The New Challenges to Reinhart and Rogoff

April 27th, 2013
in Op Ed, syndication

by Robert Huebscher,

This Article was originally published in Advisor Perspectives

Advocates for debt reduction and austerity have had no more authoritative sources than Carmen Reinhart and Ken Rogoff. But last week, these two professors had to defend claims that errors in their research - ranging from a typo in a spreadsheet to the failure to include data from New Zealand - invalidated their much-acclaimed findings.

Reinhart and Rogoff are professors at Harvard University. Their research, published in a book, This Time is Different, and several academic papers, provided the pivotal academic support for calls for cutbacks in fiscal spending, notably by Paul Ryan (R-WI) in his 2013 proposed budget. The two professors have publicly warned U.S. policymakers that further increases in the deficit would lower future GDP growth.

Last week's challenge to Reinhart and Rogoff came from three professors at the University of Massachusetts, who published a study, Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff.

Follow up:

That came after another study, Crunch Time: Fiscal Crises and the Role of Monetary Policy, which supported Reinhart and Rogoff's findings, came under scrutiny.

I wrote over a year ago (see here and here) that Reinhart and Rogoff's results have little relevance for the U.S. These new findings expose more flaws in their underlying thesis and methodology.

No country can support an endless growth in its deficit. While these studies undermine Reinhart and Rogoff's key results, they should not end the debate over the direction of fiscal policy. Deficit reduction must be a long-term goal for policymakers.

I will review the implications of these new findings carry. First, let's look at the findings of the UMass and Crunch Time studies.

Those Pesky New Zealanders

Reinhart and Rogoff's key finding (published here) was that an advanced economy's growth slows by approximately 1% annually once its public debt-to-GDP ratio exceeds 90%. The U.S. recently passed this threshold, enabling Reinhart and Rogoff's research to gain widespread prominence.

A requirement of trusted academic research is that its findings can be independently replicated and verified. That is what the three UMass professors set out to do by obtaining the data, in Excel spreadsheets, that Reinhart and Rogoff used to produce their key result.

They uncovered three errors, each of which altered Reinhart and Rogoff's results.

Reinhart and Rogoff looked at advanced economies from 1946-2009, but they omitted data for three countries: Australia (1946-1950), New Zealand (1946-1949) and Canada (1946-1950). Of those, New Zealand was the most problematic. Its data alone reduced Reinhart and Rogoff's 1% drag on growth to 0.7%.

The most embarrassing mistake was a coding error in Reinhart and Rogoff's spreadsheet, which excluded data from five countries (Australia, Austria, Belgium, Canada and Denmark).

The third error had to do with how Reinhart and Rogoff weighted their data. Their data was divided into four categories, based on debt-to-GDP ratios: 0-30%, 30%-60%, 60%-90% and over 90%. Each point of data consisted of the GDP growth rate for one country for one year. Within each category, they averaged the data for each country together, and then averaged those results across the countries.

This gave equal weighting to all countries, so that, for example, the U.K. (which had 19 years of data in the highest debt-to-GDP category) had the same weighting as the U.S. (with four years in that category). The UMass authors argued that each point of data should be weighted equally, so that, for example, the U.K. results would outweigh the U.S. results by a ratio of 19-to-4.

The table below presents Reinhart and Rogoff's findings compared with those of the UMass authors, after all the corrections are made:

The UMass authors' corrections had small impacts on results for low and modest debt-to-GDP ratios, but they had a big effect on the high-debt data, increasing the growth rate from -0.1% to 2.2%.

Reinhart and Rogoff responded to the UMass study, defending their work and asserting that they did not intentionally manipulate the data to serve a political purpose, as some might have inferred from reading the UMass study. They stated that their overall findings remained true - growth is slower for high-debt economies - regardless of the absolute values of those growth rates.

In any science, whether it is physics or economics, sound research consists of a model that provides predictable results, which are verified by empirical observations. As Einstein said,

"A theory can be proved by experiment; but no path leads from experiment to the birth of a theory."

Reinhart and Rogoff provided the experiment, but not the theory. One might be persuaded to believe them if their data were so robust that there were no conclusion other than high debt leads to low growth. But the fact that New Zealand, with an economy roughly 1% the size of the U.S., had a significant impact on their results implies that the theory must be weak.

Indeed, a response to the UMass study showed that causality may run the other way: Low growth may lead to high debt, and not the other way around.

Financial theory has something to say about the relationship between growth and debt, and I'll come back to that later. Let's turn to the second study, the response to which has direct implications for the U.S.

Crunch Time

The Crunch Time study was published in February 2013. Its authors (including Frederic Mishkin, who rose to notoriety when his role in Iceland's banking crisis was exposed in the movie Inside Job) attempted to show that high debt-to-GDP ratios and large current account deficits lead to higher borrowing costs for advanced economies. The relationship between debt and interest rates becomes unstable, they contended, and eventually reaches a tipping point when rates spike and the capital markets refuse to lend.

This is essentially the same thesis that Reinhart and Rogoff outlined in This Time is Different. They refer to a "bang point" when a country suddenly faces a fiscal crisis and its solvency is imperiled. The Crunch Time study expanded on Reinhart and Rogoff's work by considering the role of current-account deficits.

By studying 20 advanced economies during the last 12 years, the Crunch Time authors found that a country will face "nearly insurmountable problems" if its debt rises significantly above 80% of GDP and it has a large current-account deficit.

I'll focus specifically on the study's findings for the U.S., although the authors examined a number of European economies and Japan. Using Congressional Budget Office (CBO) projections - which forecast a reasonably strong recovery over the next five years - the authors stated that rising interest rates (to 4% on Treasury bills and 5.2% on 10-year bonds) would cause debt-servicing costs to skyrocket.

The authors wrote,

"The bottom line is that the CBO baseline forecast shows large structural primary budget deficits and an escalation in debt service leading to higher debt levels in the future even if the economy achieves full employment."

Based on a simulation using the 20-country data set, the authors showed that interest rates would be even higher than the CBO projects:

The authors wrote,

"Our main conclusion is that higher debt levels can have a significant impact on the interest rate path and that feedback effects of higher rates on the level of indebtedness can lead to a more dramatic deterioration in long-run debt sustainability in the United States than is captured in official baseline estimates."

Thus, Crunch Time reached the same conclusion as Reinhart and Rogoff and many other studies: High debt levels will cause the U.S. to face a fiscal crisis in the future. The timing is uncertain, but the Crunch Time authors inferred it will be in the next decade.

The paper came under a lot of scrutiny, including criticism by Matthew O'Brien in The Atlantic. Of the 20 countries studied in Crunch Time, O'Brien said that 12 of the countries do not control their currencies (they are in the EU or their currency is pegged to the euro). Those dozen countries have considerably higher interest rates than the remaining eight.

Data for countries in control of their currencies - the U.S., U.K. and Japan, for example - show they have relatively low interest rates.

Currency control is a policy tool that countries can use to forestall or avoid a debt crisis. Countries with current-account surpluses can use their foreign reserves to devalue their currencies, improve the competitiveness of their tradable-goods sector and grow their economies out of indebtedness.

The U.S., which has a modest current-account deficit (about 4% of GDP), is in a special situation because of the dollar's status as the reserve currency. The worldwide structural demand for dollars to conduct international trade helps keep interest rates low. Our reserve-currency status was not modeled by the Crunch Time authors (although they noted that the U.K. benefited from low interest rates in the 1920s, when sterling was the reserve currency).


This line of research speaks directly to the central debate over fiscal policy: Should the U.S. restrict federal spending now, in order to begin to address our growing deficit, or should it invest aggressively to accelerate the recovery, which has progressed very slowly?

The criticisms of Reinhart and Rogoff and of the Crunch Time study prove that the theory behind the linkage between debt, growth, interest rates and an eventual fiscal crisis is weak. At best, it is correlation without causation. Even then, it's not clear whether high debt causes low growth and high interest rates, or the other way around.

If one were to rely on sound financial theory, it would be that investments whose returns exceed their cost-of-capital should be undertaken - even if they require debt financing. That argues for spending on infrastructure, especially given that the U.S. can borrow money at negative real interest rates.

In the aftermath of the financial crisis, at least some economies are benefitting from increased fiscal spending. A recent New York Times Article reported on data just released by the International Monetary Fund in its semiannual World Economic Outlook. It showed that government spending by emerging economies has been much higher than in advanced economies since 2008. In turn, their growth rates, based on per-capita GDP, have also been much higher.

Economists have a dismal record when it comes to predicting crises, so there is good reason to question those whose calls for austerity are grounded in a forecast that the U.S. faces a near-term "bang point" or "crunch time."

We should be equally skeptical of those who advocate for funding of low-return projects - transfer payments, bailouts, expansion of bureaucracies, politically-motivated spending, for example. Confronting our deficit must be a national priority, but it should be done with an approach grounded in sound theory, and not over misplaced fears that our debt-to-GDP has crossed a dangerous threshold.

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