Deficits Hawks fueled a deficit hysteria or the Reinhart and Rogoff’threshold of 90% debt-to-GDP is a historic guide for policymakers, for macro-policy?
Probably there is no hotter and sometime spicy topic in American blogs and newspapers than this deficit control vs. budget spending against recession. The two camps – deficit hawks and spending doves – are clearly separate. Arguments are exchanged at light speed and we have no time to digest all the published PDF and posts, even the hundreds of comments on blogs.
On the left side of the river those urging for more “aggressive” fiscal expansion policies with deficit spending and debt growth facing the unusual uncertainty of the economic forecasts, including the risk of a double dip. On the other side those who think the moment of exit from Keynesian and pro-cyclical strategies just arrived due to high levels of government fiscal deficit and public debt ratios that will depress long-term growth.
The first camp ‘coined’ the other side as “deficit hawks” fueling a “deficit hysteria” whose main political goal is to accelerate the hard adjustment fiscal programs, like those suggested by the IMF, particularly in Greece, Europe.
The historical findings from Carmen Reinhart and Kenneth Rogoff ignited this sometimes harsh discussion. The two authors claim the empirical observation of a threshold for the debt-to-GDP ratio and a history of sovereign defaults in developed countries, including lonely superpowers of the past. The summary of 1,180 observations from 20 advanced countries fits in a short sentence: there is NO obvious correlation between debt and growth UNTIL public debt-to-GDP exceedes the 90% threshold (the case of 96 observations).
The 90% public debt-to-GDP threshold is particularly “hot” in the US – the country just reached 117 percent in the first quarter of 2010, near the peak of 119 percent in 1945. According to Reinhart and Rogoff, in advanced countries, above the 90% level median growth rates fall by 1%, and average growth falls considerably more, as the two authors recently explained at Voxeu.org. in “Debt and Growth revisited”.
The article develops the findings of ‘This time is different’, their master research book about the debt-growth nonlinear causality and the history of defaults since the 1500s (including the Spanish and the Portuguese defaults at those times related with the decline of the Portuguese world hegemony and the crash of Filipe II’s grand strategy).
We interviewed professor Reinhart recently – you can read the interview here. Now, we listen to the academic “opposition”.
© Jorge Nascimento Rodrigues, August 2010.
My invitees today
One from central part of the US and the other from the Pacific Coast
Yeva Nersisyan. An Armenian doctoral student at University of Missouri, Kansas City, State of Missouri. She writes at New Economic Perspectives blog. With professor L. Randall Wray, she published a critique of the historical findings about sovereign defaults and public debt threshold by Reinhart and Rogoff. “Does Excessive sovereign debt really hurt growth” is the title of the paper of Nersisyan and Wray, and the answer is “no” for countries with sovereign currencies. They argue about the “excepcionalism” of the United States and others with the same patterN: “any country with sovereign currency is in the same position, at least as far as domestic spending is concerned”. So, the Reinhart and Rogoff’ threshold is not relevant to the case of the US. In another paper titled “Deficit Hysteria Redux? Why We Should Stop Worrying About U.S. Government Deficits” they both argue “that deficits do not burden future generations with debt, nor do they crowd out private spending”. Conclusion: “Sovereign governments are ‘default proof’, even if their non-gov sectors are still crisis-prone”.
Peter Dorman. Professor at The Evergreen State College, Olympia, the capital city of the State of Washington, editor of Econospeak blog, Ph.D. in Economics, University of Massachusetts, 1987. Recently he criticized Reinhart and Rogoff approach as an example of the “worst aspects of empirical economics, searching tirelessly for statistical regularities, but not the mechanisms that might underlie them.” Conclusion about the risk of historical generalizations: “Because economic contexts are highly diverse, often SINGULAR, it is the PROCESS at work, not generalizations about outcomes that economics has the power to elucidate. A better kind of economics would be one that identified processes that can be applied precisely to individual cases.”
YEVA NERSISYAN: “Devising deficit-to-GDP or debt-to-GDP ratios for a sovereign government is not meaningful or useful.”
QUESTION: What is the main mistake of Reinhart and Rogoff’ threshold?
ANSWER: They are imposing a causality on the correlation that they find in the data based on the Ricardian Equivalence theory, which is simply incorrect. Reinhart and Rogoff don’t seem to understand the operational realities behind government spending and taxing. A sovereign government doesn’t finance its spending in the way private sector entities do. It spends by issuing its IOUs [I owe you; document acknowledging debt]. Hence, the arguments regarding crowding out effects as well as this assumption that the government needs to raise taxes some time in the future to finance the deficit (Ricardian Equivalence) are all wrong. Their thresholds are arbitrary as they acknowledge. Devising deficit-to-GDP or debt-to-GDP ratios for a sovereign government is not meaningful or useful.
Q: China is at the same currency sovereign status like the US or its peg or near-peg to the $US change the equation?
A: When countries peg their currency to another currency they limit their ability to spend by the amount of reserves that they hold. If it spends too much (and I mean too much relative to their foreign currency reserves) then there might be a run on the currency and it might find itself unable to defend the peg. China is a little different because of the huge amount of dollar reserves that it has accumulated by running a current account surplus with the U.S. It can basically spend like a sovereign government (or at least up to full employment) without facing pressures on the peg. It won’t have problems defending the peg.
Q: The Euro is not like the dollar. It’s a supranational currency, even not a federal one. Eurozone member states are users of the currency – not issuers, as you pointed out in the paper. What are the outcomes of this difference with the US?
A: The important point is that in the eurozone, unlike the U.S., there is a separation between the fiscal and monetary authorities. The fiscal authority is at the national level while the monetary authority, the ECB, is supranational. Eurozone governments do need to borrow or tax in order to spend which creates solvency issues for them. Hence, the problems in Greece and some other eurozone countries. And default is certainly a possibility, if not politically then economically. Germany is only able to run a smaller budget deficit (without chocking off the private sector with debt) because it’s running a trade surplus. It’s basically using beggar-thy-neighbor type mercantilist policies exporting its unemployment to other eurozone countries. Of course not all countries can run a trade surplus at the same time, somebody has to be at the other end of the transaction. Hence, this strategy cannot work for everyone.
Q: You refer that you recognize “that there are constraints even on sovereign” currency situations, but you do not argue on that. Only inflation (or hyperinflation) is the true limit for government deficit-to-GDP and debt-to-GDP?
A: Yes, sovereign government spending is not constrained by tax and bond revenue, but by inflation. The issue is the distribution of real resources. When the government spends (buys an airplane or hires an engineer) it gets hold of real resources. Considering that resources are relatively fixed in the short run, this leaves less for the private sector to consume. If the government starts competing with the private sector for the use of these resources, then this may lead to inflation. It’s a real resource constraint not a financial constraint, hence the issue is not solvency, but sustainability. In the current crisis the private sector obviously is not able to employ all the available labor resources. Inflation is not a concern; most developed economies are under the threat of a deflation. Ideally, in this situation the government needs to step in and hire all those left unemployed by the private sector. Once the private sector gets back on its feet the government can release those workers back into the private sector to avoid inflation. A job guarantee program is an automatic mechanism designed to achieve precisely this.
Q: Geopolitics does not matter? The context of sovereign US currency in the 2000s is not radically different from the 1970s through the 1990s? The foreign creditors through US bonds are irrelevants for the default equation?
A: The dollar is no more or less sovereign today than it was in 1970s (after the Bretton Woods of course) or 1980s. The U.S. government spends in the same manner today as it used to in the past: by crediting bank accounts. The attitudes toward government spending, deficits and debt have certainly changed over this period, largely due to the rise of neoliberalism. Financially there is no difference, but politically maybe deficit spending was more acceptable 20 years ago then it is now. As far as holdings of government debt are concerned, it is not important in terms of “financing” who holds the debt. The government doesn’t have to issue bonds; issuing bonds dollar for dollar for deficit spending is a voluntary operation. From this perspective it is not important who holds the debt or even whether there will be takers for the debt. Government bonds are the government’s IOU just like currency is. By buying bonds the public merely exchanges its non-interest earning liabilities for one that pays interest. Of course by accumulating dollar denominated assets one is accumulating claims on the real resources that are for sale in U.S. dollars. Currently, the Chinese, for example, are selling real goods to the U.S. and accumulating dollar denominated assets. If suddenly they decide they no longer want to sell to the U.S. and would rather spend their accumulated dollars then this will result in a U.S. current account surplus with China. In that scenario the U.S. will be giving up real resources in return for getting back those dollars that it has once spent to get the Chinese goods.
Q: Although the British pound context of the 1900s-1940s is quite different (in geopolitics and regarding the gold standard), can we learn something from the old sovereign currency decline of the previous superpower and from its peak at near 240% public debt-to-GDP in 1948?
A: It depends on what you call a sovereign currency decline. If you mean that the British pound lost its reserve currency status, then there were a number of economic and political reasons for that (as an aside, I am told by some British colleagues that for a considerable time during the Bretton Woods 40% of world trade was still conducted in the sterling). In any case, the British pound is still a sovereign currency, one that is issued by the U.K. government and is not pegged to any other metal or currency. This allows the UK government to buy anything that is for sale in British pounds. The ability of U.K. residents (including the government) to buy goods from abroad is then constrained only by the willingness of foreigners to accumulate pound denominated assets.
Q: Professor Thomas Sargent, the father of the “rational expectations revolution,” said in a recent interview for The Federal Reserve Bank of Minnneapolis, that “the euro is basically an artificial gold standard” and the fiscal rules in the Maastricht Treaty “in terms of monetarist arithmetic, make sense.” Would you comment?
A: The first part is basically correct. The euro goes even further than a gold standard. If we think of a spectrum of currency arrangements flexible exchange rate regimes would be on the one end and adopting a foreign currency would be at the other end. Managed float, gold standard and pegging to another currency would be in between the two extremes. The euro is basically a “foreign” currency for member nations. By this I mean that national central banks are not the currency issuers for each country. Rather, there is a supranational entity such as the ECB (without a corresponding fiscal authority) which is the monopoly issuer of the euro.
Q: Two recent studies from ECB (Cristina Checherita and Philipp Rother, Working Paper Series, no. 1237, August 2010) and IMF (Kumar and Woo, Working Paper 10/174) specialists and also a technical note about Fiscal Space from IMF (September, 1) advise for a threshold in the public debt to GDP ratio with impact in the growth of the GDP per capita and also the risk of a fiscal crisis after 2015 in a group of contries, particularly, in the pole position, Greece, Japan, Italy and Portugal. This is basically hawkerism putting pression on the fiscal adjustment?
A: Yes, you’re correct. Most analysts don’t understand the difference between a sovereign and a non-sovereign nation (in the monetary sense) hence they talk about Italy, Greece, the US, Japan as if they are all in the SAME position. This is illegitimate. While eurozone nations do face a possibility of an involuntary default that is not the case for countries like Japan. Mainstream economists have a very hard time explaining how Japan has been able to run high public debt (more than 200% of GDP) without facing any solvency issues. Their explanation is that Japanese bonds are held mostly by domestic residents which is nonsensical. The true reason is that Japan issues bonds in its own currency and as the monopoly issuer of that currency it can never run out of it. Greece, Portugal, Italy and other eurozone members can be forced to default. In fact, some people rightly argue that if not for the ECB’s intervention the Greeks would have no other choice. But a default by any of the member countries would have very negative consequences for those countries and for the European integration. The austerity measures that are being forced upon eurozone countries by the ECB and the IMF will necessarily backfire by killing the already fragile economies causing even larger budget deficits. Neither a default nor austerity is a good solution. As long as there is no unified fiscal authority, creating some mechanism of distributing euros to member nations on a per capita basis is a good solution.
PETER DORMAN: “They search for a single, simple pattern in growth/debt ratio space. It is ineffective physics, rather than the geology we actually need.”
Q: America and Europe is living a deficit hysteria regarding the hot topic of “debt-to-growth”, or a deficit threshold is a real problem for long-term growth?
Q: You refer, in your criticism of Rogoff and Reinhart’debt-to-GDP threshold that the most important is to identify the processes, the mechanisms governing the expansion and contraction of fiscal space. Can you argue more extensively about that?
A: Perhaps I should emphasize the particular importance of looking at public debt in the context of private debt. The US ran fiscal surpluses under Clinton, but this was possible (especially in a deficit country) only to the extent that private debt exploded. Private deficits fell in the aftermath of the dot.com bubble, and (again in the context of external deficits) the US faced the choice between much higher fiscal deficits or punishing shortfalls in aggregate demand. We went with the fiscal deficits in the 2000s, especially since we didn’t face a borrowing constraint. Spain, by contrast, was a model of fiscal rectitude in the 2000s, but their external deficits were monumental and financed by private leverage. The collapse of the housing bubble puts Spain in a position like the US in 2002, except (1) Spain’s current account deficit is even larger, and (2) they face a severe borrowing constraint. The moral of the story is that anyone who looked at the US in the 1990s or Spain in the 2000s and said: “No problem, the public budget is under control” would be making a big mistake. (And to dig back in history, the US emerged from WWII with a gargantuan public debt, far beyond the R&R cutoff, but with little private debt in the wake of Depression-era writedowns, and the prospect of large, continuing structural trade surpluses.)
Q: It seems your discussion of the Reinhart and Rogoff approach is beyond the threshold ‘detail’…
A: Yes. I used the R-R thesis as an opportunity to make a more general point about economics, what it can do well and what it can’t. Economists try to be like physicists, formulating the “laws of nature”. The Reinhart/Rogoff’ 90% rule is a rough version of this approach, aspiring to provide something like a gravitational constant. But the subject matter of economics is too complex for this approach; it is more like geology or ecology. A geologist does not have a formula that explains the location and height of every mountain range on earth, or even the “mean mountain,” but detailed knowledge of the forces (plate tectonics, erosion, isostatic uplift, etc.) that constitute the menu of possibilities. Then, he or she goes to a particular region, provides a deep description of the local factors at work, and applies the knowledge of geological processes. It is revealing that R&R have very little to say about processes–exactly how public debt/GDP ratios affect further growth. Their comments in this respect are casual, not the product of careful research. Instead, they search for a single, simple pattern in growth/debt ratio space. It is ineffective physics, rather than the geology we actually need.