Reinhart-Rogoff Weblogging: No, Their Argument for Austerity Now Out of Fear of Debt Didn't Seem to Me to Make That Much Sense

Let me highlight a passage from the "Understanding Our Adversaries" evolution-of-economists'-views talk that I started giving three months ago, a passage based on work by Owen Zidar summarized by the graph above:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart, Reinhart, and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow.

This is the most live argument today. So let me nibble away at it. And let me start by presenting the RRR case in the form of Owen Zidar's graph.

First: note well: no cliff at 90%.

Second, RRR present a correlation--not a causal mechanism, and not a properly-instrumented regression. There argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question.

The third thing to note is how small the correlation is. Suppose that we consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. Suppose that all of the correlation is causation running from high debt to slower future growth. And suppose that we boost government spending by 2% of GDP this year in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by... wait for it... 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend 2% of GDP over each of the next three years. Collect 15% of a year's extra output in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP and we have the same ten-year depressing effect of 0.06% of GDP. 15% now. -0.06% in a decade. The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year's GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP? That does not seem to me to compute.

Now tonight I have been nibbling the RRR result down. Presumably they are trying to see if it can legitimately be pushed up. This will be interesting to watch over the next several years, because RRR is the heart of the pro-austerity case right now.

And Matthew O'Brien is considerably harsher than I am:

Forget Excel: This Was Reinhart and Rogoff's Biggest Mistake: Those are important words: "associated with"…. [T]he best argument against taking R-R as austerity's gospel truth was it was just a correlation. Of course a ratio tends to increase more when its denominator increases less. That's how fractions work…. Of course, this hasn't stopped deficit hawks from touting R-R's work as proof that we must tackle the long-term debt and we must tackle it now. Including, sometimes, R-R themselves. Now, in their paper, R-R are careful…. [But do not] ignore what they said about their paper. For example, here's what they said in Bloomberg View back in July 2011:

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP…. 

The biggest risk is that debt will accumulate until the overhang weighs on growth….

Those who remain unconvinced that rising debt levels pose a risk to growth should ask themselves why, historically, levels of debt of more than 90 percent of GDP are relatively rare and those exceeding 120 percent are extremely rare (see attached chart 2 for U.S. public debt since 1790). Is it because generations of politicians failed to realize that they could have kept spending without risk? Or, more likely, is it because at some point, even advanced economies hit a ceiling where the pressure of rising borrowing costs forces policy makers to increase tax rates and cut government spending, sometimes precipitously, and sometimes in conjunction with inflation and financial repression (which is also a tax)?

To be fair, R-R do say that they only found that higher debt and lower growth are "associated" and that there's no "bright red line" (even if policymakers interpret it that way) at 90 percent. But they also make it quite clear that they think their correlation is more than just a correlation… [and] are not too shy about saying so…. Here's a piece Ken Rogoff wrote for Project Syndicate in June 2012:

In a series of academic papers with Carmen Reinhart - including, most recently, joint work with Vincent Reinhart ("Debt Overhangs: Past and Present") - we find that very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more…. Of course, there is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline.

It's the same pattern: a few caveats, and then a semi-speculative overselling…. But their biggest overselling… came behind closed doors -- in Congress…. Senator Tom Coburn's recent book about the time R-R briefed members of Congress in April 2011, a few months before the debt ceiling debacle:

Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: "Do we need to act this year? Is it better to act quickly?" 

"Absolutely," Rogoff said. "Not acting moves the risk closer," he explained, because every year of not acting adds another year of debt accumulation. "You have very few levers at this point," he warned us. 

Reinhart echoed Conrad's point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, "If it is not risky to hit the 90 percent threshold, we would expect a higher incidence."

R-R whisper "correlation" to other economists, but say "causation" to everyone else… [to] the austerians who have been desperate for any kind of justification to forget about unemployment and worry about debt instead.

The boring reality is the relationship between public debt and growth isn't clear. As Justin Fox of Harvard Business Review points out, there simply isn't enough data. Some countries run up big debts fighting wars, and then grow fine. Some countries run up big debts fighting financial crises, and then grow slowly as the private sector deleverages. Some countries run up big debts as a matter of course, and then grow slowly as rising rates crowd out private investment…. [I]t's impossible to say anything dispositive about debt and growth more broadly. But that hasn't stopped R-R from trying. This kind of overhyping is why Joe Weisenthal called them "the most dangerous economists in the world" back in 2011. And it's a far more damning error than anything they did with Excel.