Thursday, November 27, 2014

The Debt-Growth Controversy

STANFORD – The recent controversy over errors in a 2010 paper by the economists Carmen Reinhart and Kenneth Rogoff is a sad commentary on the demands of the 24/7 news cycle and the politically toxic atmosphere surrounding fiscal policy in the United States, Europe, and Japan. In their paper, “Growth in a Time of Debt,” Reinhart and Rogoff estimated large declines in growth associated with public-debt/GDP ratios above 90%. But it contained coding errors discovered by a University of Massachusetts graduate student. When corrected, the effect is substantially smaller, but nonetheless economically consequential.

The Reinhart/Rogoff paper is just a small part of a voluminous academic literature that shows high debt levels to be economically risky. A more fundamental question is causality: the state of the economy certainly affects the fiscal position, just as taxation, spending, deficits, and debts may affect economic growth.

Research errors in economics are not uncommon, but they are usually caught at an early stage, as happened once to me in a prepublication draft. Sometimes errors are not discovered until later, when they are working papers, as with Reinhart and Rogoff, or after publication, as with Nobel laureate Ken Arrow, who had to correct a mistake in the proof of his famous impossibility theorem.

Economists use different methods to analyze fiscal issues: stylized analytical models; macroeconometric models fitted to aggregate data, such as those used by the Federal Reserve, the European Central Bank, and the US Congressional Budget Office (CBO); empirical estimation of key parameters, such as spending multipliers; vector autoregressions; and historical studies. Each of these approaches has its strengths and weaknesses, and serious economists and policymakers do not rely on a single study; rather, they base their judgments on complementary bodies of evidence.

Thus, there is no excuse for the outrage, the exaggerated claims for one paper’s influence, and the attempt to use the error to discredit legitimate concerns over high levels of debt (let alone to vilify the authors).

While large deficits are usually undesirable, sometimes they can be benign or even desirable, such as in recession, wartime, or when used to finance productive public investment. In normal times, deficits crowd out private investment (and perhaps crowd in private saving and/or foreign capital), and hence reduce future growth. By contrast, in a deep, long-lasting recession, with the central bank’s policy rate at the zero lower bound (ZLB), a well-timed, sensible fiscal response can, in principle, be helpful.

But the political process may generate poorly timed or ineffective responses – focused on transfers rather than purchases, infra-marginal tax rebates, and spending that fails cost-benefit tests – that do little good in the short run and cause substantial harm later. America’s 2008 stimulus barely budged consumption upward, and the 2009 fiscal stimulus cost hundreds of thousands of dollars per job – many times higher than median pay.

We should adopt policies that benefit the economy in the short run at reasonable long-run cost, and reject those that do not. That sounds simple, but it is a much higher hurdle than politicians in Europe and the US have set for themselves in recent years.

I estimated the impact on GDP of America’s recent and projected debt increase (in which the explosive growth of public spending on pensions and health care looms largest), using four alternative estimates of the effect of debt on growth: a smaller Reinhart/Rogoff estimate from a more recent paper; a widely used International Monetary Fund study, which finds a larger impact (and which deals with the potential reverse-causality problem); a related CBO study; and a simple production function with government debt crowding out tangible capital. The results were quite similar: unless entitlement costs are brought under control, the resulting rise in debt will cut US living standards by roughly 20% in a generation.

Corroborating statistical evidence shows that high deficits and debt increase long-run interest rates. The effect is greater when modest deficit and debt levels are exceeded and current-account deficits are large. The increased interest rates are likely to retard private investment, which lowers future growth in employment and wages.

Numerous studies show that government spending “multipliers,” even when large at the ZLB, shrink rapidly, then turn negative – and may even be negative during economic expansions and when households expect higher taxes beyond the ZLB period. Permanent tax cuts and those on marginal rates have proved more likely to increase growth than spending increases or temporary, infra-marginal tax rebates; successful fiscal consolidations have emphasized spending cuts over tax hikes by a ratio of five or six to one; and spending cuts have been less likely than tax increases to cause recessions in OECD countries.

Some argue that fiscal consolidation by gradual permanent reductions in spending would be expansionary for high-debt countries, as occurred in some historical episodes. Others maintain that a temporary increase in spending now would boost growth. Both could be expansionary – or not, depending on details and circumstances. Because many countries have been consolidating simultaneously, interest rates are already low; and, for the US, which accounts for more than 20% of the global economy and issues the global reserve currency, caution in generalizing from other fiscal episodes is highly advisable.

Nonetheless, the evidence clearly suggests that high debt/GDP ratios eventually impede long-term growth; fiscal consolidation should be phased in gradually as economies recover; and the consolidation needs to be primarily on the spending side of the budget. Finally, the notion that we can wait 10-15 years to start dealing with deficits and debt, as economist Paul Krugman has suggested, is beyond irresponsible.

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    1. CommentedEmanuele Canegrati

      I completely agree with Professor Boskin and this comment seems to me one of the best ever written. It is debatable whether the 90% threshold is reasonable or not. But one thing must be clear: sooner or later (and I mean sooner or later) the debt must be repaid. In any case. It was a principle taught by Ricardo, mentioned by Barro, in any case reasonable. The public debt is only the illusion of having more wealth. A forcing imposed by bureaucrats to citizens, which produces devastating effects in terms of intergenerational equity, impossible to predict ex ante by the government. The same is true of inflation, recently invoked by Professor Krugman as "the lesser of two evils." The great von Mises, the founding father of the Austrian School of economics, was right when he warned his students to be wary of those who believe that a bit 'of inflation, even just a little', it can do well. Instead, he reminds us that in the end it only creates a distortion of price signals, loss of credibility in the currency that sooner or later will be abandoned because it lacks value. With devastating effects on the real economy. Neither the debt, or inflation can create development. Only the ideas, the technological development and the competition of free enterprises in a free market.

    2. CommentedBen Leet

      Professor Boskin seems to have overlooked the wage stagnation of the past 40 years. This stagnation has resulted in a vastly more unequal distribution of national income, note the rising Gini levels since 1970. See this article: -- Wealth and income must be distributed both for economic efficiency and for fairness, for practical and moral reasons. Professor R. Pollin who is a primary detractor of the Reinhart and Rogoff study pointedly states that wage growth since 1971 has decreased by 10% while productivity growth has doubled. This is reminiscent of Marriner Eccles (Chairman of Fed Reserve 1934 - 48) that an economy must distribute income to stay healthy: ""As mass production has to be accompanied by mass consumption, mass consumption, in turn, implies a distribution of wealth ... to provide men with buying power. ... Instead of achieving that kind of distribution, a giant suction pump had by 1929-30 drawn into a few hands an increasing portion of currently produced wealth. ... The other fellows could stay in the game only by borrowing. When their credit ran out, the game stopped."

    3. Portrait of Pingfan Hong

      CommentedPingfan Hong

      A continuously rising debt will eventually lead to a debt crisis. However, debt sustainability is not simply determined by the single indicator of the debt to GDP ratio, with a fixed threshold. Debt sustainability for a country depends on a complex set of variables, including, for example, interest rates, potential GDP growth, the proportion of debt held by foreign investors, the
      currency composition and term structure of debt, the domestic savings rate, external balances, the structure of government spending and revenue, and the demographic structure. The wide range of these variables explains why some countries have fallen into debt crisis at a moderate debt ratio while others remain solvent at a much higher debt ratio.
      Any quest for an universal threshold of debt to GDP will be in vain.

    4. CommentedRichard Barlow

      Twisted logic and misrepresenting others views do not make a compelling case for whatever the author was trying to say.
      If I understand it one of his points is that countries need to cut pensions and healthcare by an amount equivalent to a 20% increase in debt ? The future has more older people needing pensions for longer and wanting decent healthcare. At the heart of his argument is that he wants people to bear the costs via self funded retirement and healthcare and greater poverty ? I would like to see the bumper sticker for that race!

    5. CommentedKen Presting

      Project-Syndicate serves a reader who is equally dissatisfied with both one-sided advocacy, and by antagonistic dismissal of opponents. Does Prof. Boskin of Hoover believe Nobelist Prof. Krugman is "beyond irresponsible?"

      If so I can only invite him to go publish on Commentary, or National Review Online, where his level of prose will be matched by his commitment to obfuscation, rather than enlightenment of the public.

      His claim that entitlement spending is unbalancing the federal budget is what one would expect from those who mostly listen to radio, and reject David Brooks as a moderate. There is substantive literature which documents what other commenters have already pointed out - balancing FICA and Medicare is our easiest tax issue.

    6. CommentedFrank O'Callaghan

      The debt discussion has been a distraction from the beginning. It is run up as the wealthy are taxed less and less while the rest of the population are required to pay more and more.

      Inequality is the core issue. The debt has been created for the rich to be paid for by the rest. Debt is an instrument of redistribution from the many to the few.

    7. CommentedRalph Musgrave

      Michael Boskin’s article is riddled with mistakes. For example he claims that the 2009 stimulus costs hundreds of thousands of dollars per job created. The flaw in that argument is that stimulus costs NOTHING IN REAL TERMS. To put it crudely, if government needs to print and distribute $100 to every household to improve confidence and raise demand, that COSTS NOTHING because printing dollar bills costs next to nothing.

    8. CommentedZsolt Hermann

      As long as all calculations, the whole methodology is based on constant quantitative growth, all calculations will fail.
      The whole paradigm politicians, economists and basically the whole global population is using, living by is artificial, unsustainable.
      We never fixed the previous errors, the previous crisis, we simply created more bubbles around the bursting ones, we simply printed more money to cover holes, and continue the cosmetic surgery while the patient is dying.
      It has gone to such extent that in Europe they do not even talk abut people, the public when looking at the health of a country, or effects of elections, they only talk about banks and the market. The world, societies have broken into pieces, layers.
      The rising social inequality and youth unemployment brought many nations to the brink of disaster, future election results, governments fulfilling their terms has become unpredictable.
      Instead of philosophical arguments about a system that has no natural foundations first we should understand the global, integral world human network we evolved into, which network exists in a vast, closed and finite natural system.
      The laws of this natural system, which we have been ignoring for a very long time are binding and if we truly want to build a sustainable future we need to understand and accept them.

    9. CommentedRobert Winter

      The problem with the paper is hardly limited to to coding errors. The countries selected and the method of weighting country experiences also raised significant issues. Moreover, the authors implied there was some magic to 90% when the same point would be true at different percentages and they either said and implied, or let others conclude from their paper without correction, that there was a magic to 90% that had to be addressed now.

    10. CommentedG. A. Pakela

      One would expect a correlation between high levels of accumulated debt and slow growth. High - 90% of GDP levels of government debt implies that government has taken on a dominent role in credit markets- possibly at the expense of private sector business borrowing. While the former temporarily boosts demand, the latter is what finances future growth as those investments lead to more hiring, which in a virtuous cycle, lowers unemployment and increases sustainable demand as newly hired employees are able to increase their consumption.

        CommentedRalph Musgrave

        The flaw in that argument is that assuming government incurs debt so as implement stimulus, the central bank is very unlikely to let interest rates rise, because the CB will also realise that stimulus is needed. Ergo government borrowing WON’T thwart private sector borrowing.

    11. CommentedThomas Masterson

      Always a red flag when these two are lumped in together: "public spending on pensions and health care looms largest".
      Social Security is not a problem and healthcare is not a spending problem but a healthcare system problem.
      Also laughable is the idea that government debt crowding out tangible capital. When is this going to happen? Presumably some time much later than now when real interest rates on government debt is negative and corporations are sitting on piles of cash. Or don't incentives matter? If there were profitable investments to be made they would be made. But the slow recovery of demand means that it will be a long time before we reach a level of capacity utilization that will require (and make profitable) additional investment in productive capacity.