Reinhart and Rogoff erred – so what?
Carmen Reinhart and Kenneth Rogoff (R+R) are among the best known economists of the financial crisis. Their monumental 2009 book, This Time is Different: Eight Centuries of Financial Folly, has become a classic. Equally known, quoted and referenced also among policymakers is their American Economic Review article from 2010, “Growth in a Time of Debt.”
Many, and I among them, used this paper’s argument to explain why large government debt-to-GDP ratios are bad. With a new, multi-national historical dataset on public debt, the paper explores the relationship between high debt levels, growth and inflation. The authors concluded that for advanced economies, “observations with debt-to-GDP ratio over 90% have median growth lower than the lower debt burden groups and mean levels almost 4% lower.”
The conclusion that high debt levels greatly reduce a nation’s growth prospects has been employed by politicians, especially in Europe, to argue for debt reduction and austerity. Olli Rehn, European Economics and Monetary Affairs Commissioner, stated in 2011: “Reinhart and Rogoff have coined the 90% rule. High debt levels can crowd out economic activity and entrepreneurial dynamism, and thus hamper growth. This conclusion is particularly relevant at a time when debt levels in Europe are now approaching the 90% threshold, which the US has already passed.”
Recently, a study by Thomas Herndon, Michael Ash and Robert Pollin, economists at the University of Massachusetts, unveiled major flaws in R+R’s results. Using the same dataset, they conclude that “the average real GDP growth for countries carrying a public debt-to-GDP ratio over 90% is actually 2.2%, not –0.1%.”
Other economists had also criticized R+R’s findings, arguing that correlation doesn’t mean causality, i.e. that it is not necessarily a high public debt-to-GDP-ratio which causes low growth; it could also be that low growth causes a high public debt-to-GDP ratio. New here is the clear rebuke of the quantitative findings of the famous paper.
Some four months ago, the International Monetary Fund admitted that since the start of the financial crisis, it had far underestimated the fiscal multiplier and hence the negative effects that austerity measures would have on growth. This undermines still further the European rationale for austerity.
Does this mean, as ultra-Keynesian economist Paul Krugman argues, that trying to reduce government debt doesn’t make sense and is counterproductive in this environment? That we should instead focus on growth, boosting it by raising debt even further and at some stage have the renewed growth resolve the debt problem on its own?
I don’t think so. We don’t need the growth argument to understand that a high level of public debt will likely have more negative than positive effects. No study has ever argued that the higher the public-debt-to-GDP ratio, the faster a country will grow. Logically, the higher public debt is, the higher the debt service for a given interest rate will be, and thus the fewer the options that remain open for a government to spend its tax receipts on things more useful than interest payments.
This scenario is exacerbated by the fact that interest rates in many countries are now at historic lows. How damaging a sudden surge in interest rates can be is visible in the European periphery.
Paul Martin, former Prime Minister of Canada and finance minister in the mid-1990s when Canada was struggling with high public debt levels, explains this clearly, “Deficit elimination must be seen to be essential to people’s well-being. It will not be supported because of arcane economic theory or simply because business calls for it. Our message was not that servicing the public debt was crowding out private sector investment; it was that the servicing of excessive public sector debt was crowding out needed social programs: health care, education and child welfare.”
R+R might be wrong, but their “arcane” economic theory is less relevant when arguing the benefits of sound fiscal policy.
As for whether such an argument justifies pitching many European countries into a depression, this will be the topic of one of my next editorials.