debt overhang? Should there be new debt restructuring rules—some form of sovereign debt restructuring mechanism or international bankruptcy court?

    Simon Johnson retraced the history of U.S. government attitudes toward fiscal discipline to illustrate the current period’s dramatic break from the past. Throughout time, he said, the American attitude has been one of fiscal responsibility that focused on paying federal government debts even during major political shifts—a virtue, he suggested, that helped propel the United States to global predominance.

    In the past decade, Johnson said, all this has changed. Politics is partly to blame, but the fiscal fallout from the 2008 financial crisis was the real game-changer. Now, he stressed, the U.S. government must take fiscal adjustment seriously if it is to retain its position in the global economy.

    Debt and financial crises

    Citing his research with Carmen Reinhart, Rogoff observed that three years after a systemic financial crisis, a country’s debt tends to rise on average 86 percent from its original level, in part because hidden debt surfaces.

    What can policymakers do to lower debt? Economic growth, fiscal adjustment, explicit sovereign default, and inflation are all possible solutions, though some are more viable than others, he noted.

    As for Europe’s debt, Rogoff noted that the status quo in Europe was untenable. Evoking Johnson’s discussion of U.S. history, he observed that “the United States couldn’t really operate under the Articles of Confederation; it really needed a Constitution. Europe is very much in that situation—you need a governance system to decide things.” That, he said, is the big question for the future of Europe.

    Incompatible promises

    Sargent outlined a sequence of theoretical models on debt by Robert Barro and others that can help economists think about debt and make more informed decisions.

    Echoing the other panelists’ views, he stressed that, in the end, politics play a decisive role. “Fiscal crises involve either incompatible promises that have been made to people, or incompatible understandings,” he said. “You can’t simultaneously promise that you’re going to have a low-tax state and a high government expenditure state.”

    The challenge, Blanchard noted, is to reconcile these theoretical models and the actual discussions on debt restructuring taking place around the world.

    IMF participation

    At the meeting, a number of discussions were held on the pace of fiscal adjustment. In a session on the effects of fiscal policy on deep recessions, Blanchard and IMF economist Daniel Leigh presented a paper “Growth Forecast Errors and Fiscal Multipliers.” In a discussion of fiscal stimulus, Carlo Cottarelli, Director of the IMF’s Fiscal Affairs Department, explained the thinking behind the IMF’s fiscal policy recommendations in response to the crisis in Europe. The papers outlined a pragmatic, flexible, and country-specific approach to fiscal consolidation – one that allows for tightening where possible but takes care to support short-term growth.

    In a session on capital controls and the international monetary system, Jonathan Ostry, Deputy Director of the IMF’s Research Department, spoke about the evolution of the IMF’s views on the use of capital controls. In December 2012, the IMF adopted a comprehensive, flexible, and balanced view on the management of global capital flows.