I want to draw your attention to an interesting if wonkish post by James Hamilton summarizing his findings on the economic impact of external debt and Paul Krugman’s criticism of Dr. Hamilton’s recent WSJ op-ed. Here’s his retort:
It is true that you won’t find statistical confirmation of the nonlinearities reported in equation (3) if you confine yourself to recent experience in the major non-eurozone advanced economies. There’s a simple reason for that– these countries have not yet reached the tipping point in the dynamics of fiscal debt loads.
Are Krugman and O’Brien claiming that they never could? Do they maintain that U.S. debt could become an arbitrarily large multiple of GDP with no consequences for yields? If they acknowledge that there is a level of debt at which these effects would start to matter for the United States, what is their estimate of that level, and how did they arrive at it?
In our paper we offer our answer to these questions. We conclude that a country’s debt limit depends on its borrowing rate, its economic growth rate, and the fraction of GDP that the public is willing to commit to maintaining a permanent primary surplus– that is, government revenues minus spending on all items other than interest expense. If Krugman, O’Brien, or anybody else thinks they have some other answer, let them articulate it clearly and cleanly.
Whether a country is able to borrow in its own currency is completely irrelevant for the above calculation. Yes, it means the country likely won’t technically default on the debt, and could always create new money to pay off the creditors. But as Reis (2013) and Leeper (2013) have recently explained, printing money does not generate any magical resources with which to resolve a real fiscal shortfall. The central bank could create some more inflation, but anticipated inflation does nothing to alter the above determination of the limits on government debt.