Monday, June 2, 2014

Reinhart and Rogoff Were Wrong

I’ve always been somewhat leery of the notion that high public debt results in slower economic growth. Piketty’s “Capital in the Twenty-First Century” for example (which I’m in the process of reading), examines the historical record of the UK and France and generally finds this not to be true.

Here’s a more generalised result, using the very same data from the seminal Reinhart and Rogoff study that sparked off austerity-mania in the Western world (excerpt; emphasis added):

Determinants of the growth and sovereign debt correlation
Matthijs Lof, Tuomas Malinen

Since the outbreak of the financial crisis, the relationship between debt and growth has been an issue of heated debate among both academics and policymakers. Reinhart and Rogoff (2010a) showed a negative correlation between sovereign debt and economic growth, and argued that countries could be confronted with a considerable decline in their growth potential after the debt-to-GDP ratio exceeds 90%.

While the research by Reinhart and Rogoff had a substantial influence in policy circles, their results are controversial….

…Even if a negative correlation between debt and growth seems undisputed, this does not imply that debt is harmful for growth, since correlation does not always imply causation. In fact, Reinhart and Rogoff (2010b) have emphasised the possible bi-directional causality between debt and growth….To decompose the correlation into cause and effect, we apply Vector Autoregressive (VAR) models. Our main result is that debt does not seem to have any significant impact on growth....

...Based on a simple VAR analysis with panel data, we can conclude that there is little evidence for a negative long-run effect of sovereign debt on economic growth. Our findings are consistent with recent studies applying different methods, such as Panizza and Presbitero (2013), as well as Kimball and Wang (2013) who “could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth”.

Using the negative correlation between debt and growth as a justification for austerity policies could be another example of confusing correlation with causation. While high levels of sovereign debt may surely be a burden for a country, the claim that debt is harmful for growth is not supported by our results.

One of the biggest problems with the Reinhart & Rogoff studies were the strange and almost complete lack of econometric analysis, beyond simple correlations. Yet their work has been taken as the basis for fiscal austerity in Europe and elsewhere. The results of austerity, needless to say, have been less than salutary – five years on, Europe is barely beginning to recover from the impact of the Great Recession,.

The lesson here is that growth matters above all, and stabilisation policies should be directed that way rather than towards debt reduction. The other, less obvious lesson is that growth determines what level of debt you can carry. If potential growth is falling, that’s the time to tighten belts (I’m looking at you, Japan).

The historical record shows that public debt reduction generally happens via two main avenues: growth and inflation. Since inflation generally comes with growth, there isn’t a trade-off between the two. Austerity policies are only successful when economies are growing; put another way, fiscal austerity only works if you have accommodative monetary policy i.e. when private debt replaces public debt.

Reinhart and Rogoff were wrong. So there.

Technical Notes:

Lof, Matthijs and Tuomas Malinen, "Determinants of the growth and sovereign debt correlation",, May 2014 (accessed June 2, 2014)

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