Sunday, April 28, 2013

Martin Wolf puts the Reinhart/Rogoff controversy and its implications in historical, analytical, and practical perspective

Another follow-up on the controversy surrounding Reinhart & Rogoff's influential, and recently debunked, 2010 paper, "Growth in a Time of Debt".  (For some background, see here & here.)

In a column numbering a mere 1,100 words, Martin Wolf put together a brilliant comprehensive overview of the controversy over R&R's conclusions and its implications for the larger issues at stake:  "Austerity loses an article of faith ".  I would advise everyone to read the whole thing.  For the moment, let me just highlight three elements of Wolf's argument.

=>  First, regarding the historical dimension of the debate:
In 1816, the net public debt of the UK reached 240 per cent of gross domestic product. This was the fiscal legacy of 125 years of war against France. What economic disaster followed this crushing burden of debt? The industrial revolution.  [....]

As Mark Blyth of Brown University notes in a splendid new book, great economists of the 18th century, such as David Hume and Adam Smith warned against excessive public debt. Embroiled in frequent wars, the British state ignored them. Yet the warnings must have appeared all too credible. Between 1815 and 1855, for example, debt interest accounted for close to half of all UK public spending.

Nevertheless, the UK grew out of its debt. By the early 1860s, debt had already fallen below 90 per cent of GDP.  [....]
The point of this example is not that countries never need to worry about accumulating excessive levels of public debt, or that crushing levels of debt are necessarily a good thing.  The point is this:
Quite simply, there is no iron law that growth must collapse after [public] debt exceeds 90 per cent of GDP.
=>  Second, regarding the key analytical issues at stake:
Nevertheless, their work and that of others supports the proposition that slower growth is associated with higher debt. But an association is definitely not a cause. Slow growth could cause high debt, a hypothesis supported by Arindrajit Dube, also at [UMass] Amherst. Consider Japan: is its high debt a cause of its slow growth or a consequence? My answer would be: the latter. Again, did high debt cause today’s low UK growth? No. Before the crisis, UK net public debt was close to its lowest ratio to GDP in the past 300 years. The UK’s rising debt is a result of slow growth or, more precisely, of the cause of that low growth – a huge financial crisis.

Indeed, in their masterpiece, This Time is Different, professors Reinhart and Rogoff explained how soaring private debt [NB: private debt, not public debt] can lead to financial crises that generate deep recessions, weak recoveries and rising public debt. This work is seminal. Its conclusion is clearly that rising public debt is the consequence of the low growth, itself explained by the crisis. This is not to rule out two-way causality. But the impulse goes from private financial excesses to crisis, slow growth and high public debt, not the other way round. Just ask the Irish or Spanish about their experience.

It follows that, in assessing the consequences of [public] debt for growth, one must ask why the debt rose in the first place. Were wars being financed? Was there fiscal profligacy in boom times, which is almost certain to lower growth? Was the spending on high-quality public assets, conducive to growth. Finally, did the rise in public debt follow a private sector financial bust?

Different causes of high [public] debt will have distinct results. [....]
=> Third, the practical implications for economic policy in the US and Europe since the 2008 crash that initiated the Great Recession from which we are still trying to recover.  What should we be doing now, and why aren't we doing it?
Different causes of high debt will have distinct results. [Also], the reasons why deficits are high and debt rising will affect the costs of austerity. Usually, one can ignore the macroeconomic consequences of fiscal austerity: either private spending will be robust or monetary policy will be effective. But, after a financial crisis, a huge excess of desired private savings is likely to emerge, even when interest rates are very close to zero.

In that situation, immediate fiscal austerity will be counterproductive. It will drive the economy into a deep recession, while achieving only a limited reduction in deficits and debt.  [....]  Yet nobody who believes in maintaining fiscal support for the economy in these specific (and rare) circumstances thinks that “fiscal stimulus is always right”, as Anders Aslund of the Peterson Institute for International Economics, suggests. Far from it. Stimulus is merely not always wrong, as “austerians” seem to believe.

This is why I was – and remain – concerned about the intellectual influence in favour of austerity exercised by Reinhart and Rogoff, whom I greatly respect. The issue here is not even the direction of causality, but rather the costs of trying to avoid high public debt in the aftermath of a financial crisis. In its latest World Economic Outlook, the IMF notes that direct fiscal support for recovery has been exceptionally weak. Not surprisingly, the recovery itself has also been feeble. One of the reasons for this weak support for crisis-hit economies has been concern about the high level of public debt. Professors Reinhart and Rogoff’s paper justified that concern. True, countries in the eurozone that cannot borrow must tighten. But their partners could either support continued spending or offset their actions with their own policies. Others with room for manoeuvre, such as the US and even the UK, could – and should – have taken a different course. Because they did not, recovery has been even weaker and so the long-run costs of the recession far greater than was necessary.
And here is the crucial point:
This was a huge blunder. It is still not too late to reconsider.
A huge blunder, which continues to be compounded. Recognizing that has to be the first step toward doing something constructive.

—Jeff Weintraub