April 25, 2013

An Austerity Smackdown on Reinhart-Rogoff's 90%

By Anthony Harrington via QFinance

Opponents of austerity have no reason to love a couple of high powered economists who seem to be on a mission to convince senior politicians everywhere that too much debt is seriously bad for a country's prospects. The economists in question are MIT's Carmen Reinhart and her "partner in crime", Ken Rogoff, a former chief economist with the International Monetary Fund. Their mission, for some years now, has been to stiffen political resolve to cut debt. So when serious flaws appeared in a key academic paper by the two, there was general rejoicing in some sectors.

At this point, right at the outset, in other words, we need to pause and take stock. Reinhart and Rogoff are well known for two really significant and well publicized pieces of work. The first is a mammoth book called "This Time is Different", an ironic title since all the data in the book shows that debt booms and subsequent busts are, actually, all pretty much of a muchness. Things crack along, the bubble grows, the debt mounts and then at some unspecified point - the whole point being that the point is undefinable in advance - investors suddenly take fright, credit becomes more and more expensive until it dries up altogether, and things go smash.

Let us emphasize again, the whole point of R&R's analysis in this first piece of work is to show that there is no definable trigger point, or level of debt, at which investors all go "Eeek" simultaneously. All that the statistics show is that there is always this "Bang" moment. Once it happens, there is no road back. The ruin has to be lived through and debt has to be brought back under control, usually with extreme pain.

That is the couple's first, and probably main claim to fame, and we should say rapidly and clearly, right at the outset, that the blunders that have been discovered in the second most noteworthy instance of their collaboration together, have no bearing on "This Time is Different". It stands as a great work and as a warning that no bubble is actually different. The second piece of work is a paper called "Growth in a Time of Debt", produced by the duo in 2010. This argued that when a country's debt level reaches 90% of GDP, growth slows dramatically. This time the duo had produced a clear trigger point, 90%, with detailed spreadsheet analysis to back it up. Some senior politicians, most notably in the US leap onto the 90% trigger number to argue that America desperately needed to roll back its 100% debt level if it wanted to get out of a "Japan-style" zombie economy for decades to come.

Having a clear number like 90% is very nice and clean and easy for a politician to hang his or her hat on. Unfortunately the number has turned out to be the product of an incorrect formula in a spread sheet, coupled with some dodgy data manipulation. Correct the error and clean up the data and poof, R&R's lovely round number vanishes and cannot be replicated by anyone. This leaves us back with "This Time is Different", which was blindingly clear on the point that there is no magic threshold number which will scare off investors. History merely shows that if a country's debt keeps on growing, at some point it busts.

The point to note is that the two pieces of work are actually involved with two different questions.

The first can be summarized as: When will investors decide enough is enough?

The second is rather different, and can be parsed as:

At what level of debt to GDP does growth start to wilt? R&R thought they had an answer to the second, even if the first was basically unsolvable, and it turns out they don't. This is good news for opponents of austerity, who can now argue that, hey, 100% debt to GDP might not be that bad. Japan, after all, is soldiering along at around 200% debt to GDP and while its economy is flat, it couldn't be said to be dead. Personally I think that anyone who feels tempted to go down the anti austerity route should re-read This Time is Different. As John Mauldin argues in his book, Endgame, the further a country goes into debt, the worse the choices facing it become, until there is nothing left but bad choices and very bad choices.

What slightly bemuses me about R&R's second piece of work is that the two did not see that it was flatly contradictory, as it originally stood, to their first, and greatly superior, piece of work. If there was such a thing as a clearly demarcated debt-to-GDP trigger ratio then the markets, and investors, would surely have discovered it long, long ago and R&R's first piece of analysis should have unearthed it. It would have been there in the numbers ready to be unearthed.

After all, if there is a clear point at which growth starts to go backwards that would also be about the time that at least a significant subset of the smarter investors would have been quietly gathering up their shekels and heading for the exit, which would have prompted others to do the same, and so on and so forth, until the mass exodus of investors from a particular country's debt became unstoppable. As This Time is Different categorically demonstrates, there ain't no such point... which is why it behooves governments to have a care about how much debt they run up. The truly scary part is that the crash can come at any moment and at any level of debt beyond the "norm"...

Courtesy Anthony Harrington via QFINANCE (EconMatters author archive here

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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