The Fonzie-Ponzi Theory Of Government Debt

Also, investors remain in the game at the Ponzi point, happy to hold government debt, in the same way that successful Ponzi schemers are able to find willing participants right up to the end. Large, developed nations, such as the United States and Japan, can sail right past their Ponzi points with nary a flutter in the financial markets. As I’ll argue in a moment, Japan has already passed its Ponzi point.

Think of it this way:

You’re swimming in the ocean on a perfect, sunny day, unaware of a riptide that’s pulling you beyond a swimmable distance from shore. Once you realize what’s happened, you’ll struggle against the current and may pay for your mistake with your life if there’s no help at hand. But the mistake was made earlier when you ignored the water conditions and drifted past your ability to swim back safely. Let’s say it was halfway between the shoreline and where the rescue helicopter pulled you out that you unknowingly let yourself drift too far. That halfway spot was your Ponzi point.

In the swimming scenario, you should have turned around well before reaching the Ponzi point, even as there were no obvious signs of danger. By the same logic, governments should take action well before public debt rises to Ponzi levels, even though they, too, won’t get a clear warning of the eventual catastrophe.

Now for my thoughts on the Ponzi point for today’s large, developed countries. Smaller and emerging countries are different, because they often lose their creditors’ confidence before the Ponzi point comes into play. Here’s my theory for the big countries:

fonzie-ponzi 2

Thresholds are notoriously inexact in economics, which is why I use big, round numbers. It’s also why I’ve chosen a wide range for the transition from Fonzie to Ponzi. At some point between 100% and 150% debt-to-GDP, I think the sovereign debt of today’s large, developed countries fundamentally changes. Bondholders who were merely perpetuating a confidence trick become participants in a Ponzi scheme.

My estimates are based on the research summarized earlier in this chapter, which I’ll tie into the Fonzie–Ponzi theory in just a moment. I’ll first add a few more qualifiers and then some data. Here are the qualifiers:

  • Assumptions behind my transition range. I don’t recommend a range of 100% to 150% for all times and places. It seems sensible, though, for countries with spending commitments extending far into the future without proper funding behind them or even honest accounting. That happens to be many of today’s developed countries. My transition range is also more likely to apply to countries with heavy private sector borrowing. The amount of private borrowing is important because it determines the capacity for new bank credit and, therefore, the likely effects of fiscal policy changes. If private debt capacity is high, banks can cushion fiscal restraint by expanding credit to the private sector. Conversely, low private debt capacity means fiscal restraint can more easily swing bank money creation into reverse (see this article), leading to the stagnant or negative growth that invariably coincides with a broad-based deleveraging.
  • Austerity versus anti-austerity. I’m not making blanket recommendations for austerity policies—which may or may not be helpful, depending on the circumstances—nor is this a policy-oriented book in the first place. That said, I’ll offer three brief policy conclusions. First, economic risks are lowest when governments stay well clear of their Ponzi points. Second, even though sovereign defaults are highly disruptive, debt restructuring is often the best option once the Ponzi point is breached. (If you’re headed for default anyway, there may be a case to act quickly and restore public debt capacity to healthy levels.) Third, after a restructuring occurs, it’s imperative to put public finances back on a sustainable path, one that remains below the Ponzi point. Of course, politicians often reach very different conclusions.
  • Fonzie–Ponzi versus Minsky. The Fonzie–Ponzi theory is more lenient than Hyman Minsky’s financial instability hypothesis. Minsky proposed a “Ponzi finance” threshold for private debt, but we can just as easily apply it to the public sector. He said that borrowing qualifies as Ponzi finance whenever fresh issuance is needed to fund interest on existing debt. According to the common assumption that America would miss interest payments without regular increases in the statutory debt limit, we long ago triggered Minsky’s threshold.
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