Debt and Delusion
NEW HAVEN –
Economists like to talk about thresholds that, if crossed, spell
trouble. Usually there is an element of truth in what they say. But the
public often overreacts to such talk.
Consider, for example, the debt-to-GDP ratio, much in the news
nowadays in Europe and the United States. It is sometimes said, almost
in the same breath, that Greece’s debt equals 153% of its annual GDP,
and that Greece is insolvent. Couple these statements with recent
television footage of Greeks rioting in the street. Now, what does that
Here in the US, it might seem like an image of our future, as public
debt comes perilously close to 100% of annual GDP and continues to rise.
But maybe this image is just a bit too vivid in our imaginations. Could
it be that people think that a country becomes insolvent when its debt
exceeds 100% of GDP?
That would clearly be nonsense. After all, debt (which is measured in
currency units) and GDP (which is measured in currency units per unit
of time) yields a ratio in units of pure time. There is nothing special
about using a year as that unit. A year is the time that it takes for
the earth to orbit the sun, which, except for seasonal industries like
agriculture, has no particular economic significance.
We should remember this from high school science: always pay
attention to units of measurement. Get the units wrong and you are
If economists did not habitually annualize quarterly GDP data and
multiply quarterly GDP by four, Greece’s debt-to-GDP ratio would be four
times higher than it is now. And if they habitually decadalized GDP,
multiplying the quarterly GDP numbers by 40 instead of four, Greece’s
debt burden would be 15%. From the standpoint of Greece’s ability to
pay, such units would be more relevant, since it doesn’t have to pay off
its debts fully in one year (unless the crisis makes it impossible to
refinance current debt).
Some of Greece’s national debt is owed to Greeks, by the way. As
such, the debt burden woefully understates the obligations that Greeks
have to each other (largely in the form of family obligations). At any
time in history, the debt-to-annual-GDP ratio (including informal debts)
would vastly exceed 100%.
Most people never think about this when they react to the headline
debt-to-GDP figure. Can they really be so stupid as to get mixed up by
these ratios? Speaking from personal experience, I have to say that they
can, because even I, a professional economist, have occasionally had to
stop myself from making exactly the same error.
Economists who adhere to rational-expectations models of the world
will never admit it, but a lot of what happens in markets is driven by
pure stupidity – or, rather, inattention, misinformation about
fundamentals, and an exaggerated focus on currently circulating stories.
What is really happening in Greece is the operation of a
social-feedback mechanism. Something started to cause investors to fear
that Greek debt had a slightly higher risk of eventual default. Lower
demand for Greek debt caused its price to fall, meaning that its yield
in terms of market interest rates rose. The higher rates made it more
costly for Greece to refinance its debt, creating a fiscal crisis that
has forced the government to impose severe austerity measures, leading
to public unrest and an economic collapse that has fueled even greater
investor skepticism about Greece’s ability to service its debt.
This feedback has nothing to do with the debt-to-annual-GDP ratio
crossing some threshold, unless the people who contribute to the
feedback believe in the ratio. To be sure, the ratio is a factor that
would help us to assess risks of negative feedback, since the government
must refinance short-term debt sooner, and, if the crisis pushes up
interest rates, the authorities will face intense pressures for fiscal
austerity sooner or later. But the ratio is not the cause of the
A paper written last year by Carmen Reinhart and Kenneth
Rogoff, called “Growth
in a Time of Debt,” has been widely quoted for its analysis of 44
countries over 200 years, which found that when government debt exceeds
90% of GDP, countries suffer slower growth, losing about one percentage
point on the annual rate.
One might be misled into thinking that, because 90% sounds awfully
close to 100%, awful things start happening to countries that get into
such a mess. But if one reads their paper carefully, it is clear that
Reinhart and Rogoff picked the 90% figure almost arbitrarily. They
chose, without explanation, to divide debt-to-GDP ratios into the
following categories: under 30%, 30-60%, 60-90%, and over 90%. And it
turns out that growth rates decline in all of these categories as
the debt-to-GDP ratio increases, only somewhat more in the last
There is also the issue of reverse causality. Debt-to-GDP ratios tend
to increase for countries that are in economic trouble. If this is part
of the reason that higher debt-to-GDP ratios correspond to lower
economic growth, there is less reason to think that countries should
avoid a higher ratio, as Keynesian theory implies that fiscal austerity
would undermine, rather than boost, economic performance.
The fundamental problem that much of the world faces today is that
investors are overreacting to debt-to-GDP ratios, fearful of some magic
threshold, and demanding fiscal-austerity programs too soon. They are
asking governments to cut expenditure while their economies are still
vulnerable. Households are running scared, so they cut expenditures as
well, and businesses are being dissuaded from borrowing to finance
The lesson is simple: We should worry less about debt ratios and
thresholds, and more about our inability to see these indicators for the
artificial – and often irrelevant – constructs that they are.
Robert J. Shiller is Professor of
Economics at Yale University.
Copyright: Project Syndicate, 2011.
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