Accurate and Inaccurate Ways of Portraying the Debt-and-Growth Association
Accurate Ways of Portraying the Debt-and-Growth Association:
The Post-WWII G-7:
In the post-WWII G-7, the high-debt low-growth correlation is overwhelmingly driven by (a) the recent experience of Italy and Japan, in which slow growth preceded high debt; (b) the high-debt UK after WWII, but UK growth did not accelerate as its debt load fell; and (c ) the low-debt defeated axis after WWII, which rapidly rebuilt and caught up to their pre-WWII levels of prosperity.
The Owen Zidar Graph:
Countries with debt-to-GDP ratios above 90% do have slower growth than countries with lower debt-to-GDP ratios, but there is no "cliff" at 90%--and policymakers should not have been told that there is an "important marker" at 90%.
Let me highlight a passage from the "Understanding Our Adversaries" evolution-of-economists'-views talk that I started giving
three five 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. Their 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 a multiplier of 1.5 and 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?….
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.
Not so Accurate Ways of Portraying the Debt-and-Growth Association:
Carmen Reinhart and Ken Rogoff (July 2011):
Too Much Debt Means the Economy Can’t Grow: As public debt in advanced countries reaches levels not seen since the end of World War II, there is considerable debate about the urgency of taming deficits with the aim of stabilizing and ultimately reducing debt as a percentage of gross domestic product.
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. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such.
Indeed, there is a growing perception that today’s low interest rates for the debt of advanced economies offer a compelling reason to begin another round of massive fiscal stimulus. If Asian nations are spinning off huge excess savings partly as a byproduct of measures that effectively force low- income savers to put their money in bank accounts with low government-imposed interest-rate ceilings -- why not take advantage of the cheap money?
Although we agree that governments must exercise caution in gradually reducing crisis-response spending, we think it would be folly to take comfort in today’s low borrowing costs, much less to interpret them as an “all clear” signal for a further explosion of debt.
Several studies of financial crises show that interest rates seldom indicate problems long in advance. In fact, we should probably be particularly concerned today because a growing share of advanced country debt is held by official creditors whose current willingness to forego short-term returns doesn’t guarantee there will be a captive audience for debt in perpetuity.
Those who would point to low servicing costs should remember that market interest rates can change like the weather. Debt levels, by contrast, can’t be brought down quickly. Even though politicians everywhere like to argue that their country will expand its way out of debt, our historical research suggests that growth alone is rarely enough to achieve that with the debt levels we are experiencing today.
While we expect to see more than one member of the Organization for Economic Cooperation and Development default or restructure their debt before the European crisis is resolved, that isn’t the greatest threat to most advanced economies. The biggest risk is that debt will accumulate until the overhang weighs on growth.
At what point does indebtedness become a problem? In our study “Growth in a Time of Debt,” we found relatively little association between public liabilities and growth for debt levels of less than 90 percent of GDP. But burdens above 90 percent are associated with 1 percent lower median growth. Our results are based on a data set of public debt covering 44 countries for up to 200 years. The annual data set incorporates more than 3,700 observations spanning a wide range of political and historical circumstances, legal structures and monetary regimes.
We aren’t suggesting there is a bright red line at 90 percent; our results don’t imply that 89 percent is a safe debt level, or that 91 percent is necessarily catastrophic. Anyone familiar with doing empirical research understands that vulnerability to crises and anemic growth seldom depends on a single factor such as public debt.
Matt O'Brien sends us to Tim Fernholz who sends us to Senator Tom Coburn:
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."
Tim Fernholz's Reinhart-Rogoff quotes:
How influential was the Rogoff-Reinhart study warning that high debt kills growth?:
“[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.” — European Commissioner Olli Rehn.
“Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.” — House Budget Committee Chairman and former Republican vice-presidential candidate Paul Ryan.
“It’s an excellent study, although in some ways what you’ve summarized understates the risks.”— Former US Treasury Secretary Tim Geithner.
“[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.” Lord Lamont of Lerwick, former UK chancellor and sometime adviser to current chancellor George Osborne.
“The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth.”— Doug Holtz-Eakin, Chairman of the American Action Forum.