By Steven K. Beckner

JACKSON HOLE, Wyo. (MNI) – The United States and other
industrialized countries cannot afford to delay “decisive” action to
reduce deficit spending and mounting goverment debts, the top economist
for the Bank for International Settlements warned Friday.

Mounting debt-to-GDP ratios threaten to harm growth and in turn
worsen debt problems in a vicious circle unless deficits and debts are
tackled more seriously, Stephen Cecchetti, former New York Federal
Reserve Bank director of research, told an audience of Fed and other
central bank officials.

“Beyond a certain level, debt is bad for growth,” said Cecchetti,
head of the BIS’s Monetary and Economic Department, as he summarized a
paper written with BIS senior economist Fabrizio Zampolli.

“For government debt, the threshold is in the range of 80% to 100%
of GDP,” he said. “The immediate implication is that countries with high
debt must act quickly and decisively to address their fiscal problems.”

“The longer-term lesson is that, to build the fiscal buffer
required to address extraordinary events, governments should keep debt
well below the estimated thresholds.”

The paper presented by Cecchetti was one of several being discussed
at the Kansas City Federal Reserve Bank’s annual Jackson Hole symposium.
The theme of this year’s conference is Hole symposium. While the theme
is “Achieving Maximum Long-run Growth.”

The conference is taking place just a few weeks after the United
States government had its debt downgraded from triple-A for the first
time by Standard & Poor’s after President Obama signed into law a
conditional $2.4 trillion deficit reduction package that fell $1.6
trillion short of the minimum S&P had prescribed. Since then, financial
markets have been in turmoil, exacerbated by the European debt crisis.

During the lead up to the debt deal, Fed Chairman Ben Bernanke, who
is at Jackson Hole, urged Congress to adopt a long-term deficit
reduction plan. But he argued against significant short-term spending
cuts, maintaining that would hurt the economy.

A certain amount of debt is good, but “high and rising debt is a
source of justifiable concern” as shown by the financial crisis and the
more recent financial turbulence, according to Cecchetti and Zampolli.

They calculate that over the past 30 years, government, corporate
and household debt together in advanced economies has risen from 165% of
GDP to 310% of GDP.

“Given current policies and demographics, it is difficult to see
this trend reversing any time soon,” they write.

In answer to their own question “when does debt bite?” they
estimate the government debt threshold at 80% to 100% of GDP. The U.S.
debt-to-GDP ratio is roughly 70% but projected by the Congressional
Budget Office to go to 90% by 2020 and to 150% by 2030.

Cecchetti and Zampolli write that, until very recently, an
understanding of the importance of debt levels has been “missing” in
“the New Keynesian orthodoxy” that has guided economic policy among
industrialized countries in recent decades. But, they add, “the latest
crisis has revealed the deficiencies of the mainstream approach…”

Now, they write, macroeconomists must belatedly develop “models in
which debt truly matters.”

Their research shows that “the higher the level of debt, the bigger
the drop for a given size of shock to the economy,” they write. “And the
bigger the drop in aggregate activity, the higher the probability that
borrowers will not be able to make payments on their
non-state-contingent debt.”

“In other words, higher debt raises real volatility, increases
financial fragility and reduces average growth,” they continue. “Hence,
instead of high, stable growth with low, stable inflation, economies
experience disruptive financial cycles, alternating between
credit-fuelled booms and default-driven busts.”

Contrary to economists such as Paul Krugman who argue that
government should borrow to finance public spending to fill shortfalls
in private spending, the BIS economists warn, “even the ability of the
public sector to borrow is not unlimited.”

“When a crisis strikes, the ability of the government to intervene
depends on the amount of debt that it has already accumulated as well as
what its creditors perceive to be its fiscal capacity — that is, the
capacity to raise tax revenues to service and repay the debt.”

“Fiscal authorities may become constrained both in their attempt to
engage in traditional countercyclical stabilisation policies and in
their role as lender of last resort during a financial crisis,” they go
on. “That is, high levels of public debt can limit essential government
functions.”

They conclude that while “at low levels, debt is good” and can
facilitate economic growth, “at high levels, private and public debt are
bad, increasing volatility and retarding growth.”

In a nutshell, the problem they recognize is that the economy needs
to grow fast enough to raise revenues to service the debt, yet at high
levels, the burden of government debt becomes and impediment to that
revenue-producing growth.

“Without rising GDP, there will be no way to raise the revenues
governments need to reduce their exploding debts,” write Ceccchetti and
Zampolli.

They warn that “several industrial countries already have debt
levels that … might be growth-damaging. Or, they soon will be.”

“Public debt ratios are currently on an explosive path in a
number of industrial countries,” they contiinue. “To prevent further
deterioration, these countries will need to implement drastic policy
changes that reduce current deficits, as well as future contingent and
implicit liabilities.”

The economists caution that mere debt stabilisation “might not be
enough, especially if it is at a level high enough to damage growth.”
And they add, “Unfortunately, the unprecedented acceleration of
population ageing that many industrial countries are now facing may make
this task even more challenging.”

Warning again that debt to GDP ratios are set to “explode” in the
Unites States and other advanced countries, Cecchetti and Zampolli
declare that “the debt problems facing advanced economies are even worse
than we thought.”

“Given the benefits that governments have promised to their
populations, ageing will sharply raise public debt to much higher levels
in the next few decades,” they write. “At the same time, ageing may
reduce future growth and may also raise interest rates, further
undermining debt sustainability.”

“So, as public debt rises and populations age, growth will fall,”
they continue. “As growth falls, debt rises even more, reinforcing the
downward impact on an already low growth rate.”

The BIS economists issue a call to arms: “(A)dvanced countries with
high debt must act quickly and decisively to address their looming
fiscal problems. The longer they wait, the bigger the negative impact
will be on growth, and the harder it will be to adjust.”

** Market News International **

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