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1930s-style debt defaults likely, says IMF research

Many advanced economies are likely to require financial repression, outright debt restructuring, higher inflation and a variety of capital controls, a new research paper commissioned by the International Monetary Fund (IMF) has warned.

The magnitude of today's debt in Western economies will mean fiscal austerity will not be sufficient, Harvard economists Carmen Reinhart and Kenneth Rogoff said in the report, as policymakers continue to underestimate the depth and duration of the downturn.

(Read More: Reinhart-Rogoff Error Sparks Austerity Debate)

"It is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today's advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago," they said.

Delving into the realms of history, they detail the widespread default by both advanced and emerging European nations on World War I debts to the United States during the 1930s. The research suggests that "collective amnesia" of this history has led to current policies that in some cases risk exacerbating the final costs of deleveraging.

circa 1930: A view south on Broad Street from the corner of Wall Street in New York's Financial District.
Hulton Archive | Hulton Archive | Getty Images
circa 1930: A view south on Broad Street from the corner of Wall Street in New York's Financial District.

"In Europe, where the financial crisis transformed into sovereign debt crises in several countries, the current phase of the denial cycle is marked by an official policy approach predicated on the assumption that normal growth can be restored through a mix of austerity, forbearance, and growth," Reinhart and Rogoff said.

(Read More: Reinhart, Rogoff: Austerity Is Not the Only Answer)

"The claim is that advanced countries do not need to apply the standard toolkit used by emerging markets, including debt restructurings, higher inflation, capital controls, and significant financial repression." Financial repression refers to a variety of measures to reduce government debt.

This view by policymakers is at odds with the historical track record, the two economists said. They added that in most advanced economies debt restructuring or debt conversions, financial repression, and higher inflation have been integral parts of the resolution of significant debt overhangs.

Previous research by the two economists has received numerous plaudits but has also faced criticism. Their 2010 academic paper "Growth in a Time of Debt" concluded that sovereign debt above a certain level inhibits economic growth. The research is frequently cited as one of the inspirations for austerity measures, with high-profile advocates including the European Commissioner for Economic and Monetary Affairs, Olli Rehn, citing it during key debates about euro zone budgetary tightening.

(Read More: IMF will raise US economic growth forecast: Lagarde)

In April 2013, this influential research on austerity was exposed as containing a mathematical error by an economics doctoral student and two professors at the University of Massachusetts. Reinhart and Rogoff responded three times to the research paper, accepting the error but rebutting allegations that the error stemmed from "selective exclusion" and explained that it didn't change the key theme of their research.

Debt near 200-year high

Central government gross debt-to-GDP (gross domestic product) ratios this year are expected to be 95.3 percent for the euro area and 109.2 percent for the U.S., according to the IMF's projections last April. The ratio for advanced economies is expected to be 109.5 percent, with the same figure for emerging economies standing at just 33.6 percent.

Reinhart and Rogoff iterate that emerging markets actually deleveraged in the decade before the financial crisis, whereas advanced economies hit a peak not seen since the end of World War II. In fact, they estimate that the current level of central government debt in advanced economies is approaching a two-century high.

(Read More: Misunderstanding debt ceilings, deficits and defaults)

The economists suggest that there are five different outcomes in dealing with this debt and highlight a "prototype" recovery period from their previous research. Economic growth is discounted as being too rare by both economists and austerity packages (as seen in Europe since the financial crash of 2008) are deemed as being insufficient. Instead, the size of the problem suggest that debt restructurings would be needed, they add, particularly in the periphery of Europe. The solution they propose, based on a typical sequence of events in history, shows some combination of capital controls, financial repression (like an opaque tax on savers), inflation, and default.

"In light of the historic public and private debt levels...it is difficult to envision a resolution to the current five-year-old crisis that does not involve a greater role for explicit restructuring," they said.

By CNBC.com's Matt Clinch; Follow him on Twitter @mattclinch81

Contact World Economy

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