"Maybe Debt Doesn’t Matter After All"?

Tim Harford notes disagreement over the relationship between high debt to GDP ratios and economic growth:

Maybe debt doesn’t matter after all, by Tim Harford: On Saturday I wrote about the paper by Carmen Reinhart and Ken Rogoff about the chilling effect high levels of debt seem to have on economic growth. Now I’m not so sure. David Hendry, the Oxford econometrician who, for his sins, taught me econometrics (actually, he mostly taught me to spot bad econometrics), writes to point out that:

The UK became a dominant world power with [debt/GNP] ratios between 1 and 2; and the UK grew at its fastest when its debt/GNP ratio was highest, not that any causality can be ascribed to that. But essentially there is almost no relationship I can find, having tried over many years, between debt/GNP (or changes etc.) and growth, unemployment, or inflation over 1860-2000. (see Hendry, DF (2009) `Modelling UK Inflation, 1875-1991′, Journal of Applied Econometrics, 16, 255-275; and Castle, JL and Hendry, DF (2009)`The Long-Run Determinants of UK Wages, 1860–2004′, Journal of Macroeconomics, 31, 5-28 ).

Well, this is beyond my pay grade. I’d back Ken Rogoff in a chess match against Hendry any day, but not so sure about the econometrics. One possible objection is that the definition of “high debt” used by Reinhart and Rogoff (90 per cent of GDP) looks a bit arbitrary. Hendry has numerous more technical concerns.

Here are the graphs Hendry sent me for UK debt ratios and economic performance. ... Reinhart and Rogoff will hopefully respond...

No matter how this debate plays out, once employment is back on track -- which doesn't look likely to happen anytime soon -- it will be time to pay for the money that was borrowed to get us through the downturn, and to begin looking toward longer term budget issues. But if we listen to the overly anxious about the debt and begin to pull back too soon, it will delay the time it takes for labor markets to recover even further and, in the very worst case, send us back into recession. Right now, the economy needs more help, not less.

Even relying upon traditional measures of output and unemployment to execute the "correct" budget policy could cause policymakers to contract too soon. The recession "may have been deeper, and longer-lasting than previously thought" based upon standard measures of economic activity:

Is Okun’s Law Really Broken?, by Justin Wolfers: “Okun’s law” is a much-loved rule of thumb — it links increases in the unemployment rate with decreases in output. The red dots in the chart below illustrate Brad DeLong’s version of this rule, which relates the change in output over the past eight quarters with the change in the unemployment rate. Most of these dots lie pretty close to the dashed line, which suggests a stable relationship. Based on this rule, and the relatively mild decline in measured output, you might have expected the unemployment rate to have risen by 3.5 percentage points over the past two years, to about 8 percent. But the dots at the top left show what actually happened—unemployment rose by something closer to 5.5 percentage points, and the unemployment rate is closer to 10 percent. That’s a big difference. And it has led many commentators to ask whether Okun’s Law is broken.

But perhaps the problem isn’t Okun’s Law. Perhaps the problem is how we measure output growth. In fact, there are two measures of output growth—the usual measure, which adds up total spending in the economy, and the alternative, which adds up total income. In theory, the two should be exactly the same. In practice, they have been very different during this recession. The blue dots show recent changes in this alternative measure of output. These GDI numbers suggest that output growth actually declined much more sharply than had been widely understood. Based on this alternative measure, the recent sharp rise in unemployment is no mystery at all. (Indeed, the 2008 data suggest that the real mystery may be why it didn’t rise faster, earlier.)

There’s a simpler way to show all this: Let’s map out Okun’s Law using this alternative income-based measure of output. That’s what is shown in [this] figure... The rise in unemployment seems quite consistent with these alternative output data. If anything, the puzzle now appears to be why unemployment didn’t rise by more in early 2008, given the very weak state of this income-based measure of output.

What’s good news for Okun’s law, though, is bad news for the economy. This alternative measure of output growth suggests that the recession may have been deeper, and longer-lasting than previously thought, although data for the fourth quarter aren’t yet available. While many economists believe the recession ended in the second quarter of 2009, this income-based measure of output kept shrinking in the third quarter, too. And while the expenditure-based measure is back to its level from the third quarter of 2006, the income-based measure suggests that output is still 3.5 percent below that level. That’s a pretty big hole to dig out of.

Which is the right measure of output to focus on? It’s still an open question, but some interesting recent research by the Fed’s Jeremy Nalewaik suggests that we should be thinking harder about the income-based measure. And Jeremy has promised further new results, which he’ll present at the forthcoming Brookings Panel.

However it's measured, output is far too low, unemployment is far too high, and disinflation is still a worry. Don't let the deficit and inflation hawks convince you otherwise.