Debt Overhang Depresses Growth.

Siren political voices in recession-hit European countries are luring voters with the appealing notion that there is a simple choice to be made between growth or austerity: Up with growth! Down with austerity! However, the Bloomberg article below – Bond Market May Not Warn When Debt Crisis Strikes – reveals that historically examples of countries growing their way out of excess debt are very rare.
In summary, too much debt – with the critical element being Debt Overhang, defined as a 5-year period when gross public debt exceeds 90% of GDP – depresses growth by as much as 1.2% points lower than in other periods, with real interest rates also typically as low during debt overhangs as they were before. Therefore, the financial markets will not necessarily send a warning signal to a government such as the US, through higher interest rates, that their policy could be detrimental to economic performance.
According to this definition of Debt Overhang, Italy, Greece and Japan are regular members of this club and, although the US is not there yet, it first breached the 90% threshold after the 2008 financial crisis, with Belgium, Iceland, Ireland and Portugal not far behind.
Austerity is not a cure for excessive debt either with such episodes in the past involving all kinds of explicit and disorderly debt restructuring or dressed up another way as e.g. debt forgiveness.
One successful example from the past is the US which made a complete recovery from the 1944-1949 period through balanced budgets, financial repression and robust growth in the 1950s and 1960s; however, with the federal deficit set to exceed $1 trillion in 2012 for the 4th year running, necessary cuts to entitlement programmes a seemingly insurmountable challenge and consumers not in the mood to spend for growth, financial repression appears the only option today.
This means keeping nominal interest rates low and allowing inflation to reduce the real value of debt whilst real interest rates remain negative for savers. Indeed the Federal Reserve has pledged to hold its benchmark interest rate near zero at least through to late 2014 and the Bank of England seems to be following a similar policy.

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