When economists are wrong we all suffer. And we now know the debt obsession is wholly misplaced

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Two economists from the University of Massachusetts Amherst, Robert Pollin and Michael Ash, have written in the FT today, saying:

In 2010, two Harvard economists published an academic paper that spoke to the world’s biggest policy question: should we cut public spending to control the deficit or use the state to rekindle economic growth? “Growth in a Time of Debt” by Carmen Reinhart and Kenneth Rogoff has served as an important intellectual bulwark in support of austerity policies in the US and Europe. It has been cited by politicians ranging from Paul Ryan, the US congressman, to George Osborne, the UK chancellor.

The Reinhart-Rogoff research is best known for its result that, across a broad range of countries and historical periods, economic growth declines dramatically when a country’s level of public debt exceeds 90 per cent of gross domestic product.

In other words, it was argued by Reinhart- Rogoff that high debt essentially meant that the state captured all resources, used them inefficiently, prevented the private sector using them and so curtailed growth at cost to everyone.
There’s just one problem. As Pollin and Ash write:
But we have shown that several critical findings advanced in this paper are wrong.
The erros made are threefold. First, the Reinhart-Rogoff spread sheet used to reach the conclusion simply didn’t add up. Second, they used a bizarre weighting system that have one off singular adverse events equal weighting to many years of normal events, and thirdly they omitted some data for reasons that have not been disclosed. All are pretty fundamental methodological errors. The first is every data users nightmare, but is why you always double check – which is tedious but necessary. The second and third are much harder to explain. But the implications are clear:

In their work [Reinhart-Rogoff] with a sample of 20 advanced economies over the postwar period, they report that average annual GDP growth ranges between about 3 per cent and 4 per cent when the ratio of public debt to GDP is below 90 per cent. But average growth collapses to -0.1 per cent when the ratio rises above a 90 per cent threshold.

But as Pollin and Ash note:

In a new working paper, co-authored with Thomas Herndon, we found that these results were based on a series of data errors and unsupportable statistical techniques.

When we performed accurate recalculations using their dataset, we found that, when countries’ debt-to-GDP ratio exceeds 90 per cent, average growth is 2.2 per cent, not -0.1 per cent. We also found that the relationship between growth and public debt varies widely over time and between countries.

So far from stopping growth, high debt may at best impair growth a little, and without consistent evidence that it is debt that is the causal factor at all. As they note:

Consider a situation in which a country is approaching the threshold of a 90 per cent public debt/GDP ratio. It is not accurate to assume that these countries are reaching a danger point where economic growth is likely to decline precipitously.

Rather, our corrected evidence shows that a country’s growth may be somewhat slower once it moves past the 90 per cent public debt-to-GDP level. But we cannot count on this being true under all, or even most, circumstances.

As they point out, circumstances other than debt have also to be considered. The Reinhart-Rogoff result was just too simplistic, as well as being wrong. But the most important conclusion is this:

What about our present circumstances? Using Prof Reinhart’s and Prof Rogoff’s data, we found that for the years 2000 to 2009, the average GDP growth rate for countries carrying public debt levels greater than 90 per cent of GDP was either comparable to or higher than those for countries whose public debt/GDP ratios ranged between 30 and 90 per cent.

In other words, the debt obsession could be completely wrong. And they explain why:

Of course, one could say that these were special circumstances due to the 2007-9 financial collapse and Great Recession. Yet that is exactly the point. When the US and Europe were hit by the financial crisis and subsequent collapse of private wealth and spending, deficit-financed government spending was the most effective tool for injecting demand back into the economy. The increases in government deficits and debt were indeed historically large in these years. But this was a consequence of the crisis and a policy tool for moving economies out of the deep recession. The high levels of public debt were certainly not the cause of the growth collapse.

As they conclude:

We are not suggesting that governments should be free to borrow and spend profligately. But government deficit spending, pursued judiciously, remains the single most effective tool we have to fight against mass unemployment caused by severe recessions. [More] [r]ecent research by Prof Reinhart and Prof Rogoff, along with all related arguments by austerity proponents, does nothing to contradict this fundamental point.

Pollin and Ash don’t want to say that the debt obsession is wrong, per se, and of course in extremis they’re right. But the simple fact is that we are so, so far away from extremis (UK debt being lower right now than for most of the last two centuries) austerity for debt reduction makes absolutely no sense at all. That is what we can conclude from this. Which means it’s time to spend. As I’ve long argued.