High debt levels translate to slower growth, according to Vincent Reinhart. That conclusion will be disheartening to those who jumped on the errors several University of Massachusetts scholars found last month in Carmen Reinhart (Vincent’s wife) and Ken Rogoff’s research. But Vincent Reinhart is the author, along with his wife and Rogoff, of a study published in 2012 that documented the degree to which high debt-to-GDP levels correlate with slower economic growth in developed countries.
Reinhart is an economist and the co-head of global economic research at Morgan Stanley. He is also an expert on monetary policy, and teamed with Ben Bernanke to research the effects of unconventional monetary policies, prior to when Bernanke became Federal Reserve Chairman in 2006.
He spoke May 23 at a lunch sponsored by the Boston Security Analysts Society.
Reinhart said the U.S. economy is set to grow between 2.75% and 3% over the next several years, which implies that U.S. equities are favorably valued and that unemployment will not deteriorate. But he said that if he is wrong and growth is only 2%, then the U.S. faces big problems.
He also said the aggressive monetary policies undertaken by the Bank of Japan may succeed in producing the desired rate of inflation and economic growth – and the implications for investors are clear.
“It's extremely dangerous to express doubt about macroeconomic policy by shorting a security the central bank can buy,” he said.
Don’t short Japanese government bonds (JGBs), since the Bank of Japan will be buying them, and be equally cautious about shorting U.S. Treasury bonds while the Fed is engaged in quantitative easing (QE), according to Reinhart.
I’ll discuss Reinhart’s outlook for the U.S. and Japan. I’ll then turn to his remarks about the relationship between debt and growth and offer my own thoughts on that issue.
The outlook for the U.S. economy
Reinhart’s outlook for the U.S. is rooted in his research on financial crises and deleveraging. He said that 10 years after a financial crisis such as the one the U.S. experienced in 2008, per-capita GDP is typically 15% below the trend from the prior decade. That takes a significant toll on aggregate demand and supply, and financial intermediaries need to deleverage and de-risk in order for a recovery to take hold.
Fortunately, U.S. financial institutions have done so, partly as a result of regulations and stress tests imposed on banks, according to Reinhart.
“Nowhere is this clearer than in housing,” Reinhart said. House prices are rising, he said, and household balance sheets are improving. He doesn’t expect a smooth recovery in housing, though, because there is too much pent-up supply of houses not yet on the market.
He cited another source of pent-up potential growth – approximately $1.5 trillion of cash on corporate balance sheets. Corporations will invest once they see the “impetus coming from housing,” Reinhart said, and that will amplify consumer demand.
The danger is that corporations that have announced capital spending plans have seen their stock prices go down, while those that have announced dividends or share buybacks have seen their stock prices go up. “The markets have not been rewarding fixed investment,” Reinhart said.
Our recovery would have been faster if not for the drag imposed by fiscal policies such as sequestration, he said, which impeded growth by almost 2%.
“If anything, the economic data suggest the private sector has been very resilient in the face of that much fiscal consolidation,” he said, “which only make sense if this soft patch is just that, a patch, and that spending comes back.”
As long as the U.S. gets “amplification through capital spending,” Reinhart said growth over the next several years would be 2.75% to 3%. That is Morgan Stanley’s baseline assumption, and Reinhart said it would allow the Fed to gracefully exit from QE. He said the Fed has the necessary tools to manage that exit, including the ability to control the rate it pays on banks’ reserves and the ability to sell securities it now holds to banks.
Without that amplification, growth would be only about 2% and the U.S. economy would face many more challenges, he said. He did not specify exactly what those would be.
The Japanese experiment
The world’s eyes have turned to Japan, which Reinhart said is engaged in a “fascinating experiment” to generate inflation – after having failed to do so for the last 20 years.
“In our own forecast, we think they will be somewhat successful,” he said. “In fact, the Asian Pacific Rim is an engine for growth expansion.”
In order to succeed, though, Reinhart said Japan needs to do “three hard things.”
It must get the other developed countries to tolerate its currency depreciation. Reinhart said the U.S. is the key player, because if it accedes to Japan’s currency depreciation, it would give the “green light to the rest of G-20” to depreciate their currencies to a similar degree.
Voters must be happy with the inflation Japan’s policies will create, Reinhart said. The older Japanese are the most problematic, because they have enjoyed the high real rates of return created by two decades of deflation.
Third, Japan has to undergo structural reform, according to Reinhart, in order to increase aggregate demand. That means ending excess subsidizations of its agricultural and construction sectors, he said, and “providing unfair entitlements to the old.”
Japan will succeed on at least two of the three, Reinhart said, athough he did not say which two those would be. That success will come from Japan’s blurred distinction between its public and private sectors, he said, because quasi-public institutions (like the postal savings systems and big banks) would change their investment guidelines away from JGBs. Those institutions could buy sovereigns – like Treasury bonds – which would help the Bank of Japan achieve its goal of depreciating the yen.
Reinhart elaborated on his warning not to short JGBs. “You may think the Bank of Japan's policy is fundamentally flawed, that it will break down in high inflation, but that doesn't mean you can safely express that trade by shorting JGBs,” he said, “because the Bank of Japan will still be buying those.”
Growth and debt
Reinhart weighed in on the furor created by the UMass study and its criticism of the earlier research by his wife and Rogoff.
He said that the paper the three of them authored showed that high debt and low growth go hand in hand. That paper looked at the experience of 22 advanced economies since the Napoleonic War and only at situations with sustained debt-to-GDP greater than 90%. Four key findings emerged, he said.
Those episodes exceeding 90% are rare. Despite 220 years covering 22 countries, there were only 26 such episodes. “For whatever reason,” he said, “officials tend to avoid that region.”
When they do occur, they are long-lived, with a median duration of 23 years.
They are costly. Reinhart found the same effect as in the disputed Reinhart-Rogoff paper, which is that growth is about 1% slower as compared to historical trends.
Lastly, interest rates don’t always spike upward. He said that in only 11 out of 26 cases did real rates increase significantly. The market did not inflict its discipline in those cases, he said — sometimes governments can suffer slow growth even while keeping borrowing costs low.
Reinhart applied those findings to the U.S. He said that our economy is “less resilient” because of its high debt-to-GDP ratio, which is approaching 100%. To illustrate this point, he proposed a hypothetical situation. Assume that seven years ago, during the Bush administration, the U.S. had lowered its debt-to-GDP ratio by 50%, which it could have done by selling off its national parks.
Under those conditions, Reinhart said the U.S. would have done more fiscal stimulus, built more infrastructure and responded to national disasters more forcefully. “We would have grown faster over the last five years,” he said.
Let’s look at what “less resilient” means in the case of the U.S.
Reinhart’s hypothetical example doesn’t answer the key question about the relationship between debt and growth. With the ability to borrow at near-zero real rates, the U.S. has the borrowing capacity today to pursue more fiscal stimulus and infrastructure projects. Political gridlock stands in the way, not the theoretical boundary of a 90% debt-to-GDP ratio.
Policymakers cannot achieve a consensus about spending on projects that would fuel growth. This is particularly vexing, since such efforts should have support from both sides of the political spectrum. Conservatives should be willing to spend on well-vetted projects that are pro-business, and liberals should be willing to spend based on Keynesian principles.
Neither Reinhart’s hypothetical example nor his published research demonstrated that there is a causal relationship that higher debt levels lead to slower growth. In fact, the U.S. had a much higher debt-to-GDP ratio following World War II than it does now. But in the post-war period, it experienced one of the most rapid period of growth in its history.
The U.S. economy is not “less resilient” now because of its deficit, at least not based on economic theory. It is less capable of overcoming the political challenges that thwart investment in high-growth projects.
Read more articles by Robert Huebscher
