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Monday, August 16, 2010

Transcript: 400 Rogoff and Reinhart trip over the 90% debt line

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The Double Dip has hit the windshield across the mainstream media now, making it very difficult to ignore. The faithful 39 here at Demand Side have heard about this for months, well, since the so-called recovery supposedly began in June 2009. Once again, overwhelming consensus is not a good leading indicator for the economy. So we are heartened by the fact that many respected economists still expect good news just beyond the current fog bank. Unfortunately, it is not fog -- that gray is a cement wall. No investment and no government action on the spending side mean we're back in the soup.

It looks like an army of Michael Jacksons out there in the August heat, as economists and Wall Street forecasters moonwalk back their predictions of robust recovery.

In a moment we take a long and critical look at THIS TIME IT'S DIFFERENT, the book that connects government debt levels to economic malaise. We see the connection, but the causal arrow is pointing in the opposite direction from that suggested by authors Ken Rogoff and Carmen Reinhart.

First, the austerity sponsored by the IMF has begun to bear fruit in Europe. The Wall Street Journal reports that the Greek economy contracted sharply in the second quarter ... The national statistics service Ellsta said that second-quarter gross domestic product fell 1.5% on a quarterly basis, accelerating from 0.8% in the first quarter and weaker than forecasts. GDP is reported on a quarterly basis (not annualized). In the U.S. that would be reported as a 6% decline. Jobs data revealed persistently high unemployment, which ticked higher to 12% from 11.9% in April.



The big problem is, "How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.

Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.

Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.


Ken Rogoff and Carmen Reinhardt have taken their careers to a new level on their best-selling quasi economic analysis THIS TIME IT'S DIFFERENT: A PANORAMIC VIEW OF EIGHT CENTURIES OF FINANCIAL CRISES. As the title suggests, the authors have engaged in a massive mapping of data, call it the Google maps of financial crises,

They do the mapping quite comprehensively, in fact, but their conclusions and the lessons people seem to be learning from the book are just wrong. Hence, it stands ready to contribute significantly to the next series of policy debacles.

First of all, we have to establish as self-evident -- though not covered in this book -- that default on government debt cannot occur (except voluntarily) when that debt is denominated in the sovereign fiat currency of the debtor. It must be apparent that the government can make the appropriate entries in the appropriate accounts. If this is a question in anybody's mind, they need to reflect.

Secondly, this time IS different with respect to exchange rates. Prior to 1971, currencies were fixed for the most part, to the dollar or to gold. Many nations today have explicit or implicit pegs to the currencies of other countries, but others do not. Nations with sovereign currencies and floating exchange rates do not default. This includes the U.S., Britain, Japan and Australia. This group does not include the members of the EU, which is an extremely bad deal for the periphery, as we are seeing played out. Germany booms with a weakened euro, setting records for growth. While those nations who would benefit cannot to any meaningful degree.

So, as a practical and operational matter, any concern raised by Rogoff and Reinhart in terms of the United States defaulting on its debt.... Well, it is misplaced. Patently ... misplaced.

The simplistic connection between government debt and economic and financial collapse is not in the direction implied by these two economists. That is, there is a connection, but it runs in the opposite direction they suggest. That is, it is not government profligacy that creates economic weakness, but economic weakness that creates public deficits. Of course, we overstate this in the opposite direction. But only because we have had the benefit of a once in a lifetime economic experiment in the current financial debacle and yet it goes unseen and unappreciated.

The housing sector collapsed, the financial sector collapsed, the economy stumbled, and public deficits arrived from lower revenues and from automatic and discretionary stabilizers. It's hard to see how this could be more clear.

Federal debt held by the public went from 37% of GDP in 2007 to 67% in 2010. Does anyone really doubt which was the cart and which the horse? We will see Rogoff and Reinhart's answer to this question in a moment. But we insist that public debt levels are high now primarily because of the financial collapse and economic failure. Policy response included one of the most massive transfers of wealth from the public to the private sector, rivaled only by the looting of Russian industry in the chaos of IMF-sponsored shock therapy in the 1990s. The Bush tax cuts also contributed, we've argued, both by reducing revenues and by failing to provide economic foundations for growth. But that point is somewhat less obvious.

A third, and perhaps its major fatal flaw is the gross simplicity. By simply mapping defaults and debt levels against years, distinguishing only between advanced and developing countries, the two authors have not only ignored the questions of sovereign currency and floating exchange rates, but wars, famines, natural disasters, predatory rule, neocolonial exploitation and so on.

And finally, the immense private debt, both household and in some parts of the corporate sector, is totally outside consideration. Last week we talked about the multiplier for various tax cuts And government spending. We are experiencing a decline in the multiplier over time that is explained by these debt levels. Debt payments are virtual subtractions from spending on goods and services. Plus, those goods and services that were bought by debt were purchased in the past. Thus the dreadful decay in the multiplier, but also a good explanation of growth that may have been inculcated by rising debt levels before they were transferred to the public sector.

Now that we've expressed our disapproval, let's let Rogoff and Reinhart have a word.

In a recent Vox piece, they say

The main findings of that study are:

•First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP. Above the threshold of 90%, median growth rates fall by 1%, and average growth falls considerably more. The threshold for public debt is similar in advanced and emerging economies and applies for both the post World War II period and as far back as the data permit (often well into the 1800s).

•Second, emerging markets face lower thresholds for total external debt (public and private) – which is usually denominated in a foreign currency. When total external debt reaches 60% of GDP, annual growth declines about 2%; 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 US, have experienced higher inflation when debt/GDP is high). The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

Debt and growth causality

As discussed, we examine average and median growth and inflation rates contemporaneously with debt. Temporal causality tests are not part of the analysis. The application of many of the standard methods for establishing temporal precedence is complicated by the nonlinear relationship between growth and debt (more of this to follow) that we have alluded to.

But where do we place the evidence on causality? For low-to-moderate levels of debt there may or may not be one; the issue is an empirical one, which merits study. For high levels of debt the evidence points to bi-directional causality.


Growth-to-debt: Our analysis of the aftermath of financial crisis in 2008 presents compelling evidence for both advanced and emerging markets over 1800-2008 on the fiscal impacts (revenue, deficits, debts, and sovereign credit ratings) of the recessions associated with banking crises.

As we sum up,

“Banking crises weaken fiscal positions, with government revenues invariably contracting. Three years after a crisis central government debt increases by about 86%. The fiscal burden of banking crisis extends beyond the cost of the bailouts.” Reinhart and Rogoff (2008).

There is little room to doubt that severe economic downturns, irrespective whether their origins was a financial crisis or not, will, in most instances, lead to higher debt/GDP levels contemporaneously and or with a lag. There is, of course, a vast literature on cyclically-adjusted fiscal deficits making exactly this point.

Debt-to-growth: A unilateral causal pattern from growth to debt, however, does not accord with the evidence. Public debt surges are associated with a higher incidence of debt crises. [We have analyzed this temporal pattern previously.] ... In the current context, even a cursory reading of the recent turmoil in Greece and other European countries can be importantly traced to the adverse impacts of high levels of government debt (or potentially guaranteed debt) on county risk and economic outcomes. At a very basic level, a high public debt burden implies higher future taxes (inflation is also a tax) or lower future government spending, if the government is expected to repay its debts.

So the observant will see that the authors do not make the points I attribute to them as forcefully as I attribute. But I do not apologize. Their explicit purpose was to create stylized facts, and the stylized facts they have taught and which have been learned are precisely those I suggest.

Here, from Paul Krugman, confirmation.

August 11, 2010

under the title

Reinhart And Rogoff Are Confusing Me

So R-R have a new article in Vox that, they say, aims to “clarify matters”. I don’t feel clarified.

The original paper on debt and growth presented a stark correlation between high debt and low growth, and seemed to say that this was a causal relationship. In practice, the article has been widely used to claim that there’s a red line of 90 percent in the public debt to GDP ratio that one crosses at one’s peril.

Skeptics like me quickly questioned the causal interpretation of the correlation.


We pointed out that in the case of the United States, highlighted in the original paper, the debt-growth correlation came entirely from the immediate postwar years, when growth was low thanks to postwar demobilization. We pointed out that other episodes of high debt and low growth, like Japan since the late 1990s, were arguably cases in which causation ran from collapsing growth to debt rather than the other way around.

So surely the question is how much of the correlation survives once we restrict ourselves to cases in which the causation is plausibly from debt to poor growth, rather than likely being spurious or reversed.

But R-R don’t offer any response to that question. They do give us a list of peacetime high-debt episodes:

the 1920s and 1980s to the present in Belgium,
the 1920s in France,
Greece in the 1920s,
1930s and 1990s to the present,
Ireland in the 1980s,
Italy in the 1990s,
Spain at the turn of the last century,
the UK in the interwar period and prior to the 1860s and, of course,
Japan in the past decade.

If I’m reading this right, then the postwar cases other than Japan — which I’ve argued looks like reverse causation — are Belgium, Ireland, and Italy. Are these cases enough to bear the weight now being placed on that supposed 90 percent red line?

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