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Error In Reinhart And Rogoff's Theory To Affect Interest Rates?

|Includes: JPMorgan Chase & Co. (JPM), WFC

Borrowing cost for any borrower in Foreign Currency market is a function of Risk Free (NYSE:RF) Rate + Spread. For example for any borrowing denominated in US dollars, Interest rate on US Treasury is presumed to be Risk Free (RF). The spread includes the risk of default by borrower's country and its default risk, liquidity risk, collateral etc..

For the past three years ever since the publication of paper by Reinhart and Rogoff (RR) (see link below) the magic number for increase in credit spread for any country is when the country's Debt to GDP approaches 90%. As countries borrow more either during recession or for populist measures, interest rate paid by that country increases as its Debt to GDP approaches 90%. In summary RR stated that country's GDP growth rate becomes negative. Ever since the publication of this research there is constant focus by different countries and Governments to try to reduce the Debt either by higher taxes and or austerity. Even for advanced countries like US, Japan, UK and Europe, there has been constant debate about how to reduce the debt as there is a perception that higher debt levels may affect the interest rates and GDP's growth rate. The decomposition of long term interest rates for these countries is quite complex and is covered in different blog. RR's paper has been discussed at length at virtually all the important Government and Private forums. It has affected the credit spreads of countries, whose Debt to GDP keeps growing. These countries are perceived to be risky and this perception is reflected in its credit spread.

Now in a paper just published by Thomas Herndon, Michael Ash and Robert Pollin, the authors point that calculations done by RR had an error and growth was actually 2.2% and average GDP growth at public debt/GDP ratios over 90% is not dramatically different than what debt/GDP ratios are lower.

The authors are not well known as Rogoff, who was the chief economist at IMF and a professor at Harvard University. Therefore it may take some time for the paper to gain traction. If this paper gains traction, it could affect how people view the Debt to GDP ratio and this could affect not only the various debates about austerity agenda in both Europe and the US but also the interest rates paid by borrowers in foreign currency. The countries with high Debt to GDP ratio may not be perceived as risky as they are currently perceived to be. It will be interesting to see debate over the next few months on this topic and the movement in spreads.