Is Greece's debt really so unsustainable? Yes, it is.

Lorenzo Bini Smaghi, former member of the executive board of the ECB, writes for the Financial Times that Greece's debt might be sustainable.

One of the points he makes is

...the sustainability of the debt depends on the dynamics over time rather than on the overall level. A high debt-to-GDP ratio can be more sustainable than a lower one, if the former component is expected to stabilise and fall over time, while the latter continues to grow unabated. In fact, the sustainability of the debt is inversely related with the level of interest rate paid on the debt, and positively related to the expected growth rate of the economy and the primary budget balance which has been achieved.

I can't argue with that.

He makes assumptions for the four variables that pin down the dynamics of the debt-to-GDP ratio, and concludes that Greece could reduce its debt burden by 40% of GDP by 2019.

I am shocked. If there was one thing I thought I knew about the Greek crisis, it's that Greece's debt is on an explosive path, under any realistic scenario for the relevant variables. But since a simple computation, in this case, can clarify a lot, I decided to check.

The sovereign debt-to-GDP ratio is governed by the familiar GIDDY equation:

$$D_t =  (1+y-g-i) D_{t-1} + d_t $$
where \(g\) is the growth rate of real GDP; \(i\) is the inflation rate; \(D_t\) is the debt ratio at time \(t\); \(d_t\) is the deficit, as a ratio to GDP; and \(y\) is the average interest rate on the debt (yield).

(I'm assuming all debt is in denominated in domestic currency,  in this case euros, so I can ignore changes in the exchange rate.)

Bini Smaghi draws his debt projections out to 2019, although he's not explicit about his assumptions year by year. Suppose, he says, that Greece grows 3% a year through 2019; it runs a primary fiscal surplus of 4.1% of GDP every year (as Bini Smaghi says Greece will do in 2015); and the average interest rate on debt is 4% (Bini Smaghi assumes 4%, because "official creditors have accepted a reduction of the interest rate on their loans to levels comparable to those of the best eurozone borrowers").

It's not clear whether his growth assumption is real or nominal. However, the debt reduction is way too small if his assumption is for nominal GDP. Let's be generous, then, and suppose he's talking about real GDP, and add an inflation rate of 3% a year through 2019.

With all that in place, I get numbers close to Bini Smaghi's. The debt ratio goes down about seven points in 2015, just like he says, and we get to a level of 138.5%, not too far from his claim of 135%.

(You can plug in your own assumptions in this tool by the Financial Times and the IMF. Beware, though, that this calculator assumes the starting debt ratio, in 2014, is 164%, whereas I started with 175%.)

I checked the IMF's projections, as a benchmark, and it turns out he may have been using the IMF's projections all along! The WEO database shows a debt ratio of 174% in 2014, which goes down to 135% by 2019, just like Bini Smaghi says. The primary balance is 3.5% in 2015, and north of 4% after that. Real GDP growth never falls under 3% after 2015, and inflation gradually soars from 0.4% this year, to 1.75% in 2019.

IMF's projections (WEO Oct. 2014)
	2015	2016	2017	2018	2019
Real GDP growth, %	2.9	3.7	3.5	3.3	3.6
Inflation (GDP deflator), %	0.4	1.1	1.3	1.4	1.8
Primary fiscal balance (% of GDP)	3.0	4.5	4.5	4.2	4.2
Debt (% of GDP)	171	161	152	145	135

Lo and behold, however, the heroic assumptions. Three to three-and-a-half percent real growth, year in year out, through 2019? Primary surpluses above 3% for five years in a row? Are we talking about a fiscally hyper-disciplined, pro growth economy? Or are we talking about Greece?

I'm sorry, Mr. Bini Smaghi and economists at the IMF, but these are science-fiction numbers.

Suppose instead that nominal growth (real growth + inflation) is 3%, primary surpluses average 2%, and the cost of debt stays at 4%. (Still generous projections for a country with Greece's situation and track record.) The debt ratio then declines by a modest 1.3% of GDP over five years, to 173.7%.

Bini Smaghi makes a second point in his column: Greece is unlikely to default because its debt is largely held by the EFSF and it has a long average maturity. Refinancing risk, he says, is much lower than for other eurozone countries that borrow in the market.

But he's addressing two different questions here. One is whether Greece's debt is sustainable. The most likely answer is "no," based on realistic assumptions. The other question is whether Greece will default in the short term. Not necessarily (assuming there were no elections soon). A country can be insolvent in the long term and, yet, thanks to temporary arrangements, be able to service its debt in the short term. There is no doubt that Greece's cost of debt would not be 4% today, if it weren't for the EFSF. And Greece's fiscal balance would not be a surplus of 4% if it weren't for pressure from the troika. Greece is on life support, and current conditions will not, and should not, apply in the long term.

New paper on the mechanisms behind the eurozone crisis

Philippe Martin and Thomas Philippon have written a new paper about the mechanisms of private leverage and fiscal policy within the eurozone, from its creation through the Great Recession. (NBER link, ungated version).

From the introduction (emphasis mine):

There is wide disagreement about the nature of the eurozone crisis. Some see the crisis as driven by fiscal indiscipline and some by fiscal austerity, some emphasize excessive private leverage, while others focus on external imbalances, sudden stops or competitiveness divergence due to fixed exchange rates. Most observers understand that all these “usual suspects” have played a role, but do not offer a way to quantify their respective importance. In this context it is difficult to frame policy prescriptions on macroeconomic policies and on reforms of the eurozone.

[...]

...we propose a simple model that focuses on three types of shocks: household leverage, fiscal policy, interest rate spreads and exports. A key challenge is then to empirically identify private leverage shocks that are orthogonal to shocks on fiscal policy and shocks on spreads. To help us identify the eurozone shocks, we use the US as a control.

[...]

The key difference between the US and the eurozone experience is the sudden stop in capital flows starting in 2010 in the later.

[...]

Contrary to the eurozone, the US states did not experience any shock on spreads in borrowing costs and no fear an a potential exit of the dollar zone. This allows us, for the eurozone, to identify the part of the private deleverage dynamics that is not due to the spreads shocks by the private deleveraging predicted in the US on the period 2008-2012. We call this the “structural” private leverage shock.

[...]

Starting in the Spring of 2010, sovereign spreads widen and several European countries find it difficult to borrow on financial markets. The US and EZ experiences then start to diverge. While US states grow (slowly) together, eurozone countries experience drastically different growth rates and employment. A state variable that correlates well with labor markets performance in 2010-2011 in the Eurozone is the change in social transfers during the boom. Eurozone countries where spending on transfers (and also government expenditures) increased the most from 2003 to 2008 are those that are now experiencing severe recessions in the later stage. This suggests that in the second stage past fiscal policy, because of its effect on accumulated debt, had an impact on the economy through spreads and the constraint on fiscal policy it generated after 2010.

[...]

In this paper, we analyze a model where borrowing limits on “impatient” agents drive consumption, income, the saving decisions of “patient” agents and employment in small open economies belonging to a monetary union. We introduce nominal wage rigidities which translate the change of nominal expenditures into employment. We first consider the predictions of the model taking as given the observed series for private debt, fiscal policy and interest rate spreads between 2000 and 2012.

Maybe I don't understand the paper, but it seems to me that using U.S. states to identify the causal mechanisms is crucial. It also seems (and I might be wrong) that the identifying vehicle are the spread shocks. Now, there exist important differences between U.S. states and eurozone countries: fiscal, political, labor markets, cultural, etc. Insofar as those differences are not reflected in spreads or spread shocks, but played a role in determining the path of unemployment, deficits, etc., the identification strategy is flawed. Comments?

Putting those doubts aside, I love this paper.

Summary of main findings, from the conclusion:

1. The private leverage boom (in 2000-2008) was the key igniting element of the crisis, especially in Spain and Ireland.

2. Pro cyclical fiscal policy during the boom worsened the situation, especially in Greece.

3. In Ireland and Spain, a more conservative fiscal policy during the boom would have helped, but would have entailed an implausibly large fall of public debt.

4. A macro-prudential fiscal policy to limit private leverage during the boom would have stabilized employment in all countries. However, in the absence of more prudent fiscal policy, this would have induced a larger buildup in public debt.

5. Fiscal and macro-prudential policies are thus complements, not substitutes, in order to stabilize the economy.

6. The sudden stop in the eurozone worsened the crisis by further constraining fiscal policy. If the ECB's "whatever it takes" line had come earlier (and had been successful at that earlier time), Ireland, Spain, Greece and Portugal would have been able to avoid the latest part of the slump.

What caught my eye

1. How the government exaggerates the cost of education, by David Leonhardt at the New York Times.

But it turns out the government’s measure is deeply misleading.
For years, that measure was based on the list prices that colleges published in their brochures, rather than the actual amount students and their families paid. The government ignored financial-aid grants. Effectively, the measure tracked the price of college for rich families, many of whom were not eligible for scholarships, but exaggerated the price – and price increases – for everyone from the upper middle class to the poor.
[...]
Fortunately, the government isn’t the only organization that collects data on college tuition over time. The College Board also does, and it publishes different indexes on published tuition and net-price tuition, separately for public and private colleges. (Only scholarship grants are considered in the net-price calculation. Loans, appropriately, are treated as part of the tuition that families are really paying.)
Net tuition and fees at private four-year colleges have risen 22 percent since 1992, the College Board says, and the increase has been 60 percent at public four-year colleges. Community-college tuition has declined, because aid grants have outpaced published tuition. These numbers are obviously quite different from the government’s index showing a 107 percent increase.

The more challenging question is: Given the changes that we're about to see in how higher education is provided (online classes), how much will college cost in 20 years? (Hat tip to my wife, to whom I can't give a confident answer when she asks: "How much do we need to save for our [8-month-old] son's college?")

2. A measure of global systemic financial risk, from NYU Stern's V-lab, via Econbrowser, and a chart for China:

3. The U.S. can't inflate away its public debt, probably. From a recent paper by Jens Hilscher, Alon Raviv, and Ricardo Reis: Inflating away the public debt? An empirical assessment. [Ungated version.]

Abstract: We propose and implement a method that provides quantitative estimates of the extent to which higher- than-expected inflation can lower the real value of outstanding government debt. Looking forward, we derive a formula for the debt burden that relies on detailed information about debt maturity and claimholders, and that uses option prices to construct risk-adjusted probability distributions for inflation at different horizons. The estimates suggest that it is unlikely that inflation will lower the US fiscal burden significantly, and that the effect of higher inflation is modest for plausible counterfactuals. If instead inflation is combined with financial repression that ex post extends the maturity of the debt, then the reduction in value can be significant.

4. Valuing non-US equities: claims about the CAPE (cyclically-adjusted price-earnings) ratio, by Andrew Smithers. Part I. Part II.

5. The dark side of the Italian tomato. Also in French and Spanish.

Italy, the third largest agricultural producer after France and Germany, vies with Spain for first place in the production of vegetables. In the past 10 years, Italy has produced an average of 6 million tonnes of tomatoes per year (FAOSTAT). According to FAO, the exportation of concentrated Italian tomatoes was facilitated in 2001 by a reimbursement by the EU of 45 euros ($61) for every tonne of product exported (FAO). But that’s not all. Overall, according to Oxfam, the EU subsidises tomato production to the tune of approximately 34.5 euros ($47) per tonne, a subsidy that covers 65% of the market price of the final product (Oxfam). But who in Brussels is aware of the paradox of subsidising an export product that dumps on local produce in Africa? 

The European Union subsidizes local production of farm products, which puts Africans out of work in their home countries, which drives them to migrate to Europe, lowering wages in Europe. In the end, the tomato pickers might enjoy the same expected utility in Africa than in Europe, after cost and quality of living are accounted for. European producers win, African producers go out of business.

One might argue the subsidies are a net positive if tomato production is more efficient in Europe than in Africa. But if that were the case, then why would European production need to be subsidized? Leaving aside that, what's the effect of European subsidies? European farmers win, the impact on everybody else is uncertain, at best.

Japan's government debt: up

(A version of this piece will appear on Morningstar Advisor, my employer's bi-monthly magazine.)

By standard criteria Japan is in worse fiscal shape than Greece. The Japanese government hasn’t balanced a budget since 1992, and runs one of the highest deficits on earth. The stock of debt is eight times as high as annual tax revenue. Would the bank give you another loan if you owed eight years’ worth of income? The familiar ratio of debt to GDP has risen in 20 years from 80% to 243%, the highest level in the world. How did public finances get so rotten?

The road to ruin

Debt dynamics depend on five things which, properly arranged, get you GIDDY: growth (g), inflation (i), debt (D), deficit (d), and yield (y). A short equation describes the relationship:

D[t] = D[t-1] * (1 + y - g - i) + d[t]

The formula says that this year’s debt-to-GDP ratio, D[t], is equal to last year’s, D[t-1], multiplied by the term (1 + y - g - i), plus this year’s deficit d[t].

The apparent causes of Japan’s debt explosion, then, are three. First, despite ground-low interest rates, economic growth plus inflation were even lower, so the term (y – g – i) was positive for most of the last two decades. The implicit interest rate has averaged 1.9% since 1993. Real GDP has increased a mere 0.9% a year, while the GDP deflator (a broad measure of prices) has fallen 1% per year. Deflation more than erased the gain in real output.

Second, the larger the debt balance, the harder it is to pay it off, as any credit card holder knows. That’s because debt itself, D, is multiplied by the term (1 + y – g – i). Even a small positive difference between the interest rate and nominal growth makes a significant impact, once debt gets as high as Japan’s.

And third is the primary fiscal deficit, d. If expenses exceed revenues the government must finance the gap by borrowing, which adds to debt. Japan has averaged a fiscal gap of 5.4% of GDP over two decades.

Aging weighs down public finances

At a deeper level the debt problem has a demographic root: Japan’s population is aging and shrinking, fast.

Demographics touch on each of the five determinants of debt. The connection between deficit and age structure is the easiest to see. Aging widens the pool of pensioners while it shrinks the number of taxpayers. In Japan Social Security payments have almost tripled since 1990, and now eat up 40% of tax receipts. Seniors go more to the doctor, too, and Japan provides universal healthcare.

Then there’s economic growth. The working-age population gets 1% smaller every year. To achieve, then, even a modest output growth rate of 2%, output per worker must rise by 2.9% a year. No advanced economy has sustained that pace of productivity gain in the last 20 years. Most countries, including Japan, have been in the 1% to 2% range since the 1990s.

Deflation is linked to demographics as well. As former Bank of Japan governor Masaaki Shirakawa says in a recent speech: “Over the decade of the 2000s, the population growth rate and inflation correlate positively across 24 advanced economies.  That finding shows a sharp contrast with the recently waning correlation between money growth and inflation.” Shirakawa then says that aging is undermining real demand growth, which falls behind   potential output growth, fuelling deflation.  

An army of pensioners, I might add, will probably fight inflation. Life is great when you’re on a fixed income and prices decline, which is what seniors in Japan have come to expect.

Finally, aging puts pressure on interest rates. The baby-boom generation is selling its bond holdings to provide income for retirement. That raises bond yields, adds to the government’s interest bill, and accelerates the growth of debt.

Where is, then, Japan headed? To estimate the ratio of debt to GDP in, say, 2020, I roll forward the formula above and plug in projections for the five drivers of debt over the next seven years. Under those forecasts the debt ratio rises relatively little, from 243% to 257% (see the table).

Changing assumptions produces striking results. In a sunnier world of robust growth and inflation, deficits half what they’ve been since 2009, and a borrowing cost even lower than today’s, debt shrinks to 218%. Under less favorable, but more credible, conditions the debt ratio hits 297%. The odds are that debt will keep rising.

                 Projections of Japan’s government debt

		Assumptions
	Optimistic	Baseline	Pessimistic
Debt / GDP in 2020 (%)	218	257	297
Debt / GDP in 2013 (%)	243	243	243
GDP growth in 2013-20 (%)	1.5	0.9	0.5
Inflation in 2013-20 (%)	2.1	1.1	0.1
Primary deficit in 2013-20 (%)	3.4	4.4	5.4
Implicit int. rate 2013-20 (%)	0.5	1.0	1.5

                      Source: IMF; author’s calculations.

Interest rates are key

Key to the outlook, and most uncertain, are interest rates. Yields have stayed low due to steady demand for bonds from domestic buyers. The Japanese private sector produces large cash surpluses, which get recycled into Japanese government bonds (JGBs) via the banks. Commercial banks have been more than happy to invest in sovereign debt, as loan demand is sluggish. Where else would they find an investment with a real return of 2.5% and no capital requirements?

Financial repression has played a role too. The Ministry of Finance has used its clout to force pension funds and insurance companies to buy public debt. The Japan Post Group, which includes a massive bank and a major insurance company, is owned by the state, and thus another reliable buyer.

Thanks to this loyal domestic demand, the government with the highest debt in the world pays the lowest borrowing costs.

The private sector, however, cannot absorb public deficits forever. An aging population means the household saving rate is falling. Soonish it will turn negative. Corporations still produce excess savings, but not enough to cover the public financing needs. If firms kept buying JGBs eventually all of Japan’s private wealth would be held in government bonds. What would happen then?

A recent paper by professors Takeo Hoshi and Takatoshi Ito answers this question. They argue that, once domestic savers are tapped out, Tokyo must borrow abroad. Foreigners are presumably less willing to accept ultra-low yields, so the interest expense will surge.

Today the Ministry of Finance spends over half of tax revenues on interest payments, even though the implicit borrowing rate is below 1%. Just a modest increase to 2%, then, would put interest charges above tax receipts—what Hyman Minsky called “Ponzi finance.” The markets would deem the government insolvent, and default would follow. Under every simulation run by Hoshi and Ito, bankruptcy would come by 2023.

Japan’s policymakers are aware of this possibility, which is perhaps why they’ve turned to the central bank. After winning the November 2012 election, prime minister Abe appointed a new head of the Bank of Japan (BoJ). Under governor Kuroda the BoJ announced that it would buy 7.5 trillion yen of bonds a month, or 70% of all new issuance. These purchases have anchored yields. With a boundless balance sheet, the central bank can keep financing the government forever, in theory. In practice, as centuries’ worth of sovereign debt crises show, monetization of the deficits can lead to hyperinflation.

Mr. Abe is betting he can dodge both default and hyperinflation. If he can keep funding the deficit with long-term bonds at tiny interest rates; if moderate inflation keeps chipping away at the pile of debt; and if deficits decline somehow, despite population aging, the government might contain the swell of debt. That’s a lot of ifs, and they will take years to work. The question is: Will markets bear with Japan that long?

Leaders in other aging countries might draw a message of hope. Japan proves that it’s possible to combine slow growth with persistent deflation, soaring public debt, and cheap borrowing, all while avoiding unpopular fiscal decisions, for decades. Most prime ministers, who have a four-year calendar, will take the gamble.