Thursday, September 10, 2009

From Financial Crisis to Debt Crisis?

Ken Rogoff wonders if government efforts to ameliorate the financial crisis will lead us to a debt crisis. He makes an important point that even economies with unsustainable levels of debt can plod along for a while before the sudden stop occurs:
Our models show that even an economy that is massively overleveraged can, in theory, plod along for years, even many decades, before crashing and burning.

It all boils down to confidence and coordination of expectations, which depend, in turn, on the vagaries of human nature. Thus, we can tell which countries are most vulnerable, but specifying exactly where and when crises will erupt is next to impossible.

A good analogy is the prediction of heart attacks. A person who is obese, with high blood pressure and high levels of cholesterol, is statistically far more likely to have a serious heart attack or stroke than a person who exhibits none of these vulnerabilities.

Yet high-risk individuals can often go decades without having a problem. At the same time, individuals who appear to be ``low risk" are also vulnerable to heart attacks.

Of course, careful monitoring yields potentially very useful information for preventing heart attacks. Ultimately, however, it is helpful only if the individual is treated, and perhaps undertakes a significant change in lifestyle.
The large debts we are incurring are reducing the negative consequences of the financial crisis, but these were emergency measures. Will be able to unwind them successfully?


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