Last week I outlined how a debt default would unfold in America. I pointed to the nuances of how a debt default happens, especially with regard to the difference between full and partial defaults. I also noted that a government may still pay principals on expiring treasury securities, but defer interest payments—or it may fail on both.
I also explained that there is no unique “trigger point” that all fiscal crises have in common. A combination of mutually reinforcing factors will cause the crisis, but each crisis appears different in terms of what this combination looks like.
With more of the public spotlight being placed on the so-called debt-ceiling negotiations here in the United States, there is naturally more attention paid to the possibility of a U.S. government debt default. Although such an event is ruled out here in June (for political reasons), it will happen basically any time in the next 6-24 months.
Yes, the window is that wide. One reason why we cannot narrow it further is that it is close to impossible to draw meaningful conclusions from debt crises in other countries. All crises have some basic fiscal and financial anatomies in common, but those are too limited to allow us to build formal predictive models.
I say this because it is extremely important that lawmakers in any country at risk of a debt crisis are educated on how to act in order to prevent a crisis, and how to respond if one happens.
I will return to the first problem next week (barring any unforeseen events); for now, let me share a few words of caution on the response to a crisis. As I explained last week, the political conventional wisdom here in America would likely condition Congress and the president to respond in ways that would escalate, not mitigate, a crisis. Therefore, unless they are better educated they would be well advised to leave the crisis response to the Federal Reserve.
But can our political leadership be educated enough to respond well to a crisis? Yes, but those who do the education must make sure they have done their own homework. Unfortunately, I see too many examples of policy experts who have not done that. They are therefore at risk of providing advice that, if followed, could exacerbate a crisis instead of ending it.
A major reason for this is the academic literature that is supposed to inform policy experts. There are two problems in this literature: over-complicated analysis and an over-reliance on the construction of economic models.
The first problem is prevalent throughout the academic literature, especially in the social sciences. Trust me—I have been there, too. Having written both academic books and numerous peer-reviewed journal articles over the years, I am deeply familiar with (and guilty of) scholarly research making the simple look complex and the obvious being turned into the obscure.
So long as academic over-complexity is limited to all things academic, without any connection to reality, it doesn’t harm anyone except the students who have to endure lectures on pre-Euclidean geometry, two-dimensional astronomy, or gender studies. However, sometimes academic writers fly out into the real world, borne by ambitions to explain the lives in which we live—and make a difference to it.
I would like to welcome them to reality. The problem is that college academics who venture into reality often bring their complexity with them, and there are few subjects where this is more prevalent than in economic policy. To take one example, closely related to the debt-default subject: economist Alberto Alesina and his co-authors of their book Austerity: When It Works and When It Doesn’t (Princeton, 2019). In an ambitious effort to generalize experiences from several episodes of fiscal austerity across time and space, they confine themselves to strict technical analysis.
In order to separate policy success from policy failure, they resort to dubious metrics. In brief, they claim that austerity improves the economy because episodes of austerity are followed by periods of strong economic growth. In doing so, they reduce their scholarly quest to the fiscal-policy equivalent of the following question: If I beat my dog and then stop beating it, is my dog happy because I beat it, or because I stopped beating it?
Their technical analysis leads them to the fiscal equivalent of the first dog-beat option, yet with a different methodology applied to the same material, we quickly reach the opposite conclusion. The reason is in part that the methodology applied by Alesina et al. prohibits the inclusion of significant institutional differences between countries as part of their success-or-failure metrics.
Others avoid their mistake, among them Robert Skidelsky and Niccoloó Fraccaroli, who edited Austerity vs. Stimulus: The Political Future of Economic Recovery (Palgrave, 2017). Their essays, especially in Part III, limit the technical aspects of a debt crisis to the simple question of investor confidence: they allow the exhibit of weaker confidence as higher interest rates, and stronger confidence as lower rates.
In other words, one simple variable is directly tied to a common form of economic behavior. The rest of the debt-crisis issue is treated as largely a political phenomenon. That is a productive approach with more promise to it than the technical analysis.
The latter approach is well represented by an oft-cited article called “Catastrophic Budget Failure” by Leonard Burman et al. (National Tax Journal, Sept. 2010). Its popularity has to do in part with the authors’ efforts to generalize debt crises based on a tradition of technical analysis found in the academic literature on the subject.
Burman et al. make one of their big mistakes when they define the crisis starting as “the bursting of a bubble in the market for U.S. government securities” (p.573). In other words, there is now something we are supposed to be able to measure—a bubble much like a real-estate or stock-market bubble. The problem with the comparison is that in the latter two cases the “bubble” is real, namely severely inflated values in the very assets which investors suddenly decide to run away from. No such inflation is necessary to set in motion a government debt crisis: the only necessary condition for a debt crisis is that investors in the sovereign-debt market no longer believe that they will get either coupons (interest payments) or the principal on the debt they own.
Burman et al. are led into their technical analysis because the literature they rely on tries to do just that. Their intent is noble: if we can isolate common factors of a debt crisis and see patterns in how it unfolds, then we can create predictive models for them.
Sadly, this cannot be done. In order to build any kind of economic model, we need a wealth of statistical information. That information consists of solid time-series data allowing for the repetitive study of a phenomenon over an extended period of time.
We also need clearly defined variables that are similar in the cross-section dimension—between countries—so we know that the data related to those variables are sufficiently similar. If they are not sufficiently similar, we cannot compare experiences of debt crises between nations where they have occurred.
This is a major problem, and the Burman et al. article is a good example of it. The debt-crisis ingredients are too different, and there is no better place to see this than in the main decision-maker variable that the debt-crisis literature discusses.
This variable is the politician, or—to be exact—the political leadership. Those who have written about debt crises over the years have made an undue implicit assumption over the years. They believe that the political environment where debt-crisis related decisions are made is similar enough from country to country to be compared without complications. Burman et al. make the same assumption.
To see why this is a mistake, consider the debt crisis in Sweden in 1992 and a hypothetical one in the United States in 2024. Back in ’92, the Swedish political environment was characterized by strong political hegemony: there were few if any differences between the right and the left in parliament. In terms of fiscal policy, their differences were minimal. By comparison, there are major differences between the two big parties in the U.S. Congress, so big that the two most recent Democrat presidents have not even been able to hold orderly budget negotiations when the House of Representatives has been under Republican control.
Thanks to its hegemony and aversion to deep political differences, the Swedish parliament quickly closed ranks when faced with a fiscal crisis. It passed very unpopular policies, which I accounted for in chapter 2 of Industrial Poverty (Gower, 2014). They did so with a political expediency that is rivaled only by countries normally considered totalitarian.
The U.S. Congress would never act in such unity, not even in the face of a fiscal crisis; bipartisanship is almost a vice on Capitol Hill. These major differences in political culture are tied to major differences in the institutional structure of the governments. There is no separation of powers in Sweden, whose parliamentary democracy in this respect is fairly similar to, e.g., Denmark and Greece (both of which have experience with fiscal crises). By contrast, the U.S. government is strictly divided into three branches. While the judicial branch is of less importance here, the executive and legislative branches are different enough to make rapid-response policies difficult at best.
In fairness, as we saw during the recent pandemic, U.S. politicians can overcome these differences and act quickly. However, this ability of Congress is strictly limited by the concern that its 535 members have for their relations with their voters. They face those voters in direct re-election bids, with the 435 Representatives going back to voters every other year. This means they have to face voters in person regarding every decision the voters are upset about.
Swedish politicians are almost impervious to voter dissent. They are largely protected from individual votes: Swedes vote for party lists with limited opportunities to select an individual candidate. The vote-count system is also relative; even unpopular political parties get seats in parliament.
With such major differences in the legislative process and political culture, it is simply impossible to use the political response to a fiscal crisis in one country to infer the political response to a similar situation in another country.
Another aspect of generalization gone awry in the debt-crisis literature relates to the role of the central bank. Here, we find a striking difference between Greece and the United States. As part of the euro zone, Greece has no monetary sovereignty; the United States enjoys the strongest of the kind in the world.
From a policy-conclusion perspective, Greece had no chance of monetizing its deficits—generally speaking, the U.S. government would have a substantial ability to do so.
The literature on debt crises tends to suggest that in a debt crisis, the latitude for monetary accommodation—deficit monetization—is limited in one way or the other. The premise appears to be that if the central bank intervenes, it will be seen as a sign of weakness by sovereign-debt investors and they will flee that government’s debt.
To show the absurdity in such generalizations, based on the following factoids I could claim that monetary hardlineship—if I may invent a new term—helps shorten a fiscal crisis:
- When the Greek debt crisis began in 2009, the ECB was still considered a monetary hardliner with no intent to monetize deficits; a year later that same monetary institution was deeply involved in exactly that sort of activity;
- The Swedish central bank was also a hardliner during their fiscal crisis, eventually allowing the nation’s interest rates to rise to an extreme 500%.
The conclusion that monetary accommodation is good for the economy is, of course, absurd. This example is given purely for illustrative purposes.
Since it is impossible to generalize the political response to a fiscal crisis, it is also unwise to generalize advice on how politicians ought to respond. The Cato Institute’s Debt Dispatch makes this mistake in a piece citing the aforementioned article by Burman et al. That does not rule out advice per se; on the contrary, it is the duty of public-policy experts to try to convince policy makers to make the right decisions. But whatever advice is given, especially when it comes to policy specifics, must be carefully tailored to the country where it is supposed to be implemented.
I welcome the Cato Institute’s interest in helping America avoid a debt crisis. The more voices we have, the better. That said, it is quintessential that we do our homework; we only get one chance to save America from the abyss of a debt crisis. Let us make sure we get it right on day one.
