Monday, November 24, 2014

Who’s Afraid of the Big Bad Debt?

CAMBRIDGE – It has been a while since a debate among academic economists attracted so much interest from the mainstream press as has the row between Carmen Reinhart and Kenneth Rogoff, on one side, and Paul Krugman, on the other. In fact, it has even become fodder for television comedy shows.

At issue is an influential 2010 paper by Rogoff and Reinhart that purports to show that high levels of public debt are associated with lower long-term economic growth. A new paper by Thomas Herndon, a graduate student at the University of Massachusetts at Amherst, and two of his professors, Michael Ash and Robert Pollin, questioned this finding, and Krugman made their work famous.

Herndon, Ash, and Pollin argue that the results obtained by Reinhart and Rogoff are based on coding errors and questionable methodological choices. But, after all their quibbles, their paper weakens but does not refute the Reinhart/Rogoff paper’s main result. So why all the fuss?

The debate is considered important because it is supposed to have implications for the choice between cutting the deficit and stimulating the economy now. But this is just not so. Instead, the paper needs to be understood in the context of the debate between Keynesians and (as Krugman calls them) “Austerians” – those who propose fiscal austerity to stem spiraling government debt.

The Keynesian prescription is simple: If the economy is weak, fiscal policy should be used to stimulate it; if it is overheating, spending cuts or tax hikes should be used to cool it down. Public-debt levels will rise and fall, but policymakers should not pay too much attention. After all, look at the United States and the United Kingdom: despite high deficits and rising debt, inflation remains subdued and long-term interest rates are at historic lows. Why not use this opportunity to stimulate the economy and invest in its future?

Interestingly, Reinhart and Rogoff broadly agree with this recommendation (at least for the US), and they even support heterodox policies such as writing down mortgages and targeting a higher inflation rate. But their paper is really about a different subject. It is about the long-term effects of high levels of public debt, which they argue are deleterious to growth.

That conclusion implies that Krugman is wrong to claim that one can be blasé about the debt level. Krugman would argue that, if the economy remains weak, interest rates will remain low, despite high and rising public debt. Fear of a speculative attack by so-called “bond vigilantes” is unwarranted, he would claim, as the US and the UK show.

The Reinhart/Rogoff paper provides worldwide evidence in favor of the view that high public debt can become a problem, and that countries should beware of putting themselves in a vulnerable position. But the ensuing debate sheds no light on the question of whether policymakers should disregard debt levels when their economies are depressed, as Krugman recommends. There really is a big bad debt wolf, and the world is full of examples in which it has emerged from its lair to create havoc.

Consider Spain. When the 2008 crisis erupted, the G-20 convened that November to coordinate a Keynesian response. All member countries were supposed to fight the coming recession by stimulating their economies through simultaneous fiscal expansion. Pedro Solbes, Spain’s finance minister at the time, quickly ordered an acceleration of public investment and spending.

By the spring of 2009, however, Solbes was forced to reverse course. With tax revenue collapsing and expenditure ballooning, the government found itself running such large deficits that the markets were spooked – government-bond prices collapsed, interest rates soared, and the country found itself unable to finance its deficit. Where were the rock-bottom interest rates that are supposed to characterize periods of weak growth and high unemployment?

Financial history is full of similar examples: Mexico in 1994, Russia in 1998, Ecuador in 1999, Argentina in 2001, Uruguay in 2002, the Dominican Republic in 2003, and even the UK in 1976. All were battling recession and high unemployment, only to find themselves unable to finance their deficits. In fact, when a country is in this predicament, fiscal contraction may end up being expansionary to the extent that it reestablishes financial confidence and lowers sky-high interest rates.

As much as Krugman has made of the Reinhart/Rogoff paper, the debate between “Austerians” and Keynesians has limited relevance outside of the US. Krugman does not mention issues that he knows are central to fiscal choices.

The level of debt does matter, and its currency composition matters even more. The US is in the enviable position of issuing debt in its own currency. The Federal Reserve can create as many dollars as it sees fit in order to buy government debt. Moreover, as the world’s reserve currency, the dollar plays a very particular role in the global economy.

Japan, too, can finance its deficits, despite astronomical public debt, because it borrows in yen – and overwhelmingly from Japanese institutional investors.

By contrast, Spain’s debt is in euros, a currency that it cannot print, and is held mostly by foreigners. And many emerging-market countries are in a similar position. In a recent paper with Ugo Panizza of the Graduate Institute of Development Studies in Geneva, we show that in the aftermath of the 2008 crisis, emerging-market countries that could run the kind of counter-cyclical Keynesian policies espoused by Krugman had low levels of foreign-currency debt. It is only because they were “Austerians” before the crisis that they could afford to be Keynesians afterwards.

Whatever weaknesses one finds in the Reinhart/Rogoff paper, it does not follow that countries in recession should always disregard deficits and debt levels and focus on stimulus. That might be the right recommendation for the US today, but as a universal rule of thumb, it is just plain wrong.

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    1. CommentedOmololuoye Majekodunmi

      People like misquoting krugman. krugman has always acknowledged the advantages of having ones own currency. Spain is a wrong example to use because it doesnt borrow in its currency and big brother Germany is not ready to help. look at US/JPN and look at the euro area. the difference is as plain as fact look at UK which has its own currency but pursued austerity. its a shame academic economists believed in the confidence fairy and expansionary austerity.

      You mentioned that 'fiscal contraction may end up being expansionary to the extent that it reestablishes financial confidence and lowers sky-high interest rates'. my response is where has the confidence fairy been?

    2. CommentedLeo Arouet

      En total desacuerdo. En Perú hemos aplicado políticas anticíclicas sin haber sido austeros antes... Simplemente es necesario estimular la economía porque de lo contrario una austeridad rigurosa traerá una mayor precariedad. Y si esto de ve como en Estados Unidos que necesita infraestructura, aumentar los sueldos y conservar los empleos mucho mejor, bienvenido Keynes.

    3. Commentedjack lasersohn

      Krugman's argument is a bit more subtle than how it is portrayed. He does not argue that debt does not matter, but rather that stimulus now will lower debt/gdp ratios in the future, by causing GDP to grow faster than the debt is accumulating.
      The real gap in this argument , that he never addresses (ever), is whether that is true or not. He simply assumes that because austerity does not seem to be working that the inverse must be true: that stimulus will produce a permanent increase in the rate of GDP growth. This is not necessarily true and is frankly not very likely to be true.
      It is hard to imagine how a temporary stimulus should produce a permanent increase in output. The only way is if it leads business to permanently expand production (through hiring and capital investment), but i can assure you that most businessmen are much more likely to meet what is obviously a temporary blip in government induced demand by temporary hiring or simply ignore it completely. Krugman is an extremely smart guys who has been right most of the time, but he has simply never made a persuasive argument in support of the idea that temporary stimulus will actually produce permanent increases in growth rates (frankly, neither did Keynes).
      The real role of stimulus is to very inefficiently provide funds to persons who would otherwise be in financial extremis and default on their debt obligations causing a Minsky cascade of defaults. It would be vastly more efficient to do this by providing highly target debt relief to aid in rapid deleveraging , but even liberals find the moral hazard and inequity of that approach unacceptable.

    4. CommentedOliver Kovacs

      Stimulus or austerity? In my opinion, a potential solution may be somewhere in between. The real question is whether we can find a new growth model, fields that are worth to concentrate on fiscally which may lead to not only quantitative, but qualitative growth.

      The crisis is still out there by summoning the bad times of earlier economic history. Even though Marx stated that history repeats itself first as tragedy, if we are cautious and aware enough, we can pursue a solution / /

    5. CommentedJuan Daniel Montenegro Cabrera

      Another interesting part of the debate is their claim that high debt is the cause of low growth, when in fact there is only a negative correlation demonstrated and not the direction of the cause which could also be the other way around, low growth can be the cause of high debt.

    6. CommentedJuan Daniel Montenegro Cabrera

      the author forgets that this rock-bottom interest rates are true for countries who still have their own currency to devaluate which is no longer true for countries like Spain which have taken the Euro and have no such mechanism.

    7. CommentedMark Pitts

      Japan has had huge debts for a generation, and little growth. Italy and Greece had huge debts and little growth (even before 2007). Now, the whole developed world has huge debt and little growth. The pattern seems to prove Rogoff and Reinhart right.

    8. CommentedTomas Kurian

      Only countries that does not have their own central bank are at the mercy of bond vigilantes. Thats the point of having one, private lenders can panick - central bank is the final defense.

    9. CommentedRalph Musgrave

      Ricardo Hausmann doesn’t understand this subject. His basic argument is that countries that are reliant on foreigners to fund deficits (e.g. EZ countries) cannot ignore deficits and debts. Well obviously!!!! He then concludes that “countries in recession” should be careful with deficits and debts. Well as he himself just pointed out, it’s countries that are reliant on FOREIGN FUNDING that face a problem there. In contrast if you can print your own money (like the US, Japan, UK, etc) then it’s INFLATION that is the real constraint. Debts and deficits are irrelevant.

    10. CommentedFrank O'Callaghan

      Rogoff and Reinhart have become a joke. However they say something very important; Nonsense, no matter how crude or obvious, can be accepted in economics as long as it serves the ends of the dominant ideology.

      The lesson should be restated frequently. To do otherwise is to collude in the selective amnesia that marks conspiracy or complicity in deceit.

    11. CommentedProcyon Mukherjee

      When lack of humility is replaced by an arrogance that instead of believing in the 'gradual increase of assurance' that Hume summarized in his Treatise on Human Nature, we have the current genre of Economists muddled in the virtues of a science that is not based on falsifiability, but in inductive reasoning, that at best could serve the needs of a partial inquiry which must be held with due skepticism as to the nature of their applicability.

    12. CommentedKen Presting

      It's just astonishing at this date to read an article on the Rogoff-Reinhart paper which does not mention that it had blatant admitted errors, not just in calculations, but as Brad DeLong points out, in the essence of its non-parametric method. It was never the data which showed a "threshold" effect where debt became dangerous. It was only the authors who created an arbitrary-sized category over 90% debt-to-GDP.

      Anyone who stumbles across Prof. Hausman's dubious apologia here, should quickly turn to Prof. DeLong's piece on this same site. There is a stimulating discussion already in the comments there too.

    13. CommentedPeter P

      The level of debt does matter for interest rates ONLY for countries on pegs and using foreign currency. Not to sovereign issuers. Please read up on MMT, it predicted this result long before the crisis and thus warned against the Euro: not because monetary policy cannot be adjusted, but because of exploding debt costs in the event of a continent-wide recession.

        CommentedRobert Lunn

        Maybe a bit of an over read? Krugman started attacking R&R piece as something the talking heads latched onto in order to explain macroeconomics like home economics.
        I read their book and came away thinking the evidence showed some cause and effect but not total. Subsequently, Rogoff has positioned himself in the "balanced" approach camp.
        I'd caution Krugman to be a little careful. When the likes of Joe Scarborough used R&R to make his case, R&R should have scrambled. Now, Krugman has the same issue upside down. He should be careful if not humble.