University of Maryland Professor Carmen Reinhart co-authored one of the most important economics books of 2009, “This Time Is Different: Eight Centuries of Financial Folly,” a catalogue of financial crises, their causes and consequences. In January, Ms. Reinhart and her co-author, Harvard Professor Kenneth Rogoff, both former International Monetary Fund economists, produced a sobering follow-on to the book, a new paper called, “Growth in a time of Debt,” which reviewed the painful consequences of the rising government debt loads that often follow financial crises.

We interviewed Mr. Rogoff and Ms. Reinhart in October. With worries about public debt now mounting in financial markets, we decided to catch up with Ms. Reinhart again in Washington D.C. this week. As she sipped on a hot cup of tea, she offered the following sobering assessment of the many challenges ahead for policy makers in the U.S. and Europe:

WSJ: How serious a danger do you see in Greece right now?

REINHART: Since independence in the 1830s, Greece has been in a state of default about 50% of the time. Does that tell you something? They were in a state of default until the mid-1960s. If you relocated Greece right now outside of Europe, anywhere, you plop it down in Latin America or Asia or anywhere else, bet on an Argentina-style default. But it is a part of Europe. The European community sees itself very threatened by this. They’re going to do what they can. What I think is a likely scenario is that rather than have a default with a big bang, we’ll have a quieter type of default. If you look at a Standard & Poor’s definition of a default, it is anything that changes a debt contract to less favorable terms from the original contract to the lenders. In other words, lower interest rates or longer maturities. What we’re already seeing in Greece is the makings of that. We’re going to see a voluntary and less-than-voluntary shifting in Greece from marketable debt to non-marketable debt, with a bit of arm twisting.

WSJ: The market is asking, ‘Who’s next?’

REINHART: There are a lot of scary scenarios out there. Take governments that were virtuous governments, and continue to be virtuous. I’m talking about Ireland now. Their public debts were trending down and they have acted quickly and they’re credible. But external debt in the private sector is huge, more than 300% of GDP. In a crisis environment, private debts become public debts pretty quickly. Who knows what will happen with the Iceland referendum, and whether they vote to default on the Danish and the Brits.

WSJ: Are we seeing a second-wave of financial distress?

REINHART: Ken and I have been arguing fairly forcefully that historically, following a wave of financial crises especially in financial centers, you get a wave of defaults. You go from financial crises to sovereign debt crises. I think we’re in for a period where that kind of scenario is very likely. I don’t think a repeat of the fall of 2008 is at stake here, where it looks like the world is going to end. But I do think there is still, for reasons that are beyond me, quite a bit of complacency out there. Eastern Europe is another source of concern, and Europe has limited resources. You can rescue one. You can maybe rescue two. But you can’t rescue all of them. The Baltics are very vulnerable. Romania is vulnerable. Hungary is vulnerable. Problems in these countries feed back to their lenders. Austrian bank exposure to Eastern Europe is great. The Italian exposure to Eastern Europe is great. The Swedish exposure is non-trivial. You started out with a major financial crisis in 2007 and 2008, in which some of these countries have seen their worst recessions, in a way that really harms fiscal sustainability, even if you were in a good shape fiscally at the outset of the crisis. It is the pattern that has been prevalent in the past, that these major financial crises have been followed by an afterwave of debt crises.

WSJ: What point, in the hundreds of years of history that you looked at, does this moment look most like?

REINHART: With all of the differences in policy responses taken into account, the Great Depression is still the benchmark. We have not seen an economic downturn so synchronized, a downturn in trade so sharp and widespread, post-World War II. We have not seen this many economies in the advanced world, which accounts for the lions’ share of world GDP, simultaneously have financial crises since the 1930s. Nothing even close.

WSJ: Let’s talk about the U.S. Based on your reading of history, where will the U.S. economy be in five years?

REINHART: What lies ahead is a rough patch. We are going to have a period of subpar growth. We’re all in agreement we’re going to have a recovery. Everything points to a recovery. But debt is very much at the forefront of the subpar growth. There are public debt issues and private debt issues. There is still a lot of serious deleveraging that lies ahead of us. For households, deleveraging implies curbs on spending. And don’t forget that households have been the engine of growth during recoveries from more recent past recessions. Households are overstretched.

WSJ: But households have started to make some progress on deleveraging.

REINHART: How is that being achieved? Not entirely by repayment, but importantly also by default. And default has lasting consequences. Then there is the issue of the toxic debts of the banks. One of the reasons which in my view the Japanese crisis lingers and lingers and lingers, is that the debt overhang problem in banks was never fully resolved. The good news was they didn’t have a blowout recession. But then again, they didn’t recover either. Our attitude of forbearance toward bank debts means the malaise of a toxic debt overhang is persisting. Japan is the relevant comparison there. And we have a prodigious buildup in public debts and that prodigious buildup in public debts begets uncertainty in the private sector about future taxes and public sector benefits. If you’re a firm, you become more cautious about investing. If you’re a household with long-term plans, you’re also more careful. Debts are a big drag on our economy right now, and that is not going to go away quickly.

On that uplifting note, let me add another one. Guess what. Most of the advanced world is in similar shape. My hair stood on end when President Obama said that our exports are going to double. I know some emerging markets are doing well, but if you look at the world’s largest economies, they’re mired and swimming in debt also. This is not gloom-and-doom, things-are-going- collapse, fall-of-2008. But it is a period in which you have a lot of albatrosses around your neck and those albatrosses are going to weigh down our growth performance. And our political system right now is not dealing with this issue head on. We might need to wait until we get downgraded until we decide we have a debt problem. I’d like to remind people that Japan was downgraded several times after its financial crisis and they lent to the rest of the world. We don’t lend to the rest of the world, we borrow from the rest of the world.

WSJ: I was going to ask you about best case scenarios, but I’m not going to bother.

REINHART: A best case scenario may be that over the near term something like Greece, Iceland, Eastern Europe or a combination of these events, scare enough people about what debt problems are really like that you get more willingness in the United States to tackle the necessary issues.

WSJ: Policy makers have to make a hard choice, between addressing deficits and trying to support growth and jobs.

REINHART: This economy is still frail. One thing that scared me in looking at the Japanese experience was that they declared victory too soon and withdrew stimulus very soon, and wound up with a bigger debt and bigger deficits as a consequence because things rolled over and died and you wound up with the worst outcome. So when I talk about fiscal discipline, it is not that we go out and implement belt tightening tomorrow. But we plan to, and develop a plan that puts the deficit and debt on a sustainable path. That is necessary today. I would attach a higher weight to getting the recovery going first. You stay the course on the fiscal side but you come up with a plan that puts fiscal footing on a sustainable path. That is easy for me to say, but hell for anybody to implement. You’ll have politicians from every angle, whose time horizon not what happens in five years, but what happens five weeks from now.

WSJ: The Fed has been very aggressive about articulating its exit strategy but also aggressive about reassuring people that they’re not going to start it now.

REINHART: The Fed can do that with one voice and in a way that is credible. With the divisions that we have in the political spectrum right now …

WSJ: That is the key test for fiscal policy makers.

REINHART: Yes.

WSJ: Your research shows that when public debt hits about 90% of GDP, that is almost like a threshold for slow growth. There is some disagreement about where we are on that spectrum. If you take just debt held by the public, it is in the 60s. But if you look at all debt, gross debt, including debt held by government agencies like Social Security, it’s much higher. Where are we on that spectrum?

REINHART: Debt is debt. We’re very close to that 90%. Other government agencies are holding government debt and netting that out, but in the end the federal government is going to be liable. And gross debt of the federal government still doesn’t take into account the massive guarantees (by government-owned Fannie Mae and Freddie Mac). If anything, 90% is a generous measure.

What the data seem to reveal is that at lower ranges of debt, you really can’t make a link between debt and growth. But once you hit a certain threshold, you hit a wall. You can pile on the debt for a while, and you’re not seen as risky. You can accumulate a certain amount of debt without a threat to your debt sustainability. But then you reach a point where that debt sustainability is called into question. It becomes an issue.

WSJ: You and Ken Rogoff have been working together for nine years on these issues. What are the areas where you disagree most?

REINHART: I think Ken may have a little more faith in markets than I do. Unfortunately, I don’t have faith in the government either.