Economic Argument for Austerity Based on Excel Error?

[fhdz]

Skin in the game eliminates moral hazard.

Very much so.

[Zanza]

So if Greece is so fucked right now, is it a good time to visit? Should be pretty cheap, right?

Not really. They still have a strong currency and prices are not that flexible going down.

[Sheilbh]

Yeah, they're still in the Euro which isn't cheap and prices haven't fallen a great deal though labour costs have. Their competitors like Turkey, Croatia and Bulgaria are probably far cheaper.

[Berkut]

Hmm. Well, that is dissapointing. I guess I won't be planning that long delayed honeymoon then.

[Neil]

Yeah, it turns out the Euro was really a terrible idea for everyone except Germany.

[The Minsky Moment]

Solution: punishments for those convicted of the new economic crimes.  Bad CEO?  Lose your assets.  Encouraged risky banking practices and lost?  TAKE A HAIRCUT.

You can't make depositors take a haircut unless you want bank runs.
You can't make senior bondholders take a haircut in a crisis unless you want to risk shutting banks out of the capital markets.

[citizen k]

Dear Paul:

Back in the late 1980s, you helped shape the concept of an emerging market debt overhang.  The financial crisis has laid bare the fact that the dividing line between emerging markets and advanced countries is not as crisp as once thought.  Indeed, this is a recurring theme of our 2009 book, This Time is Different:  Eight Centuries of Financial Folly.  Today, the growth bind of advanced countries in the periphery of the eurozone has a great deal in common with that of emerging market economies of the 1980s.

We admire your past scholarly work, which influences us to this day.  So it has been with deep disappointment that we have experienced your spectacularly uncivil behavior the past few weeks.  You have attacked us in very personal terms, virtually non-stop, in your New York Times column and blog posts.  Now you have doubled down in the New York Review of Books, adding the accusation we didn't share our data.  Your characterization of our work and of our policy impact is selective and shallow.  It is deeply misleading about where we stand on the issues.  And we would respectfully submit, your logic and evidence on the policy substance is not nearly as compelling as you imply.

You particularly take aim at our 2010 paper on the long-term secular association between high debt and slow growth. That you disagree with our interpretation of the results is your prerogative.  Your thoroughly ignoring the subsequent literature, however, including the International Monetary Fund's work as well as our own deeper and more complete 2012 paper with Vincent Reinhart, is troubling.   Perhaps, acknowledging the updated literature-not to mention decades of theoretical, empirical, and historical contributions on drawbacks to high debt-would inconveniently undermine your attempt to make us a scapegoat for austerity.  You write "Indeed, Reinhart-Rogoff may have had more immediate influence on public debate than any previous paper in the history of economics."

Setting aside this wild hyperbole, you never seem to mention our other line of work that has surely been far more influential when it comes to responding to the financial crisis.  Specifically, our 2009 book (released before our growth and debt work) showed that recoveries from deep systemic financial crises are long, slow and painful.  This was not the common wisdom at all before us, as you yourself have acknowledged  on more than one occasion.  Over the course of the crisis, and certainly by 2010, policymakers around the world were using our research, alongside their assessments, to help justify sustained macroeconomic easing of both monetary and fiscal policy fronts.

Your desire to blame our later 2010 paper for the stances of some politicians fails to recognize a basic reality:  We were out there endorsing very different policies.  Anyone with experience in these matters knows that politicians may float a citation to an academic paper if it suits their purposes.  But there are limits to how much policy traction they can get with this device when the paper's authors are out offering very different policy conclusions.  You can refer to the appendix to this letter for our views on policy through the financial crisis as they were stated publicly in real time.  We were not silent.

Very senior former policy makers, observing the attacks of the past few weeks, have forcefully explained that real-time policies are very seldom driven to any significant extent by a single academic paper or result.

It is worth noting that in the past, polemicists have often pinned the austerity charge on the International Monetary Fund for its work with countries having temporary or permanent debt sustainability issues.  Since its origins after World War II, IMF programs have almost always involved some combination of austerity, debt restructurings, and structural reform.  When a country that has been running large deficits is suddenly no longer able to borrow new funds, some measure of adjustment is invariably required, and one of the IMF's usual roles has been to serve as a lightning rod.   Even before the IMF existed, long periods of autarky and hardship accompanied debt crises.

Now let us turn to the substance. The events of the past few weeks do not change basic facts and fundamentals.

Some Fundamentals on Debt

First, the advanced economies now have levels of debt that surpass most if not all historic episodes. It is public debt and private debt (which often becomes public as a crisis unfolds). Significant shares of these debts are held by foreigners in most cases, with the notable exception of Japan.  In Europe, where the (public and private) external debt exposures loom largest, financial de-globalization is well underway.  Debt financing has become an increasingly domestic business and a difficult one when the pool of domestic saving is limited.

As for the United States: our only short-lived high-debt episode involved WWII debts, which were held by domestic residents, not fickle international investors or central banks in China and elsewhere around the globe.  This observation is not meant to suggest "a scare" in the offing, with bond vigilantes driving a concerted sell-off of Treasuries by the rest of the world and a dramatic spike US in interest rates.  Carmen's work on financial repression suggests a different scenario. But many emerging markets have stepped into bubble-like territory and we have seen this movie before.  We should not take for granted their prosperity that makes possible their continuing large-scale purchases of US debt.  Reversals are possible.  Sensible risk management means planning for these and other contingencies that might disturb today's low global interest rate environment.

Second, on debt and growth.  The Herndon, Ash and Pollin paper, using a different methodology, reinforces our core result that high levels of debt are associated with lower growth.  This fact has been hidden in the tabloid media and blogosphere discourse, but this point is made plain by even a cursory look at the full set of results reported in the very paper they critique.  More importantly, the result was prominently featured in our 2012 Journal of Economic Perspectives paper with Vincent Reinhart on Debt Overhangs, which they do not cite. The main point of our 2012 paper is that while the difference in annual GDP growth between high and lower debt cases is about one percent a year, debt overhang episodes last on average 23 years. Thus, the cumulative effect on income levels over time is significant.

Third, the debate of the last few weeks does not change the fact that debt levels above 90% (even if one entirely rejects this marker for gross central government debt as a common cross-country "threshold") are very rare altogether and even rarer in peacetime.  From 1955 until right before the recent crisis, advanced economies spent less than 10% of those years at a debt/GDP ratio of higher than 90%; only about two percent of the years are above 120% debt/GDP. If governments thought high debt was a riskless proposition, why did they avoid it so consistently?

Debt and Growth Causality

Your recent April 29, 2013 NY Times blog The Italian Miracle is meant to highlight how in high-debt Italy, interest rates have come down since the European Central Bank's well-placed efforts to act more as a lender of last resort to periphery countries.  No disagreement there. However, this positive development is meant to re-enforce your strongly held view that high debt is not a problem (even for Italy) and that causality runs exclusively from slow growth to debt.  You do not mention that in this miracle economy, GDP fell by more than 2 percent in 2012 and is expected to fall by a similar amount this year. Elsewhere you have stated that you are sure that Italy's long-term secular growth/debt problems, which date back to the 1990s, are purely a case of slow growth causing high debt.  This claim is highly debatable.

Indeed, your repeatedly-expressed view that slow growth causes high debt but not visa-versa, is hardly supported by the recent literature on the subject.  Of course, as we have already noted, this work has been singularly ignored in the public discourse of the past few weeks.  The best and worst that can be said is that the results are mixed.  A number of studies looking at more comprehensive growth models have found significant effects of debt on growth. We made this point in the appendix to our New York Times piece.  Of course, it is well known that the economic cycle impacts government finances and therefore debt (causation from growth to debt).  Cyclically adjusted budgets have been around for decades, your shallow characterization of the growth-debt connection.

As for ways debt might affect growth, there is debt with drama and debt without drama.

Debt with drama.  Do you really think that a country that is suddenly unable to borrow from international capital markets because its public and/or private debts that are a contingent public liability are deemed unsustainable will not suffer lower growth and higher unemployment as a consequence? With governments and banks shut out from international capital markets, credit to firms and households in periphery Europe remains paralyzed. This credit crunch has a crippling effect on growth and employment with or without austerity.  Fiscal austerity reinforces the procyclicality of the external and domestic credit crunch.  This pattern is not unique to this episode.

Policy response to debt with drama.  On the policy response to this sad state of affairs, we stress that restoring the credit channel is essential for sustained growth, and this is why there is a need to write off senior bank debt in many countries. Furthermore, there is no reason why the ECB should buy only sovereign debt-purchases of senior bank debt along the lines of the US Federal Reserve's purchases of mortgage-backed securities would be instrumental in rekindling credit and working capital for firms.  We don't see your attraction to fiscal largesse as a substitute. Periphery Europe cannot afford it and for Germany, which can afford it, fiscal expansion would be procyclical.  Any overheating in Germany would exert pressure on the ECB to maintain a tighter monetary policy, backtracking some of the progress made by Mario Draghi. A better use of Germany's balance sheet strength would be to agree on faster and bigger haircuts for the periphery, and to support significantly more expansionary monetary policy by the ECB.

Debt without drama.  There are other cases, like the US today or Japan since the mid-1990s, where there is debt without drama.  The plain fact that we know less about these episodes is a point we already made in our New York Times piece.  We pointedly do not include the historical episodes of 19th century UK and Netherlands among these puzzling cases. Those imperial debts were importantly financed by massive resource transfers from the colonies. They had "good" high-debt centuries because their colonies did not.  We offer a number of ideas in our 2012 paper for why debt overhang might matter even when there is no imminent collapse of borrowing capacity.

Bad shocks do happen. What is the foundation for your certainty that as peacetime debt hits new records in coming years, the United States will be able to engage in  forceful countercyclical fiscal policy if hit by a large unexpected shock?  Furthermore, do you really want to find out the answer to that question the hard way?

The United Kingdom, which does not issue a reserve currency, is more dependent on its financial sector and suffered a bigger banking bust, has not had the same shale gas revolution, and is more vulnerable to Europe, is clearly more exposed to the drama scenario than the US.  And yet you regularly assert that the situations in the US and UK are the same and that both countries have the costless option of engaging in an open-ended fiscal expansion.  Of course, this does not preclude high-return infrastructure investments, making use of the public balance sheet directly or indirectly through public-private partnerships.

Policy response to debt without drama.  Let us be clear, we have addressed the role of somewhat higher inflation and financial repression in debt reduction in our research and in numerous pieces of commentary.  As our appendix shows, we did not advocate austerity in the immediate wake of the crisis when recovery was frail.  But the subprime crisis began in the summer of 2007, now six years ago.  Waiting 10 to 15 more years to deal with a festering problem is an invitation for decay, if not necessarily an outright debt crisis.  The end may not come with a bang but with a whimper.

Scholarship: Stick to the facts

The accusation in the New York Review of Books is a sloppy neglect on your part to check the facts before charging us with a serious academic ethical infraction.  You had already implicitly endorsed this from your perch at the New York Times by posting a link to a program that treated the misstatement as fact.

Fortunately, the "Wayback Machine" crawls the Internet and periodically makes wholesale copies of web pages. The debt/GDP database was first archived in October 2010 from Carmen's University of Maryland webpage.  The data migrated to ReinhartandRogoff.com in March 2011.  There it sits with our other data, on inflation, crises dates, and exchange rates.  These data are regularly sought and found for those doing research who care to look. The greater disclosure of debt data from official institutions is testament to this.  The IMF began to construct historical public debt data only after we had provided a roadmap in the list of our detailed references in a 2009 book (and before that in a 2008 working paper) that explained how we had unearthed the data.

Our interaction with scholars and practitioners working on real world questions in our field is ongoing, and our doors remain open. So to accuse us of not sharing our data is an unfounded attack on our academic and personal integrity.


Recap

Finally, we attach, as do many other mainstream economists, a somewhat higher weight on risks than you do, as debts of all measure -- including old age liabilities, public debt, private debt and external debt -- ascend into record territory.   This is not a conclusion based on one or two papers as you sometimes seem to imply, but rather on a long-standing body of economic research and extensive historical experience about the risks of record high debt levels.

You often cite John Maynard Keynes.  We read Keynes, all the way through.  He wrote How to Pay for the War in 1940 precisely because he was not blasé about large deficits - even in support of a cause as noble as a war of survival. Debt is a slow-moving variable that cannot - and in general should not - be brought down too quickly.  But interest rates can change much more quickly than fiscal policy and debt.

You might be right, and this time might be, after all, different.  If so, we will admit that we were wrong.  Whatever the outcome, we intend to be there to put the results in proper context for the community of scholars, policymakers, and civil society.


Respectfully yours,

Carmen M. Reinhart and Kenneth S. Rogoff
Harvard University.

[The Minsky Moment]

The econ blogosphere has gone critical over this.  Even made Mankiw's blog and he rarely updates.

I really think R&R should have just let this lie.  It's true that Krugman's blog is infected with a snarky tone and its ratio of light to heat is much lower than optimal.  But IMO Krugman's comments on R&R - at least the ones I saw - seemed quite restrained by his standards.  He has said over and over again that the real problem was not the R&R paper itself or R&R, but what others did in misinterpreting the paper.  His only real beef vs. R&R is that R&R were not aggressive enough debunking the abuses of their paper by Ryan et al (which has some truth to it but IMO not totally fair) and their failure to unambiguously reject the notion of 90% as a critical breakpoint.  The latter criticism is somewhat fair and in fact is reinforced by this very letter which while rejecting the literal threshhold cites to the 90% line.  Also - Krugman's line about the influence with the paper, while hyperbolic, is essentially true.  R&R's suggestion that Krugman rejects the "association" between high debt and slow growth is not true.  I could go on but there is a lot in this letter that is dubious.

The bigger point is that R&R have a broader problems to deal with than the annoying gadfly that is Paul Krugman.  The questions he has posed are also being asked insistently by a lot of others in the profession.   I really don't think they did themselves a service by writing such a public document that raises the personal aspects of this to a higher level.

[The Minsky Moment]

Preliminary draft working paper from Arin Dube at UMass, testing the R&R theory for reverse causation: https://dl.dropboxusercontent.com/u/15038936/RR%20Timepath/Dube_Growth_Debt_Causation.pdf

Tentantive results are that after accounting for potential reverse causality, the correlation dimishes significantly and the regression results are no longer statiscally significant.

Note that UMass' economics deparment is pretty well known for its left-leaning tendencies, for whatever that matters.

[Berkut]

Not sure what that means.

Can you dumb it down for us?

Does it mean we should just keep on spending money we don't have?

[derspiess]

A couple of my beer-drinking buddies are English PhDs from UMASS.  I suspect they're a bit on the left but they do a good job hiding it.

[Razgovory]

Solution: punishments for those convicted of the new economic crimes.  Bad CEO?  Lose your assets.  Encouraged risky banking practices and lost?  TAKE A HAIRCUT.

Skin in the game eliminates moral hazard.

What's the punishment for elected officials that drive their state or city into bankruptcy?

Throbby: Absolutely.  Nontradeables should be pretty damn cheap right now.

An interesting notion.  Are you suggesting that public officials should be paid on the basis of the financial situation of the entity they represent?

[MadImmortalMan]

Bringing back ostracism would be a good move.

[The Minsky Moment]

Not sure what that means.

It means one of the following:
1.  High debt levels do not cause lower economic growth in the future.
2.  High debt levels do decrease future economic growth, but the data we have is insufficient to prove that with confidence.

It does seem to be clear that lower economic growth tends to cause debt to increase.

[Berkut]

So as I suspected, it turns out that high debt is awesome, and we can just spend forever and ever without any concern.