Gavyn Davies on Reinhart/Rogoff
How much of Reinhart/Rogoff has survived?: The work of Carmen Reinhart and Ken Rogoff (RR) on public sector debt ratios, and their relationship with GDP growth, has been extraordinarily influential… had appeared to establish an important stylised fact: that debt ratios above 90 per cent were associated with much lower rates of GDP growth than debt ratios under 90 per cent. The sudden drop in growth at a debt ratio similar to that reached in many developed economies acted as a wake up call to governments and encouraged the adoption of austerity programmes.
This week, a paper by Thomas Herndon, Michael Ash and Robert Pollin (HAP) argued that the RR stylised fact was based on simple statistical errors, including a spreadsheet error which RR have now acknowledged. Their critique of the original RR stylised fact promises to establish an alternative conventional wisdom, which is that high public debt ratios are never damaging for GDP growth. But the truth is more complicated than that, and far less certain….
[H]ere is my (hopefully not too biased) commentary on the current state of the debate.
First, the original work of RR never really established that GDP growth was likely to decline suddenly once a 90 per cent debt threshold had been exceeded….
Second, not all of the difference between RR and HAP is attributable to the spreadsheet error which has become infamous this week. In fact, it appears that only 0.3 per cent stems from this, with another 0.1 per cent coming from a transcription mistake. The remainder of the difference is due to a combination of missing data in the original RR paper, and to a methodological dispute about how countries should be weighted…. My interpretation is that HAP have had the better of this element in the debate, because the RR method has the very odd effect that a few years of New Zealand data in the late 1940s appear to have depressed their critical estimate…. This alone explains most of the difference between HAP and RR.
Third… even HAP confirm that the RR cross-country database does show that higher public debt ratios are usually associated with lower GDP growth rates….
Fourth, as Paul Krugman has argued many times, this negative correlation between debt and growth does not establish the direction of causation….
Fifth, the work which has been done by Arindrajit Dube on the timing of these effects suggests that changes in growth precede changes in debt, and not the other way around….
Sixth, there really is no reason why we should expect the relationship between public debt and GDP growth to be stable through time and across all countries. In a fully employed economy (which applies to most countries in the period under consideration above), a deliberate rise in the budget deficit will raise interest rates, and crowd out private investment. This will reduce long term GDP growth rates. However, if the economy is working well below capacity, a rise in the budget deficit may not raise interest rates, but may instead raise aggregate demand and thus boost GDP growth. Under some circumstances, this might even reduce the debt ratio for a while.
In summary, the most dramatic version of the RR stylised fact is no longer a stylised fact…. [I]t is an illusion to expect that the complicated relationship between public debt and GDP growth will always and everywhere be the same.