More Reinhart and Rogoff

Peter Dorman comments on the debate over the usefulness and validity of the Reinhart and Rogoff results concerning debt levels and economic growth:

Reinhart and Rogoff: There’s No There There, by Peter Dorman: Here’s the core problem with Reinhart and Rogoff’s claim that public debt levels above 90% of GDP cause reduced growth: it’s all correlation and no mechanism. It epitomizes the worst aspects of empirical economics, searching tirelessly for statistical regularities, but not the mechanisms that might underlie them. Because economic contexts are highly diverse, often singular, it’s the processes at work, not generalizations about outcomes, that economics has the power to elucidate.

Sorry to be so abstract.

The R&R dataset, as the authors proudly explain, encompasses 44 countries over two centuries. We’ve got Finland, Spain, Japan and the US, Thailand, Mexico and Colombia. We’ve got the aftermath of the American Revolution against England and WWII, banking crises under the gold standard, the third world debt crisis of 1982. It’s all there in one hopper, ready to be crunched. I would convert to Rosicrucianism before I would embrace the belief that a single statistical relationship captures all these places and times.

Paul Krugman has highlighted two cases in particular, the US demobilization following WWII and the Japanese lost decades (still lost). Yes, he says, there is a correlation between public debt and slow growth, but in the US episode it’s spurious (war gave us the debt, demobilization the slow growth), and in Japan the causation runs from slow growth to high debt.

Just scanning the R&R list, I see lots of countries that have battled external deficits, a condition that weakens growth and puts governments in the position of running deficits in order to delay adjustment. And what about price shocks that cripple countries with a narrow export base or particular import dependencies? The R&R list is thick with these cases too. Given these interrelationships, it is revealing that, under “Debt and growth causality”, R&R consider only “Growth-to-debt” and “Debt-to-growth”, without the vast third category of “joint causation by other factors”.

Which gets us back to mechanisms. What are the forces, economic, political or otherwise, that cause runups of public debt? Under what circumstances does debt feed back to these other factors? What mechanisms govern the expansion and contraction of fiscal space? These are the kinds of things we need to know.

R&R have it backwards: they are looking for broad generalizations that might be identified over large samples but have uncertain application to any particular case. A better kind of economics would be one that identified processes that, while they generate diverse outcomes with no discernible central tendency over large samples, can be applied precisely to individual cases.

Like, for instance, ours.

Very few people are saying that there is nothing to worry about in the long-run. There are some who say this, but they are rare. The vast majority of observers agree that we will need to address the debt problem, which is mostly a health care cost problem, at some point.

The question is whether we need to take action today while the economy is still struggling, or whether it would be best to wait until the economy is on more solid ground before beginning to cut back on government spending and/or raise taxes.

The case is far from air tight, but even if you accept that Reinhart and Rogoff have made the case that there is a connection between high debt levels and growth in the long-run, that doesn't necessarily imply that we need to take immediate action to fix the problem. I don't see anything in the analysis above that implies the debt problem must be addressed starting yesterday or we will be forever saddled with lower growth (particularly since bond markets show no evidence of worry over this problem). But I do know about cases where governments did, in fact, begin to tighten too soon, the 1937/38 experience for example, and the result was lower economic growth, precisely what the deficit hawks are worried about.

As I've said before, I've been hesitant to address the long-run debt problem because it is too easily misinterpreted as a call for austerity today rather than during better times or times of excess. The time will come to address this problem, and when it does I will be one of the ones pushing hard for health care reform and other policies that can put the budget on a more sustainable long-run course. But that time is not here yet, and trying to fix the debt problem too soon stands a good chance of making things worse, not better, by prolonging the recession.

For some, the time to reduce the deficit will never be right (it will kill jobs!), and we have a history of failing to pay the bills incurred during bad times once things do improve. But the answer to that problem, a problem that is largely the result of a poisonous political atmosphere in Congress, is not premature austerity and a prolonged recession.