80 is the number of the Debt-Gods

Finally got down to doing this, though as you'll see, a lot of people have already got there first. Takedown? Sort of. 

There's a paper out (couple of weeks, perhaps) by four authors, one of which is Mishkin. On a side-note, that immediately brought back summer school memories of college back to me. 7:00 AM - Three hours of Money & Banking. Go figure!

Anyway...It's regarding the whole debt-level debate. Namely - is there a debt level beyond which...BAD things happen? I think a holistic way to approach this is to admit defeat. Even if you're country specific, you're dealing with annual data, which is no fun. More importantly, the whole "original sin" literature comes into play. Is there really default risk when you're issuing your own currency? What kind of premium would investors demand? An inflationary risk? What else?

Just a few thoughts such as these would force one to immediately rule out what the authors proceeded to do...A PANEL! 20 advanced countries (more on this later!), 12 years (2000 - 2011) (the data is annual), and it all starts with a regression on average nominal yields on long-term debt - later the dependent becomes the interest rate and the predictors are gross debt, net debt and the CAB. 

Yup, as easy as that.

As someone who had a really really tough time doing a fair bit of graduate work in statistics, being appalled could be an understatement here. Essentially, you're grouping a diverse set of countries. You're not accounting for a lot of differences and then you're "panelling" them together conveniently, cutely concluding (among other things) that:

a) the coefficients of gross and net debt are highly "statistically" significant.

b) If the primary deficit increases by 1%, the cost of borrowing would move up 4.5 basis points. 

c) 80% is when bad things happen (okay i'm being a bit mean and general here but still...they said it not me - "Countries with debt above 80 percent of G.D.P. and persistent current-account deficits are vulnerable to a rapid fiscal deterioration as a result of these tipping-point dynamics”)

I'd better be done otherwise I'd spend the rest of the evening reading, re-reading and writing/ranting furiously. The good thing is that a lot of my work here has already been done - a fair bit of the online media/blogosphere has it covered.

Matt O'Brien at the Atlantic has this to say:

"Not all debt is created equal. Countries that borrow in a currency they control play under a different set of rules. They can never run out of money to pay back what they owe, since they can always print what they need as a last resort. That's not to say they actually do or should turn to the printing-press to finance themselves. But the option to do so calms markets. After all, inflation is a lot less bad than default for creditors. That's why it's not so easy for countries that don't borrow in a currency they control. They can default. And this is a case where thinking can make things so. Indeed, as Paul De Grauwe points out, countries that don't have their own central bank, like euro members, can fall victim to self-fulfilling panics that push them into bankruptcy. In other words, markets force up interest rates because they fear default -- which then pushes them into default. It's a bank-run on a country.

So we have to answer one big question. How much of Greenlaw & Co.'s results are driven by euro countries that have completely different debt dynamics than non-euro countries? "

I'm sure you asked that too. Here's the answer:

"12 of the 20 countries they look at are either part of the euro, or, in Denmark's case, pegged to it. The remaining ones show no signs of anything resembling debt tipping points. Often the reverse. That's simple enough to see if we break up their sample. The chart below looks at the pre-crisis years from their sample, and shows the non-euro countries in red, the core-euro countries in green, and the (later) troubled PIIGS countries in blue. Back then, at least, there wasn't any difference between -- except for Japan, which had far more debt, and far lower borrowing costs. Nor was there much of any discernible relationship between debt and interest rates."

O'Brien proceeds to go ahead and do somewhat what I would have done if I found the time. Recreate the data set and SPLIT THE COUNTRIES! Non-euro and PIIGS.

"Translated: our equation for the PIIGS tells us increasing debt by 1 percentage point of GDP increases borrowing costs by 8.4 basis points -- but increasing the current account deficit by 1 percentage point of GDP increases borrowing costs by 91 basis points! The PIIGS do have a serious problem, but that problem is borrowing too much from foreigners, not too much government borrowing, in general. Of course, this isn't exactly new information. Paul Krugman, among others, has been pointing out for years that the euro crisis is really a balance of payments crisis that just looks like a debt crisis because of the common currency."

Basically the variables are faaaaaaaaar from significant.

Enough on O'Brien though, Binyamin Applebaum at Economix looks at the ephemeral anomaly that is Japan to which the authors wax eloquent of the specialty that is Japan and then lop it off (that's 5% of the sample, FYI). He's less wonkish, more middle-ground (seemingly!) and admits that it's naive to put numbers on this just as it is naive to have what is (in my own words) a VERY SPURIOUS sample! He says, 

"This is quite possibly true. But because there are not very many developed countries — in this study Japan is just one of 20 — it also might cause a reader to wonder about the universality of any rules derived from the remaining 19 cases, particularly since half of the remaining sample share a currency and an economic union. They are not exactly independent variables."

Really?!!

But moving on, Megan McArdle for the Daily Beast writes,

" There is a real danger in leaning too heavily on data from small countries that don't have the same control over their currency that the US enjoys.  Borrowing in a foreign currency (or ceding control over your monetary policy through mechanisms like currency zones or currency pegs) creates a new category of risks that places like the US don't face."

The problem with Ms. McArdle is what she writes next:

"Now that Democrats are starting to argue that our goal should be to just stabilize the debt over the next decade at 75-80% of GDP, these question has some fairly timely policy relevance. If there is a tipping point, and we're close to it, we should probably be trying to back off the precipice.  Slowly and cautiously, so as to avoid some sort of rock slide--but back away, none the less."

And finally Neil Irwin over at Wonkblog for the WaPo has this to add,

"Considering that the paper was presented at a monetary policy conference, and that its authors include a former Federal Reserve governor (Mishkin), it seems not to grapple enough with the crucial difference between the United States and many of the countries that are among the nations included in the historical analysis the paper is based on. Almost all of the countries that have experienced major financial crises in the recent past have in some way lacked control over their currency. For Greece and Ireland, that is because they use the euro, whose value is determined by the European Central Bank, the value of which is better suited for Germany and France than for those troubled peripheral European economies. In the East Asian crisis of the late 1990s, much of the damage came about because the countries involved had borrowed money in dollars, so when the value of their domestic currencies fell they suddenly had more onerous debt burdens than they had expected."

Irwin writes that for the fiscal scene to turn sour, one could think of a "confidence crisis" (sounds like a vigilante attack!) in US debt leading to capital outflows blah blah. But this paper doesn't do that. 

What this paper is, amongst many other things, as Boston Fed Pres Rosengren put it SO APTLY, is "parsimonious". Which in this case, is statspeak (unless parsimony is used for good!) for this-is-too-simple-do-you-not-realize-we're-in-the-real-world-here. Rosengren also asks about banking sector stability among other things. 

Anyway, I've suddenly gotten a bit tired of this paper now. 

I wish people would question it more. 

I wonder what 90%-ers Reinhart and Rogoff think of this. 

And I can't believe the man who taught me Money & Banking (well...through his proxy, my actual Professor!) was a part of this!

Just look at the traction this has gained. It's quite unbelievable to my inexperienced mind. That's all.

Oh, here's the paper.