AMERICAN FUTURE

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. “

– John Maynard Keynes, The General Theory of Employment, Interest and Money

Diligent readers of this blog (hopefully, there are some) may have noted that I have, on several occasions, taken exception to Reinhart’s and Rogoff’s (R&R) contention that a government’s debt-to-GDP ratio is the metric of choice for assessing its exposure to a sovereign debt crisis. Their seminal work published in 2009, This Time Is Different: Eight Centuries of Financial Folly, has been highly influential, as has their January, 2010, paper, “Growth in a Time of Debt.” It is not an exaggeration to say that the book and paper have become the standard references for policymakers and opinion leaders (the “practical men” to which Keynes refers) who argue that the primary ingredient in the recipe for restoring the health of the American and European economies is public sector fiscal consolidation. In the book and paper, these individuals find the intellectual justification for austerity programs intended to reduce public sector debt-to-GDP ratios.

By the time the paper was published, the financial abyss had been avoided. Naturally, attention then turned to how a repeat of the near-disaster could be avoided and prospects for long-term economic growth could be enhanced. It was in this context that, in the abstract of the paper, R&R summarized their findings as follows:

We study economic growth and inflation at different levels of government and external debt. Our analysis is based on new data on forty-four countries spanning about two hundred years. The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies. Second, emerging markets face lower thresholds for external debt (public and private)—which is usually denominated in a foreign currency. When external debt reaches 60 percent of GDP, annual growth declines by about two percent; for higher levels, growth rates are roughly cut in half. Third, there is no apparent contemporaneous link between inflation and public debt levels for the advanced countries as a group (some countries, such as the United States, have experienced higher inflation when debt/GDP is high.) The story is entirely different for emerging markets, where inflation rises sharply as debt increases. [Emphasis added]

The paper provided what the book did not: a metric. Since early 2010, 90 percent has become a magic number; when a country’s debt-to-GDP ratio is greater than 90 percent, its economic future is endangered. While R&R do not state explicitly that this is a cause-and-effect relationship, they come very close to doing so. While they say that the relationship is “weak” below the 90 percent “threshold,” no proviso is attached to the relationship when the ratio is greater than 90 percent.  Their words make it sound like causality is at work. Of course, because the threshold value was established on the basis of a statistical analysis, the result of R&R’s research is to establish a correlation. Thus, by its very nature, it cannot establish cause and effect. One suspects that this critical distinction is easily, if not purposely, overlooked — specifically, by organizations, governments and columnists having ideological agendas predisposing them to view austerity in a favorable light.

The most glaring defect in the policy prescription implicit in R&R’s conclusions is that it hasn’t worked. Despite the ever widening adoption of ever more draconian austerity programs in mature economies, debt-to GDP ratios have risen and investor confidence has fallen. As highly trained economists, R&R are surely aware of the “paradox of thrift.” Perhaps they failed to consider the possibility that numerous countries would more-or-less simultaneously enact fiscal consolidation programs.

“For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.”

– John Maynard Keynes, The General Theory of Employment, Interest and Money

If only a small number of countries accounting for a modest percentage of mature economies’ GDP were tightening their fiscal policies, austerity could work, as the other countries could easily absorb the spillover effects. But that’s not what happening. Every country — including those with historically low interest rates — has tightened. The result is a feedback loop that is more than vaguely reminiscent of the feedback loop created by competitive currency devaluations and tariff increases in the 1930s. Widespread fiscal austerity at a time of private sector deleveraging is a recipe for a downward spiral.

Nothing could be worse than having the results of a widely-adopted policy be the opposite of what was intended, but this comes close: the fixation on austerity as the cure-all for economic and financial distress has prevented eurozone governments and international financial organizations — in particular, the Bank for International Settlements (the central bankers’ bank) and the International Monetary Fund — from correctly identifying the root cause of the currency union’s sovereign debt crisis.

In his totally convincing column in the Financial Times, Martin Wolf unambiguously places the blame on current account imbalances within the eurozone and, especially, on Germany “for not recognizing the nature of the crisis.” He reaches this conclusion after using readily available macroeconomic data to rule out the alternatives: fiscal deficits and public (sovereign) debt, both of which were useless as leading indicators of the sovereign debt crisis:

Take a look at the average fiscal deficits of 12 significant (or at least revealing) eurozone members from 1999 to 2007, inclusive. Every country, except Greece, fell below the famous 3 per cent of gross domestic product limit. Focusing on this criterion would have missed all today’s crisis-hit members, except Greece. Moreover, the four worst exemplars, after Greece, were Italy and then France, Germany and Austria. Meanwhile, Ireland, Estonia, Spain and Belgium had good performances over these years.

Now consider public debt. Relying on that criterion would have picked up Greece, Italy, Belgium and Portugal. But Estonia, Ireland and Spain had vastly better public debt positions than Germany. Indeed, on the basis of its deficit and debt performance, pre-crisis Germany even looked vulnerable.

In contrast, the predictive power of current account deficits was perfect:

Now consider average current account deficits over 1999-2007. On this measure, the most vulnerable countries were Estonia, Portugal, Greece, Spain, Ireland and Italy. So we have a useful indicator, at last. This, then, is a balance of payments crisis. In 2008, private financing of external imbalances suffered “sudden stops”: private credit was cut off. Ever since, official sources have been engaged as financiers. [My emphasis]

When truth — a readily available and easily comprehended truth, at that — is staring you in the face, it’s difficult to understand why it’s been ignored by policymakers. In a case like this, all I can do is follow the money. One country’s current account deficit is another’s current account surplus, and within the eurozone, Germany’s surplus is by far the largest. Countries with surpluses want to maintain them (think China), and Germany is no exception. What this means, of course, is that Germany would have the most to lose if policies aimed at reducing the eurozone’s “structural imbalances” were implemented. The German Government would rather have its weaker siblings in the eurozone implement austerity policies than have its current account surplus reduced. And, given Germany’s economic and financial dominance within the eurozone, it’s in a position to get what it wants.

I’ve yet to read a commentary suggesting that Germany’s policy position isn’t self-defeating. In time — and probably soon — forcing austerity down the throats of the eurozone’s have-nots (of which there’s a growing number) will weaken German exports. Surely, Germany must understand this. If so, its policy preference is politically, not economically and financially motivated.  Public opinion polls indicate that a voluntary reduction of the structural imbalance would be seen by a substantial majority of the thrifty, hard-working Germans as bailing-out the spendthrift, lazy “Club Med” countries. What will not happen voluntarily will take place involuntarily which, in the twisted logic that seems to be in play, is the more politically palatable of the two alternatives.

Robert Shiller of Irrational Exuberance fame proffers a different kind of criticism of the 90 percent magic number:

One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category. [My emphasis]

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.

The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.

I couldn’t agree more and I seem to remember learning a long time ago that, appropriately juggled, statistics can be used to prove just about anything. Caveat emptor.

The most resounding  and thorough criticism of R&R’s methodology is hidden away about a third of the way through Credit Suisse’s 174-page 2012 Global Outlook. The Credit Suisse analysts are so sure of themselves that they are willing to directly confront R&R by proclaiming that “this time is different.” In the section of the report titled “Questioning Reinhart & Rogoff on Long-Term Growth,” they lay it on the line. Because the density of information is so great and the content isn’t easily condensed, I’ve chosen to include this section in its entirety. All emphases are mine.

Many of our clients think that developed market growth will be weak for years as a result of high debt levels. The theme was famously explored in the book This Time is Different by Carmen Reinhart and Kenneth Rogoff. We find, however, that there is almost no evidence of a relationship between trend growth rates and government debt levels or between debt and an economy’s ability to get back to full employment after a shock.

The history of sovereign debt is intertwined with wars and deflationary shocks. Often, debt appears to affect growth when war itself is driving the path of activity. In times of deflation, debt levels can grow sharply, but the solution is aggressive monetary policy, which need not worsen the debt burden and can usually help it.

There are simple reasons why government debt should not affect underlying trends in real growth. Government debt doesn’t destroy a nation’s factories; it won’t make a population less intelligent and industrious; it can’t halt the technological progress that has driven efficiency for centuries. However, many market observers, citing Reinhart and Rogoff’s research, insist that fiscal tightening is essential to encourage future economic growth.

Of course, a ballooning interest burden creates the need for a government to run a primary surplus in order to maintain stable debt dynamics. A sudden shift toward primary surplus might negatively affect short-run growth, but longer term, there is no relationship between primary balance and trend growth, except for the tendency for primary balances to increase with high growth as tax revenue floods in.

Output gaps, in contrast to debt levels, do consistently forecast above-trend future growth. Economies running well below potential output tend to grow above trend as they return to full employment. Clearly, low resource utilization creates deflation risks, but competent central banks often can manage those. In the second part of this note, we examine the current drags on US growth and argue that today’s missing output is mostly housing related and likely to return over time. This real adjustment should make higher primary surpluses easier to establish and maintain, but admittedly, the US has a long way to go in both output adjustment and in budget adjustment.

Debt adjustments can occur as an economy simultaneously returns to full employment while establishing higher primary surpluses. For forecasting purposes, this is a radically different proposition from starting by observing debt levels and claiming that growth must be weak as a result. We believe that much of the anxiety about debt levels in the developed world represents a misreading of history. Although it is ironic, given the title of Reinhart’s and Rogoff’s seminal work, the biggest reason not to worry about high debt levels is that this time really is different from the historical episodes that drive Reinhart’s and Rogoff’s conclusions.

Consider what is perhaps Reinhart’s and Rogoff’s strongest evidence. They provide a table that presents mean annual growth rates for developed nations. It clearly demonstrates that nations typically experience lower annual growth when their debt levels exceed the 90% threshold. The evidence is mixed across the whole sample, but the numbers for the US in particular stand out. Although this is strong prima facie evidence for believing that high debt can affect growth, there are key problems with this method of analysis.

The first problem is simply that the variable of interest, annual growth rates, doesn’t properly capture the “long-run growth” of a nation. Annual growth rates are volatile and mean reverting, suggesting that a low annual growth rate doesn’t provide much evidence of persistent economic malaise. Switching to a ten-year future growth rate, we can see a much clearer picture of how an economy evolves in response to high levels of sovereign debt.

. . . changing the focus to longer-term growth removes a great deal of the effect identified by Reinhart and Rogoff. In addition to this methodological adjustment, however, there is a much deeper problem with the application of Reinhart’s and Rogoff’s result to the present situation of developed economies. Their results areprimarily driven by extreme historical circumstances (war, in particular), which are not easily applicable to contemporary debates on debt.

To show this, it makes sense to go more in depth into historical experiences of high sovereign debt. Perhaps the most eye-popping statistic in Reinhart’s and Rogoff’s table is the fact that US growth averaged -1.8% when debt/GDP exceeded 90%. More than any other nation, the US has experienced a falloff in growth (to the point of outright contraction) when its debt has risen above this threshold.

However, what the table fails to display is the historical circumstances surrounding the US experience with high levels of debt. First, it is worth noting that in the 220 years of data available on US debt/GDP, in only 6 of those years (1944-1949) did debt levels exceed the 90% threshold. Indeed, the reason for the high debt levels was the massive mobilization of resources for World War II. And unsurprisingly, the run-up in debt was associated with impressive levels of economic growth. As debt levels rose from 44% of GDP in 1939 to 91% of GDP in 1944, the economy grew 14% per annum.

Coincidently, however, the United States reached the 90% debt/GDP threshold at the beginning of the post-war demilitarization. In 1945 alone, the economy contracted by 11%. However, it would be absurd to believe that this contraction was caused by a high debt-to-GDP ratio. Even if there were no debt, the fact would remain that nearly half (48%) of US GDP in 1944 that was dedicated to fighting the Axis powers ceased to be useful in 1945. This can be seen clearly by looking at GDP growth ex-government spending. Indeed, the entire six years of high debt saw US private GDP grow at a 23% average annual rate.

It is absurd to believe that this historical episode offers any insight for current debates about national debt. Yet Reinhart and Rogoff’s table is full of similar cases. Unsurprisingly, the frequency of high-debt episodes peak around World War II. In these cases, growth outcomes were not caused by high debt levels. Clearly, the actual cause of debt and growth levels is total war, which commands a huge amount of resources and leads to vast destruction of human and physical capital. It is unreasonable to imagine that
these historical experiences provide any insight to the potential consequences of current debt-to-GDP levels in the developed world.

The other obvious clusters occur in periods of Gold-Standard deflation: the late 19th century and 1920s-1930s. In this case, it is easy to see both high debt and low growth simultaneously caused by monetary contraction. As in World War II, high levels of debt appear to be a side effect of a more plausible cause for low growth – deflation. Although these historical examples might be relevant to the present European debt crisis, there is little similarity to economies with independent monetary policy.

However, economic history does offer some evidence that applies to current debates about sovereign debt. In particular, one of the best examples for thinking about the United States’ present situation comes from public finance in the United Kingdom. In the 179 years of data used by Reinhart and Rogoff, the UK had a debt-to-GDP ratio in excess of 90% for 81 years. National debt peaked following the Napoleonic Wars and again in the two World Wars. But unlike most other nations, the UK paid down these debts slowly and consistently – carrying large levels of debt for long periods of time. This allows us to see the effects of high debt during relatively ordinary times, rather than exclusively during extreme historical episodes. In the entire UK sample, debt appears to have had no impact on growth whatsoever. Although annual growth was slightly lower, as reported in Reinhart and Rogoff, long-term future growth was actually slightly higher for high levels of debt.

The statistics produced by Reinhart and Rogoff are an invaluable contribution to economic history, but it is important to think deeply about when they might apply to a contemporary situation. Their simple table relies on the crucial assumption that all high-debt episodes are comparable. Yet the United States is not in the midst of a World War. It is not on the gold standard. It has not lost the Franco-Prussian war, unified the Italian Peninsula, or struggled to maintain territories in Latin America. Economic history has a great deal to teach us – as long as we always remember that this time is very different.

Conclusion

While Reinhart and Rogoff are living, not “defunct” economists, Keynes was right when he said that “practical men” distill their “frenzy” from academics. In the present instance, the distillation is from academic works which, when applied to the problems the world currently faces, are methodologically flawed and persuade practical men to conceive and implement counterproductive policies. Austerity is a bridge to worse than nowhere.