Sovereign debt in the Second Great Contraction: is this time different?

• Author: Rogoff, Kenneth S.
• Position: The 2011 Martin Feldstein Lecture

As the aftershocks of the recent financial crisis continue to radiate, it is a troubling period for the global economy. While the current popular moniker for the recent crisis is "The Great Recession," perhaps a more appropriate description is "The Second Great Contraction", as Carmen M. Reinhart and I have argued. This term is parallel to Friedman and Schwartz's description of the Great Depression as "The Great Contraction," referring to the global contraction of debt and credit, in addition of course to output and employment. Unfortunately, a long sub-par recovery is typical of deep financial crises. (1)

My remarks will focus on one aspect of the ongoing great contraction, sovereign defaults on external debt. Long historical experience shows that major global banking and financial crises often are followed by a wave of sovereign debt problems. (2) With the euro zone periphery countries already under severe duress, and with a significant risk that default problems will spread east as generous IMF loan programs unwind, it is becoming increasingly clear that this time is not different. Indeed, there is even a palpable risk that sovereign debt woes will result in a partial breakup of the euro zone, a risk that a number of American economists, including Martin Feldstein for whom this lecture is named, have long warned of.

To say the least, this is an extraordinarily important moment for basic academic research in international macroeconomics. The Great Depression, of course, challenged economists to explain how, if we really live in a world of Walrasian perfectly clearing goods and labor markets, could it be possible for a country like the United States to have sustained unemployment for almost a decade, reaching as high as a quarter of the working population. (3) Through three quarters of a century of debate, economists have more or less reached a truce whereby all but a few die-hard real business cycle theorists acknowledge that short-term nominal frictions in goods and labor markets have a significant influence on macroeconomic fluctuations. I use the term "truce" because there is little agreement on the roots of monetary non-neutrality, leaving many open questions about the ultimate welfare effects of policy.

The Second Great Contraction similarly challenges the plausibility of another widely employed assumption in modern macroeconomic theory: that financial markets are perfect and complete in the profound Arrow-Debreu sense of spanning an incomprehensible range of public and private risks. Students of modern macroeconomic theory understand that the assumption of complete financial markets is a huge analytical convenience, allowing one to aggregate individuals and firms while eschewing the need to keep careful score of how shocks idiosyncratically affect winners and losers. There is certainly a great deal of analysis of more general cases allowing for limited asset markets, private information, and yes, sovereign credit risk. (4) Yet, because any departure from complete financial markets quickly can become an accounting and aggregation nightmare, mainstream macroeconomic theorists have been understandably reluctant to embrace alternatives that might be useful in one dimension but difficult to generalize in others, much less to parameterize and quantify.

Still, even before the onset of the Second Great Contraction, it should have bothered macro-theorists more that such a large fraction of world capital markets consists of non-contingent debt, including public and private bonds, as well as bank credit. It is difficult to pin down global aggregates, but a recent McKinsey study found that at the end of 2008, the equity market accounted for roughly $34 trillion out of $178 trillion in global assets, with government debt, private credit, and banking accounting for the rest. This figure, of course, is exaggerated by the global stock market crash that occurred after the collapse of Lehman Brothers in 2008, but even at the pre-crisis equity level of $54 trillion, equity markets represented less than one third of the total. True, there is...