A few years ago, an economic paper by Harvard professors Carmen Reinhart and Kenneth Rogoff helped fuel the push for austerity. It was met with some criticism from economists, but was widely embraced by the press and by politicians on both sides of the Atlantic. The study has now been demonstrated to have had serious flaws, but will those in power fold? Or will they double down on bad economic policy?
There have been two major research themes by Reinhart and Rogoff (RR) in recent years. The first, expanded upon in their book This Time is Different, added to previous studies on the nature of economic downturns. Specifically, the authors showed that recessions that are caused by financial crises tend to be more severe and longer lasting, while their recoveries generally take a long time. There was little criticism of their research on the nature of past financial crises, and the results have important implications for the current environment.
The other line of research was more controversial. In a paper titled “Growth in a Time of Debt,” RR suggested that economic growth slows down significantly when the ratio of government debt to annual GDP rises above 90%. In the paper, the authors state clearly that correlation does not imply causation. However, in op-eds and in discussion will fiscal policymakers, they were much more emphatic. The press eagerly accepted the 90% figure as if were a rule of nature, like Planck’s constant or the speed of light, and certain politicians, already predisposed to smaller government, used the 90% figure as justification for large budget cuts. However, the economic blogosphere was not as accepting, with many noting that it was more likely that the causation runs the other way. That is, slower economic growth tends to lead to higher budget deficits.
After some period, RR has finally released the spreadsheet they used in their study and the subsequent analysis is not good. Apaperby Thomas Herdon, Michael Ash, and Robert Pollin (HAP) shows that “coding errors, selective exclusion of available data, and unconventional weighting of summary statistics led to serious errors that inaccurately represent the relationship between public debt and GDP growth.” HAP still shows that slower rates of growth are correlated with higher government debt, but nowhere near as much. RR suggested that countries with a debt to GDP ratio over 90% would be associated with GDP growth of -0.1%. HAP puts the figure at +2.2% – hardly a dramatic slowing and one that certainly wouldn’t justify the high costs of austerity (higher unemployment, a delayed recovery).
A further analysis byArindrajit Dubedemonstrates that the causality indeed goes the other way. Dube notes “current period debt-to-GDP is a pretty poor predictor of future GDP growth at debt-to-GDP ratios of 30 or greater—the range where one might expect to find a tipping point dynamic. But it does a great job predicting past growth.” In other words, high debt-to-GDP ratios are more likely to be caused by slow economic growth than the other way around.
Will this new analysis lead to policy changes? No, but it should. In Europe, the financial crisis is seen as a morality play. The Germans tightened fiscal policy a decade ago, and the economy did fine. However, the German economy was overcoming unification strains and benefited greatly from the reduction in transaction costs associated with the introduction of a common currency. While Europe’s current crisis is called “a sovereign debt crisis” the problem is capital flows. Capital flowed into the peripheral countries, generating housing bubbles (Ireland, Spain) and boosting real wages. The capital has now flowed out, but real wages are slow to adjust to the downside. If the troubled economies had their own currencies, they could devalue, and real wages would adjust quickly, but they can’t devalue with a common currency, and the real wage adjustments are likely to be lengthy and painful. Efforts to reduce budget deficits weaken their economies and result in little actual improvement in the deficits. This is madness. The euro area also suffers from the absence of fiscal and banking unions, which should come about over time.
In the UK, the conservative government was predisposed to reducing the size of the government. RR provided a handy excuse. However, the economy has weakened. Some of that is due to weakness on the continent, but austerity hasn’t helped.
In the U.S., there is no doubt that the federal budget is on an unsustainable long-term trajectory. That is nothing new. We have known about it for decades. However, large budget deficits are not a problem in the short term. The main reason that the deficit widened in recent years is not due to runaway spending. Federal spending fell last year and is likely to decline again this year. Federal government payrolls are up only 10,000 since Obama took office. The main reason for large deficits is that we just went through a severe recession. Recession-related spending is falling and tax receipts are rising. The Congressional Budget Office estimates that the budget deficit for the current fiscal year would be about 2.5% of GDP if the economy were close to its potential. That hasn’t stopped the push for austerity.
Economists at the CBO, the Federal Reserve, and the IMF are on the same page. This year, the rise in the payroll tax and the sequester are expected to subtract about 1.5 percentage points from GDP growth. Growth would likely have been 3.5% or more if not for the austerity. Instead, it’s expected to be around 2.0%. Note that we’re not talking about the need for added fiscal stimulus here. We are talking about a self-inflicted restraint on growth – and very bad economic policy.
© Raymond James