Saturday, November 29, 2014

Austerity and Debt Realism

CAMBRIDGE – Many, if not all, of the world’s most pressing macroeconomic problems relate to the massive overhang of all forms of debt. In Europe, a toxic combination of public, bank, and external debt in the periphery threatens to unhinge the eurozone. Across the Atlantic, a standoff between the Democrats, the Tea Party, and old-school Republicans has produced extraordinary uncertainty about how the United States will close its 8%-of-GDP government deficit over the long term. Japan, meanwhile is running a 10%-of-GDP budget deficit, even as growing cohorts of new retirees turn from buying Japanese bonds to selling them.

Aside from wringing their hands, what should governments be doing? One extreme is the simplistic Keynesian remedy that assumes that government deficits don’t matter when the economy is in deep recession; indeed, the bigger the better. At the opposite extreme are the debt-ceiling absolutists who want governments to start balancing their budgets tomorrow (if not yesterday). Both are dangerously facile.

The debt-ceiling absolutists grossly underestimate the massive adjustment costs of a self-imposed “sudden stop” in debt finance. Such costs are precisely why impecunious countries such as Greece face massive social and economic displacement when financial markets lose confidence and capital flows suddenly dry up.

Of course, there is an appealing logic to saying that governments should have to balance their budgets just like the rest of us; unfortunately, it is not so simple. Governments typically have myriad ongoing expenditure commitments related to basic services such as national defense, infrastructure projects, education, and health care, not to mention to retirees. No government can just walk away from these responsibilities overnight.

When US President Ronald Reagan took office on January 20, 1981, he retroactively rescinded all civil-service job offers extended by the government during the two and a half months between his election and the inauguration. The signal that he intended to slow down government spending was a powerful one, but the immediate effect on the budget was negligible. Of course, a government can also close a budget gap by raising taxes, but any sudden shift can significantly magnify the distortions that taxes cause.

If the debt-ceiling absolutists are naïve, so, too, are simplistic Keynesians. They see lingering post-financial-crisis unemployment as a compelling justification for much more aggressive fiscal expansion, even in countries already running massive deficits, such as the US and the United Kingdom. People who disagree with them are said to favor “austerity” at a time when hyper-low interest rates mean that governments can borrow for almost nothing.

But who is being naïve? It is quite right to argue that governments should aim only to balance their budgets over the business cycle, running surpluses during booms and deficits when economic activity is weak. But it is wrong to think that massive accumulation of debt is a free lunch.

In a series of academic papers with Carmen Reinhart – including, most recently, joint work with Vincent Reinhart (“Debt Overhangs: Past and Present”) – we find that very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more. The cumulative costs can be stunning. The average high-debt episodes since 1800 last 23 years and are associated with a growth rate more than one percentage point below the rate typical for periods of lower debt levels. That is, after a quarter-century of high debt, income can be 25% lower than it would have been at normal growth rates.

Of course, there is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline.

It is sobering to note that almost half of high-debt episodes since 1800 are associated with low or normal real (inflation-adjusted) interest rates. Japan’s slow growth and low interest rates over the past two decades are emblematic. Moreover, carrying a huge debt burden runs the risk that global interest rates will rise in the future, even absent a Greek-style meltdown. This is particularly the case today, when, after sustained massive “quantitative easing” by major central banks, many governments have exceptionally short maturity structures for their debt. Thus, they run the risk that a spike in interest rates would feed back relatively quickly into higher borrowing costs.

With many of today’s advanced economies near or approaching the 90%-of-GDP level that loosely marks high-debt periods, expanding today’s already large deficits is a risky proposition, not the cost-free strategy that simplistic Keynesians advocate. I will focus in the coming months on the related problems of high private debt and external debts, and I will also return to the theme of why this is a time when elevated inflation is not so naïve. Above all, voters and politicians must beware of seductively simple approaches to today’s debt problems.

Read more from our "The Great Debt Debate" Focal Point.

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    1. CommentedRobert Wolff

      We must precisely distinguish between debt due to debt leveraging by productive businesses and consumer debt. The cause of consumer debt is that wages are too low to buy the results of production, creating a situation in which [excess] profits beyond what businesses reinvest to increase production (which creates growth) are necessarily lent to consumers to so they may buy the total results of production.

      Such consumer loans, though they are funded by what businesses call profits, are really nothing more than funds held back from wages then loaned to consumers to buy excess production to maintain the condition wherein supply equals demand.

      The huge accumulation of consumer debt means that excess profits have been accumulating in large amounts, and been lent to consumers over a very long time to buy excess production beyond what their wages can afford.

      Keynesian redistribution can solve this problem after the fact, but we can now see the political crisis it creates. The spats over redistribution of wealth have now created a political crisis in Europe and America.

      Better yet would that the watchman had cried out long before the accumulation of excess profits lent out as consumer debt got so large that we incur a political crisis necessating huge redistributions of wealth that make Keynesian policies appear radical.

      A stitch in time saves nine.

        CommentedRobert Wolff

        Debt due to debt leveraging is performed to increase corporate profits at the expense of lowering the profit margin (ROI). The macro effect if all corporations do this is that it is the gross reduction in profit margin.

        The short term effect of debt leveraging is that it increases profits for those that get in on the beginning of the trend but the long term effect is that it drives up the risk to reward ratio of investment.

        Eventually, the risk of investment drives up the cost of capital, which drives down ROI that is already marginal, and the capitalist system collapses.

    2. CommentedRalph Musgrave

      Rogoff is totally clueless. First, he doesn’t get the point (made by Keynes and Milton Friedman) that it is totally unnecessary to run into debt in order to bring stimulus. That is, a deficit can accumulate as monetary base instead of debt if need be.

      Next, he claims that “governments should aim only to balance their budgets over the business cycle..” Complete nonsense: they never have done. Why doesn’t he look at the FACTS?

      I could go on.

      I don’t blame those Harvard economics students for walking out of their lectures. They should have walked out of Harvard university altogether.

        Commentedpeter fairley

        Rogoff only errs on Keynes in not being more emphatic that govt's have failed to heed Keynes' warning 'that budget deficits in boom times worsens the business cycle'.
        I respect Rogoff but wish he would answer Shiller at Yale in his critique of the 90% debt to GDP measure. Professors should not get paid just to talk to themselves and us amateurs.

    3. CommentedMichel Brouwers

      Thanks for this interesting article.

      I wonder whether the following...

      "The average high-debt episodes since 1800 last 23 years and are associated with a growth rate more than one percentage point below the rate typical for periods of lower debt levels."

      ... must also hold true in the opposite direction, i.e. how much extra growth was created due to leveraging? And what would be the net effect of both over time?

    4. CommentedMike Muller

      What? You start the paragraph saying that high debt may not be related to high interest rates and then you go on to say beware of the risk of high interest rates! And you connect this contradiction with "Moreover" as if the negation of the former followed from the former. Please remain sober. :-)

    5. CommentedThomas Lesinski

      See Matt Yglesias' critique of this interpretation of the historical evidence:

      Is it that excessive debt weighs on growth, or is it that governments hit by recessions, unable or unwilling to stimulate their economy cannot grow their tax base enough to pay down their debts ?

    6. CommentedJan Smith

      I've learned a great deal from Rogoff and Reinhardt, and from Professor Rogoff's many fine columns. And yet I am persuaded this time really is different.

      For the past 30 years, in spite of fundamental innovation in a wide range of capital and consumer goods, total American debt--private and public--has been accelerating while income growth has barely kept up with the previous century's average.

      That 30-year-old road is now closed.

      If there is anything in the technological pipeline that might replace the microelectronic revolution, no one can see it.

      But the enormous and prolonged Malthusian shock, starting in 1979, precipitated by the fall of communism but rooted in the demographic transition, still is working its way through the world economy. Old Malthus is coming home, and neither liquidity nor public debt can stop him.

      So within a few years, it will be evident even to the immortal Dr Pangloss that the USA must choose between becoming another Germany or another Greece. That is to say, either the Americans will tighten their own belt or others will do it for them.

      How tight, and for how long? Please, don't even ask.

        Commentedjimmy rousseau

        coming down the pipeline is the economic battle to fight climate change. This will rival WWII in economic impact and it cannot be averted.

    7. CommentedJoel Rosenblum

      I'm not an economist and I haven't read Prof. Rogoff's book so prudence should dictate that I keep my mouth shut, BUT... :-)
      It seems to me that in this essay he seems to aggregate the economic effects of all debt "overhangs" without regard to the underlying causes. As if a country doesn't balance it's spending over the business cycle (i.e. it spends too much and refuses to tax itself) is morally or economically equivalent to one which is bailing itself out of a financial crisis.
      He cites Japan as the examplar, as if Japan had merely overly stimulated in an inventory-cycle recession. But my recollection is that Japan had the mother of all financial crises. Would their GDP really be 25% higher now had the government let the financial system collapse?
      Is a financial crisis different from a normal business-cycle recession? Is a tornado qualitatively the same as a thunderstorm, just larger?

    8. CommentedHarlan Green

      There is a way out of the debt mess...see my Huff Post column: "What Happened to the Bush Tax Cuts?"...

    9. CommentedPaul A. Myers

      First, my view is that the US is already half way to where it should go. My look at the CBO 10-year projection is that the debt-GDP ratio starts to decline by 2014 if the Bush tax cuts are allowed to lapse and legislated health care savings are actually realized through policy implementation.

      Second, state and local government spending is down and so overall total government spending in the US is down. Now that it is lean, possibly government should be made meaner?

      Third, all the job growth in the Obama era has been private sector job growth. This is economically tested, economically useful job growth. The overall job foundation of the US is becoming more solid, more productive.

      Fourth, the missing piece is public infrastructure spending. When government borrows a dollar to build a dollar of public assets, the impact is quite different than spending on public consumption. A dollar of public assets will generate increased income in the future (and if doesn't it hasn't met the definition of "asset"). So a dollar of debt to build a dollar of assets is not such a scary thing.

      The US president who puts the pieces together is going to do quite well on the upside.

    10. CommentedDave Thomas

      Why not means test social security and medicare immediately.
      Why not increase the co-pays for Medicare immediately.
      Why not cut marginal tax rates across the board for everyone so that the economy will expand and people will be working at jobs and paying taxes instead of not working and adding to the annual deficit by relying on government programs?

    11. CommentedRobert Guy Danon

      Authorities have three choices:

      1- Go through many years of austerity and or growth enhancing policies to reduce both deficits and debt to sustainable levels a very long process of perseverence.

      2-Central banks abandon their narrow mindedness and allow inflationary EXPECTATIONS (it is this variable expectations, that is important to trigger demand side incentives)

      3-Even more importantly design a process to redistribute wealth to households by increasing motgage debt forgiveness and thus wealth, allowing for increased final demand as net worth and prosperity values rise.

      In summary, it is a function of transfering wealth from creditors to debtors. If this process is not accelerated then it will be imposed by market forces and or political and ultimately social repercussions. This effectively, is what is currently happening in Greece.

      It goes without saying that a combination of all is also another desirable mix.

    12. CommentedMike Jake

      Who are these "simplistic Keynesians", Kenneth? Name some names so we can see if their positions actually match this caricature.

      Or are you just trying to position yourself in the sensible center?

    13. Commentedsrinivasan gopalan

      Prof.Rogoff hits the nail on the head when he succinctly put it that 'it is wrong to think that massive accumulation of debt is a free lunch'. Living on borrowed money is the bane of modern society--whether it is by individual or by sovereign governments, though the latter cannot escape its hold as its agenda is wider and ineluctable. Leaving aside hard economics that is readily used by politicians swearing faith either in Keynesian pump-priming or in fiscal fundamentalism, the fact remains that borrowing binges by governments without thought to the long-term repercussions would eventually make the zero-interest western countries to live with exorbitant ones if they do not in the meanwhile mend their ways and sacrifice short-term enjoyment to long-lasting happiness in the future. But the politicians without any understanding of the past or any clue to the future would not be the ideal choice to weather the crisis without astute advice from economists of repute. Debt by any way is a surefire road to perdition and it is wiser to contract debt that could be discharged in one's life-time .This is applicable to nations as it is to individuals. Any one interested in the common good of humanity would definitely be with the learned Prof.Rogooff in decrying debt with its manifest wart and all. Emerging economies like India should benefit by salutary counsel from evolved economists who speak for the summum bonum of all and not to this or that country.

    14. CommentedHamid Rizvi

      Alright, so in this edition of your admonitions and over analysis has told us nothing except what we should not do. I do appreciate the fact that you conclude by saying there is more to come. I, await with bated breath in the hope you might then tell us what we indeed should be doing.

    15. CommentedDavid Doney

      We can walk and chew gum at the same time, with short-term stimulus, long-term austerity, structural reform, and mortgage write-downs. Some examples:

      Short-term stimulus: Infrastructure, forgive the debts of doctors and nurses past and future that stay in the profession for 10 years, write-down mortgage debts for those significantly underwater. Payroll tax cuts.

      Long-term austerity: Raise the retirement age, reduce cost of living adjustments in pension programs, as progressively as possible. Phase out the Bush tax cuts for the wealthy first and everyone else over 5 years. Raise the healthcare premiums for the obese.

      Structural reform: Prohibit offshoring to low-wage countries, to offset our $650 billion goods trade deficit that has killed our jobs engine. Take high school dropouts and draft them into a military-style high school completion program. Everybody graduates.

      All of the above, not "this or that" which is a false choice.

      We are in this mess due to too much debt; we have too much private debt due to offshoring and a dead jobs engine; we have too much public debt because we have too much private debt.

      Find the causes...fix the problems.

    16. Portrait of Michael Heller

      CommentedMichael Heller

      Kenneth Rogoff:

      I suppose the signal Ronald Reagan sent out in 1981 is similar to the one now advocated by people who favour backloading commitments to reduce government spending. Debt is the root problem. I’m persuaded by your arguments which fairly represent the moderate centre ground today. Corrective strategy can begin with acceptance of the need for backloading and also inflation, and with rejection of the simplistic extremes you have outlined.

      It seems, however, that the middle ground is actually institutional in fundamental ways, and this dimension gets insufficient attention. Institutional reform is not a luxury to be postponed until better economic times. Nor, in Europe, does it necessarily require a utopian level of political union. Governments have urgently to make formal institutional commitments without U-turns: introducing the permanent interventions rather than the temporary interventions advocated by simplistic Keynesians; simple decisive legislative changes; and predictive financial market regulation in one or another form, so that markets will believe governments and so that pressured incentives for states to reform are maintained.

      The logjam in Europe is that Germany will understandably not consider temporary interventions or eurobonds and assorted rescue measures that could cost it dearly until there has been the needed European treaty change and until individual countries have used the short window of opportunity to reform their national institutional rules and shown reasonably credible intent regarding labour laws, privatization, and fiscal and monetary rules. A humane and balanced approach to writing down debt can start as soon as the rules are agreed on. They are on the table already. Certain countries and highly vocal and articulate leftwing economists are recklessly blocking sensible agreement and implicitly giving encouragement to debtor countries to “call the bluff” of creditor countries.