April 20th, 2013
in Op Ed
by Andrea Terzi
This article was originally published in Mecpoc.org
It seems that anybody with an internet connection knows of Herndon, Ash, and Pollin’s (HAP) rebuttal of Reinhart-Rogoff’s (RR) paper on public debt and growth. Minutes after the news started to go round the web, I was asked what I thought by friends whose interests are quite far from economics. They were shocked that Harvard professors could make such embarrassing mistakes in their excel file, and that austerity decisions could be based on such an imprudent error.
I gave them another perspective:
Reinhart-Rogoff’s paper has more serious flaws than an excel error. And austerity hysteria will not go away after Herndon-Ash-Pollin’s review.
So this is my take (especially addressed to my fellow non economists):
The paper became famous because the authors claimed they found the “magic number” that tells us the highest level of public debt we can afford before economic conditions begin to worsen. There was no number until then! The European Union had fixed a ceiling for the public debt/GDP ratio at 60% for countries joining the euro, but the figure was not economically justified, and it was an exclusively political compromise. Until RR found the true figure! In their paper, they claimed that public debt does not hurt growth much until remains below 90%. Once debt goes beyond the 90% threshold, economic growth comes to a halt.
Many policy makers have used this number, notably Olli Rehn in Europe, who used it to claim that there is no alternative to austerity (as it is well known, public debt in a number of EU countries is above 90% of GDP).
HAP’s review of RR’s paper did justice of this particular claim. Once the excel file is corrected, there is no magic number!
And yet, as said above, there are more serious flaws in RR’s paper, apart from miscalculations.
1. Empirical Analysis: Does Debt/GDP Correlate with Growth?
RR explain that one key contribution is that of incorporating new historical data from forty-four countries spanning about two centuries. When doing statistical analysis you normally wish for more observations, and the authors are proud to inform us that they used “3,700 annual observations covering a wide range of political systems, institutions, exchange rate and monetary arrangements, and historic circumstances”.
This would seem a valuable feature: exploring the same phenomenon under different circumstances may serve the purpose to identify stable relationship that may prove robust to changing conditions. Using this approach to study the relation between public debt and economic growth makes no sense at all. Public debt management as well as the causes and consequences of public debt differ enormously, depending on institutional setups such as exchange rate arrangements, gold parity, limits to central bank operations, banking regulation. Any calculated average over such a broad time span for numerous countries is simply mixing apples and oranges, and is not significant. For this reason, I’ve never been much interested in the numbers their empirical analysis generated. Now that HAP found an error, I’m glad I did not waste my time.
2. Theory: Does Debt/GDP Cause Lower Growth?
In their rebuttal, RR stress that they were “very careful … to speak of ‘association’ and not ‘causality’.” This is the most obvious in any professional statistical work. However, their statement is not genuine. When describing how growth and debt relate, RR clearly suggest that public debt is a potential threat to growth and that public debt builds up for two reasons: a) war (and this is intentional) and b) in peace time, “unstable underlying political economy dynamics” (and this is also the result of political decisions). The framework they use to interpret their (hardly significant) numbers is one where the debt/GDP ratio is assumed to be clearly and uniquely interpreted as exogenous, i.e., determined by the political process.
They thus choose to ignore that the debt/GDP ratio is largely endogenous, i.e., determined by the growth of output and jobs. They do admit that debt has grown following the recession, but they describe this increase as being the result of deliberate fiscal decisions that, as RR suggest, may be inevitable and useful, but, once the worst is over, policy should act to lower that ratio to avoid even worst outcomes. All this means that when they find that high debt countries have low growth, they do not even suspect that this may be the outcome of too small a public deficit.
Yes, I said too small a public deficit, because the deficit is the fuel of aggregate demand and the source of private savings (private assets are public sector liabilities), and if the deficit gets smaller, private savings get smaller. And if private savings are too low for households’ and firms’ desires, then households and firms will attempt to save more and cut their spending, sending the economy into a recession. When this happens, the public deficit will (automatically) get bigger and prevent a free fall of the economy. When the deficit has gotten bigger enough, the economy stops falling.
The problem of austerity (justified on the basis of RR’s view that public debt is a threat) is that it prevents the upturn and forces the economy into more recession.
In essence, correcting for an excel error hidden in a Harvard paper is good and useful. Yet, even with ‘correct’ numbers, RR’s empirical analysis remains equally useless (for the reason discussed above under 1) and wholly misleading (for the reasons discussed above under 2).
Apart from their poor excel file, RR need to get their theory about ‘public debt’ right.
About the Author
He has taught at Rutgers University, USA, the Institute for International Studies in Florence, the European College of Parma, and the Catholic University in Milan, Italy, and has been Jean Monnet Fellow at the European University Institute in Florence. He has published in both American and European scholarly journals. Author of a book on money and co-author and coeditor of Euroland and the World Economy: Global Player or Global Drag? (Palgrave Macmillan, 2007). Areas of interest include macroeconomics, monetary theory, central banking, and financial instability. Current research topics include systemic liquidity crises and international financial regulation. In the 1990s, designed the new program in Economics and Finance, and since 1993, has organized seminars and conferences bringing a number of prominent economists to speak in Lugano. Currently, he is Professor of Economics at Franklin College and he is the coordinator of the Mecpoc project that promotes and encourages education and research in new concepts and methods of economic policy analysis.