Interesting research by Kenneth Rogoff, Carmen Reinhart and Vincent Reinhart takes a look at 200 years of public debt overhang episodes where public debt-to-GDP levels exceed 90 percent for at least five years. In the paper entitled "Debt Overhangs: Past and Present", released in the spring of 2012, the authors look at the impact of high public debt on economic growth and interest rates and how long these excessive debt episodes last. Here is a summary of their findings.
Let's open by taking a look at a graph from the paper showing how gross government debt for both emerging markets and advanced economies has varied as a percentage of GDP since 1900:
Notice that, since the middle of the first decade of the new millennium, the debt transgressors that consisted of the emerging markets in the 1980s and 1990s have been replaced (and rather rapidly so) by the debt "sins" of the world's advanced economies. The debt of the emerging market nations has fallen from a high of just under 100 percent of GDP to its current level of just over 40 percent whereas the debt of the world's advanced economies has done exactly the opposite, rising at an exponential rate. The authors project that the 22 nations of the advanced economies are now experiencing a public debt overhang as their average debt exceeds the 90 percent of GDP hurdle. You will also notice that the advanced economies had a debt peak in the 1940s; this was a result of massive spending on World War II. A somewhat lower peak developed for the world's emerging countries during the early 1930s as a result of spending during the Great Depression.
Here is a chart showing the debt-to-GDP for the Eurozone nations among other debt and deficit data:
Out of the EU27, five nations have a debt overhang and the major economies of France, Germany and the United Kingdom are well on their way to reaching the 90 percent level. Looking further afield, two of the world's largest economies, Japan and the United States, also have debt-to-GDP levels that exceed the 90 percent mark with Japan hitting just under 200 percent and the United States passing the 100 percent mark earlier this year.
If we look at the growth in the total gross public debt as a percentage of GDP of all of the 22 advanced and 25 emerging economies since 1970, here's what we end up with:
The total debt of the 22 advanced economies is 250 percent of GDP, nearly 10 times the total debt-to-GDP for the 25 nations of the emerging economies. That is nothing but amazing and is a bit counter-intuitive to what many people would expect.
Among the 22 advanced economies over the 200 years of the study, which had the worst debt situations? Nine countries, including Austria, Denmark, Finland, Germany, Iceland (until 2009), Norway, Portugal (until 2010), Sweden and Switzerland had no debt overhangs. All other nations had at least one debt overhang where debt exceeded 90 percent of GDP. Here is a chart from the study showing the worst offenders with debt overhangs of more than a decade in length:
Here is a companion chart showing the episodes of public debt in excess of 90 percent that are of less than a 10 year duration:
Greece is the worst offender of the 13 lengthy overhang nations with four episodes of very high debt-to-GDP since 1848, covering a total of 95 years out of the 163 year sample (58 percent of the time). Italy has four episodes since 1861 (one is less than 10 years in length) covering at total of 74 years out of the 150 years (49 percent of the time). All told, for the 10 nations with long debt overhangs, the average length of the overhang is a stunning 27.3 years! For the entire sample of all nations including those with shorter duration overhangs, the average period of high debt levels is a still amazing 23 years.
Now that we've established that the world's largest economies are in a debt overhang position as defined by the authors of the paper and that these debt overhangs can last for decades, what are the repercussions?
1.) Lowered GDP growth: From data for the advanced economies, prior to the debt surpassing the 90 percent hurdle, real GDP growth averaged 3.5 percent per year over the full period of time that debt remained below the debt overhang threshold. During the debt overhang episodes, economic growth slowed to an averaged of 2.3 percent with a median of 2.1 percent, a drop of either 1.2 or 1.4 percent from the lower debt period. Here is a graph showing the cumulative effect of lower growth over a 23 year-long debt overhang (in red):
We wonder why our economies just don’t seem to be firing on all cylinders since the Great Recession, don’t we? Perhaps all of that stimulus did exactly what governments didn’t expect! To put the 1.2 percent per annum drop into a long-term perspective, over the 23 year period (the average of debt overhangs as noted above), total real economic growth loss is 24 percent.
2.) Interest Rates: It is generally thought that as debt rises, the interest rate premium on that debt rises as well, since the risk on each nation's debt securities rises. In this study, of the 26 episodes of high debt, 15 periods had higher real interest rates and a not insignificant 11 episodes actually had lower real interest rates. Interestingly enough, four of the 26 episodes had both low interest real interest rates and lower economic growth, a seeming contradiction to what we would normally expect.
In summary, the world is facing a debt hurdle that may last far, far longer than we would expect. When we read headlines in the mainstream media that predict that Europe's debt problems appear to be solved, we should not be terribly surprised when a new issue seems to appear out of nowhere. After all, when compared to precedents set over the past two centuries, the world's current public debt crisis appears to be in its infancy. What will be telling is to see whether the world's debt markets can continue to absorb the massive amounts of new sovereign debt that will be required to keep the world's economy turning.