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.