America has decided: Despite unemployment above-9% and GDP growth sub-2%, the government should be focusing on reducing spending, not stimulating the economy.Sure, the cuts aren’t all that deep in the new deficit deal, but it’s the direction and the priorities that matter.
Of course, Republican politicians in Washington don’t see cutting spending and stimulating the economy as an either/or decision. One justification for cutting spending is that it’s “pro-jobs” because it instills confidence in the private sector.
And though nobody takes the “confidence fairy” argument very seriously, pro-cutting politicians are armed with some intellectual heft: Frequently during the debate we heard politicians cite the work of economists Carmen Reinhart (University of Maryland) and Ken Rogoff (Harvard), who have argued over the last couple of years that higher public debts contribute to lower GDP growth. And, conveniently, they’ve made a big deal over this idea that a 90% debt-to-GDP ratio represents some kind of tipping point, over which growth slows fast. Their ideas are outlined in the book This Time It’s Different, which has been a huge hit.
There’s something kind of reasonable sounding about this. More debt seems bad. Reducing debt seems good. So yeah, let’s reduce our debt load, unburden the economy, and voila, growth!
Reingoff logic hasn’t just been employed in the US, of course. It’s essentially at the core of IMF economic prescriptions. Countries like Greece have been told to cut their way to lower deficits/prosperity, and they’ve wound up with both higher deficits and a weaker economy.
Fortunately, not everyone buys it.
Last month Robert Shiller (who nobody takes as a crank or a hack) took Reinhart and Rogoff to task over the absurdity of magical debt thresholds.
Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?
That would clearly be nonsense. After all, debt (which is measured in currency units) and GDP (which is measured in currency units per unit of time) yields a ratio in units of pure time. There is nothing special about using a year as that unit. A year is the time that it takes for the earth to orbit the sun, which, except for seasonal industries like agriculture, has no particular economic significance.
We should remember this from high school science: always pay attention to units of measurement. Get the units wrong and you are totally befuddled.
If economists did not habitually annualize quarterly GDP data and multiply quarterly GDP by four, Greece’s debt-to-GDP ratio would be four times higher than it is now. And if they habitually decadalized GDP, multiplying the quarterly GDP numbers by 40 instead of four, Greece’s debt burden would be 15%. From the standpoint of Greece’s ability to pay, such units would be more relevant, since it doesn’t have to pay off its debts fully in one year (unless the crisis makes it impossible to refinance current debt).
Shiller points out several other flaws, but the biggest one is that they don’t really do anything to establish a causal link between a high debt-to-GDP ratio and slowing growth. In fact, if there is a cause, it’s probably the opposite: Countries that see their growth rates plummet (as the US’ did in 2008/2009) pile on the debt as stimulus (again, like the US in 2008/2009).
It’s not just Shiller who has a bone to pick with Reingoff.
Richard Koo, the most astute observer of balance-sheet recessions, specifically addressed them in his latest client note.
We’ll excerpt a big chunk here:
Causal link between national debt and economic growth is not one-way
A source frequently cited by the Republicans in the fiscal consolidation debate is Carmen Reinhart and Kenneth Rogoff’s This Time Is Different: Eight Centuries of Financial Folly (Princeton University Press, 2009), which presents research showing that countries with national debt exceeding 90% of GDP have growth rates averaging 1.3ppt lower than economies with less debt.
That finding was based on a study of financial crises over the past 800 years, but—as Paul Krugman has noted—the causality is not necessarily one-way.
There are cases in which growth rates have fallen because of large fiscal deficits, but there are also instances in which fiscal deficits have increased because growth has slowed. In the former cases, excessive government deficits crowded out private investment and depressed growth rates, while in the latter, governments administered fiscal stimulus to prevent further declines in the growth rate as the private sector paid down debt during a balance sheet recession.
On the surface, the two patterns appear similar since they are both characterised by large deficits and low growth rates. What sets them apart is yields on government debt, which are high in the first case and low in the second.
The three countries in which the most clamor has arisen over fiscal deficits—Japan, the US, and the UK—are all characterised by record low yields on government debt, and their private sectors are engaged in deleveraging on a massive scale.
The conclusion we should draw from this is that all three economies are in a balance sheet recession and that fiscal deficits should be used to prevent growth rates from falling any further.
Inasmuch as deficit reduction efforts in Japan, the US, and the UK will have a greater (negative) impact on growth, the fiscal consolidation programs being pursued by governments in these nations will have exactly the opposite of the desired effect.
Support for fiscal consolidation will continue until economy suffers
Over the past year I ran into Mr. Rogoff twice and Ms. Reinhart three times at economic conferences. In each case, it was the organisers’ intention for us to present our very different views and let listeners come to their own conclusions.
However, my theory—which holds that fiscal stimulus is essential during a balance sheet recession—has yet to gain the widespread acceptance of their very mainstream view that “deficits are bad.” Consequently, it continues to have only a limited influence.
Recently I had the opportunity to speak at a function sponsored by Britain’s Chartered Institute of Public Finance and Accountancy (CIPFA), a 160-year-old professional organisation for certified accountants working in the public sector. There my views were received with great surprise, as the people listening were hearing them for the first time. I participated in this conference because I hoped to hear the views of those on the front lines of fiscal consolidation efforts in the UK. That people at this level had never heard of balance sheet recessions (although the organiser of the conference had, which was why I was there) suggests the theory of balance sheet recessions has yet to gain significant acceptance. That means the Cameron government’s push for fiscal consolidation will almost certainly continue until it leads to major problems in the UK economy.
Koo has been dead on. Fiscal consolidation didn’t work in Greece, it’s failing in the UK, and per his work on Japan, it failed (where not only did growth weaken, deficits didn’t even go down!).
The problem with Reinhart and Rogoff is that they don’t come off as particularly ideological. They don’t sound like WSJ-opinion-page economists, who preach supply-side dogma (think: Art Laffer).
Instead, they sound like sober academics here to tell us a painful truth (and they are!) and that’s why their ideas have such currency, and that’s why they’re dangerous.