Markets are getting slightly more bullish on Greek debt — and Peter Boone and Simon Johnson are crying bubble. I’m not so sure, but I think their argument highlights something else: the possibility of multiple equilibria in sovereign solvency.
What they argue, basically, is that with Greek debt likely to hit 150 percent of GDP, the burden of servicing that debt will be intolerable. They reach this conclusion by assuming that Greece will have to pay very high interest rates, say 10 percent, on its debt.
But in the past, some countries have managed levels of debt that high or higher, without default:
By the way, this wasn’t all about wars. In the 20th century, British debt passed 150 percent of GDP for the first time in 1921; it didn’t fall below 150 percent again until 1937.
So how is that possible? Suppose that Greece had as much credibility as Germany, and could borrow at a real interest rate of 2 percent. Then stabilizing the real value of its debt, even with a debt ratio of 150 percent, would require a primary surplus of only 3 percent of GDP. That’s certainly possible for some countries, although maybe not for Greece.
Boone and Johnson assume, however, that Greece would have to pay 10 percent nominal, say 8 percent real. Servicing that would require a primary surplus of 12 percent of GDP, probably impossible for almost anyone.
So this suggests that optimism or pessimism about future default can, to at least some degree, be a self-fulfilling prophecy. Not a new insight, I know, but it looks increasingly important for thinking about where we are now.
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