Reinhart and Rogoff refuted

By Doug on Tue, Apr 23, 2013 - 3:29pm

Interesting refutation of Reinhart and Rogoff.  Apparently even they (R&R) admitted they got their numbers wrong.

Given the prominence of their book, how does this refutation affect the way we think about public debt?  90% debt:gdp no longer a cliff, just a milepost.


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Debt to GDP Ratio Is Dumb; Austerity vs. Spending

The Wrong Measure
Rogoff and Reinhart made mistakes in calculations. Maybe even pushed the wrong numbers. However, the entire process is wrong, and economists' short-hand for figuring government debt sustainability and potential growth should not be measured by National Debt to GDP.

Such a simple ratio - and any assumptions made based on that ratio - fails to take into consideration any of the following:

  • Government revenues as a percentage of GDP. You could have a high GDP and low revenues, and therefore are not in much of a position to service high debt.

  • Available revenues to meet interest payment and/or principal repayment (after expenses). In the case of Japan or the United States, there are zero available revenues after expenses to pay towards interest or principal. In fact, borrowing is required to meet expenses and to make interest payments.

  • Artificial additions that inflate GDP. Making one think the National Debt to GDP ratio is lower than it actually is. For example, our GDP includes the value of "rent" that homeowners who have fully-paid-for home could pay themselves if they were actually renting from themselves. Or including food that a family grows in their own garden to feed themselves.

  • The interest rate environment. Low interest rates allow higher debt levels due to cheaper debt service. Future expectations and forecasts of interest rates also have an effect. If interest rates have been rising, debt servicing capability can quickly grow out of control. This also covers confidence in the currency (whether the country is stable, whether the central bank is printing money) and how investors price bond yields - as Greece and the other PIIGS nations have come to see.

  • Economic expansion or contraction. GDP would rise in expansion, drop in expansion. Economic prospects and forecasts can have an effect. More importantly, expansion is usually tied to increased revenues, while contraction is usually tied to decreased revenues and increased expenses (hits to social safety nets, welfare, Keynesian spending, etc.) This also covers confidence in the economy and the willingness of investors to invest in it or invest government debt.

As you can see, the above 5 areas alone tell you there is much more to measuring debt sustainability and its impact on economic growth than using a simple National Debt to GDP ratio, let alone apply a 90% "magical threshold" posed by Rogoff and Reinhart. Comparisons cannot be made apples to apples. And I haven't even mentioned other factors like whether the country has made unsustainable social welfare promises (not actually part of the "National Debt", but still worrisome potential liabilities), is engaged in war (and likely will see spending as a result of that war peak out some 3 to 4 decades after war has ended, in order to pay for benefits for veterans), or how much of GDP is tied to exports, what the country's demographic spending pattern is like, or if national expenses include investments in future income-generating assets, etc.

Austerity Or More Government Spending?
Both austerity measures and government spending to smooth out the depressions in economic cycles have their advantages and pitfalls. It really depends on what you think the prospects for the economy are. I like to think of it in terms of what you can do if you were to lose your job:

  1. Austerity. You could hunker down on expenditures and try to make it until the next job. It hurts, you tighten your belt, but everyone in the family eats and stays alive. And when you get a new job, you're used to lower expenses and you enjoy more disposable income whether the new job pays less or pays more. Also, even in propsrity, you may be more inclined to save for a rainy day. Like the Germans and Japanese before, and Chinese today.
  2. Irresponsible Spending. You could put money on the credit card and continue with spending as before. If it's particularly bad, you may decide to spend even more. You hope that when you get a new job, it's soon and it pays better - because you want to pay off the debt and yet not have an austere future. But if the next job is not much better, a huge chunk of your future income now goes to debt service. To smooth out the rough spots, you've taken a hit to the good times or descended even in okay times. Also, if the economic downturn takes too long, you may find yourself in an even worse position due to debt than if you had cut back on spending from the beginning.
  3. Responsible Spending With Some Austerity. You could borrow some money, but spend wisely. Maybe on practical training or education (not all training or education guarantees a better job, but chances are greater with some choices than others), and work on maximizing efficiencies and targeting austerity in some areas (like cutting the cable service and eliminating the land line and changing the oil on the car yourself). Hopefully, you can now get a better-paying job due to that training - even if you have to repay debt -  and you also enjoy fewer expenses. This is the ideal response, because it recognizes that what used to work has changed (which is why you lost your job) and you've adapted to the new environment by making the right investments.

Most governments, however, use the excuse of further government spending (and borrowing to spend) because austerity is unpopular. They fail to target the spending to both keep people fed and sheltered, while also overhauling segments of their economy via investments and targeted austerity for a better future. Instead, most of the spending goes to special interests with lip service to jobs. A stimulus that spends $300,000 per each $50,000 job created or saved is nothing more than a handout to special interests. Irresponsible spending does not build a foundation for future revenue streams (for example a hydro-electric dam to sell electricity to the country next door, or actual infrastructure to drastically reduce the transportation costs of businesses and individuals, or retraining smart young college graduates with crash courses in science and engineering - assuming these are good fields). Irresponsible spending pretty much guarantees more national pain in the future as the borrowings have to be repaid somehow, and the country's economic prospects haven't changed or continue to get worse. We are in such a future already.


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