Confessions of a Supply-Side Liberal

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On the Great Recession

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Graph from “US Jobs Losses & Some Bad Omens for Europe…” on the True Economics blog

I am honored to have David Andolfatto discuss my proposal for eliminating the zero lower bound in his post “Are negative interest rates really the solution?" David asks what model I have in mind when I write, for example, in "America’s Big Monetary Policy Mistake: How Negative Interest Rates Could Have Stopped the Great Recession in Its Tracks,” 

Even without the ZLB [the zero lower bound on nominal interest rates], there would have been some hit from the financial crisis that ensued with the bankruptcy of Lehman Brothers on Sept. 15, 2008, but negative interest rates in the neighborhood of 4% below zero would have brought robust recovery by the end of 2009. 

This post gives that model. 

Read more …

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Enkhjargal Lkhagvajav: John Taylor is Wrong—Inequality *Is* Holding Back the Recovery

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Enkhjargal Lkhagvajav, who goes by “Enjar”

The students in my “Monetary and Financial Theory” course at the University of Michigan write 3 posts per week on an internal class blog. I liked Enjar’s post so much that I asked if I could publish it here as a guest post. Enjar said yes. I think you will find the analysis interesting. Here is what Enjar has to say:

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Rising Inequality Explains the Weak Recovery, Not Vice Versa

In this article, I will not passionately try to convince you of the post title [in bold, just below the row of asterisks]. Instead, I will make points on how John B. Taylor’s argument on the topic fails under more scrutiny. In his article in the Wall Street Journal, titled ”The Weak Recovery Explains Rising Inequality, Not Vice Versa”, John B. Taylor makes following use of data to make his point that today’s inequality isn’t a cause of the type of recovery we are witnessing. First, he explains what the people who he is arguing against say: the slow recovery has been a result of growing inequality. He writes down their argument as follows:

“The key causal factor of the middle-out view is that a wider income distribution slows economic growth by lowering consumption demand. Saving rates rise and consumption falls if the share of income shifts toward the top, according to middle-out reasoning, because people with higher incomes tend to save more than those with lower incomes.”

And then he goes on to counteract this view by data he collected and put some make up on. He gives what his data shows:

“The data for the recovery since mid-2009 do not support this view. The 5.4% overall savings rate during this recovery is not high compared with the 8.4% average since 1960. It is relatively low compared to past recoveries, such as the 9.3% savings rate during a comparable period during the recovery in the early 1980s.”

In my curiosity, I was able to look at the data he worked on. It is data on personal saving ratio-the ratio of personal saving to disposable personal income. The following graph shows what the saving rate has been.
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John Taylor is correct on that the saving rate has been averaging 5.4% since the end of the latest recession. However, when he tried to compare this rate to the 8.4% average rate since the 1960, he makes wrong comparison. Due to the general downward trend of this rate over the last decades, he shouldn’t compare this 5.4% average rate of saving during the recovery to the all time average saving rate. But if we compare the 5.4% average rate during the recovery with the average saving rate between the end of 2001 and the start of the recession, which is 3.9%, we can see that the saving rate today is higher than its pre-recession level. Therefore, we have just disproved his claim by using the same argument he tried to use. In other words, with data on how the income inequality has grown, we have further see that the saving rate also increased after the recession.

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Hence, we are able to claim that the increase in inequality indeed increased the saving rate; therefore, the total consumption demand has declined, which is exactly what the people he argued against said.

One could argue that increased personal saving rate isn’t caused by the increasing inequality . It is possible that because people might be willing to save more than what it was saving before the crisis to use their saving when another crisis comes during the recovery and uncertainty. Therefore, one could say inequality isn’t playing a much role in hindering a recovery today.

However, this surge in the saving rate after any given recession has been witnessed only twice, once after 2001 and again after 2007-2009 recessions.  The prior recoveries experienced the saving rate which was actually lower than its level before the crises. If we look at the average saving rate between November 1970 and November 1973, it was 12.8% which is higher than the saving rate after the recession, between April 1975 to December 1979, which is 10.8%. The same decrease in the saving rate was seen also during the early 1980′s recovery. We can see this trend of decrease in the saving rate following any recession in the above graph except for the last two recoveries. In last two recoveries, the saving rate surged and stayed at the higher level than it was before the recessions.

In my very first blog post, I compared the income inequality during the pre-recession periods for the Great Depression and the Great Recession and argued the recovery the economy is going through now is unhealthy one. One could agree with John Taylor on that the weak recovery is causing the widening inequality and the first problem policymakers should tackle is to boost the recovery by any means. However, the increasing inequality could be the heart of the problem, and the policymakers should prioritize equality to change the speed of the recovery. But how the inequality must be tackled should be devoted to a number of blog posts itself. I believe recent discussions and steps toward solving the inequality is a way to fasten the recovery.

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Monetary vs. Fiscal Policy: Expansionary Monetary Policy Does Not Raise the Budget Deficit

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Alan Blinder

Monetary policy and fiscal policy are not equally good as ways to stimulate the economy. Traditional monetary policy (that is, lowering the short-term interest rate) has two key advantages over traditional fiscal policy:

  • It does not add to the national debt
  • Because many governments have—however controversially—been willing to let monetary policy be handled by an independent central bank, it is not doomed to be tangled up politics to the same extent that discretionary fiscal policy inevitably gets tangled up in long-running political disputes about taxing and spending.

My subtitle “Expansionary Monetary Policy Does Not Raise the Budget Deficit” is a quotation from Alan Blinder’s October 25, 2010 Wall Street Journal op-ed "Our Fiscal Policy Paradox," where Alan also points to the political difficulties of using discretionary fiscal for macroeconomic stabilization:   

The practice of monetary and fiscal policy is fraught with difficulties, but the central concept is straightforward, compelling and, by the way, 75 years old: The government should push the economy forward when unemployment is high and slow it down when inflation threatens.

To do so, governments normally have two principal sets of weapons. Fiscal policy means moving some taxes or elements of public spending up or down to either propel or restrain total spending. In the United States, such decisions are made politically, by Congress and the president. Monetary policy normally (but not now) means lowering or raising short-term interest rates to either speed up growth or slow it down. That power, of course, resides in the technocratic Federal Reserve….

There are plenty of powerful weapons left in the fiscal-policy arsenal. But Congress is tied up in partisan knots that will probably get worse after the election….

But what about using monetary policy? Chairman Ben Bernanke and his Federal Reserve colleagues are not paralyzed by politics. They have not fallen victim to misleading advertising claiming that past policies have not helped. And expansionary monetary policy does not raise the budget deficit. So why the hesitation?

Monetary Policy. My view is that we need tools for macroeconomic stabilization that (a) can be applied technocratically and (b) do not add greatly to national debt when they are used to stimulate the economy. Monetary policy fills that bill, once it is unhobbled by eliminating the zero lower bound. Here is what I wrote in my column “Why Austerity Budgets Won’t Save Your Economy”:

For the US, the most important point is that using monetary policy to stimulate the economy does not add to the national debt and that even when interest rates are near zero, the full effectiveness of monetary policy can be restored if we are willing to make a legal distinction between paper currency and electronic money in bank accounts—treating electronic money as the real thing, and putting paper currency in a subordinate role….

Without the limitations on monetary policy that come from our current paper currency policy, the Fed could lower interest rates enough (even into negative territory for a few quarters if necessary) to offset the effects of even major tax increases and government spending cuts.

The Costs of National Debt. That column is also important in giving some of the best arguments I know for worrying about the national debt now that it is hard to argue that national debt slows economic growth. (On the effect of national debt on economic growth, see my two columns with Yichuan Wang “After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth" and Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data? and the other work they flag.) Here is what I had to say about the costs of debt in ”Why Austerity Budgets Won’t Save Your Economy”:

…lenders are showing no signs of doubting the ability of the US government to pay its debts. But there can be costs to debt even if no one ever doubts that the US government can pay it back.

To understand the other costs of debt, think of an individual going into debt. There are many appropriate reasons to take on debt, despite the burden of paying off the debt:

  • To deal with an emergency—such as unexpected medical expenses—when it was impossible to be prepared by saving in advance.
  • To invest in an education or tools needed for a better job.
  • To buy an affordable house or car that will provide benefits for many years.

There is one more logically coherent reason to take on debt—logically coherent but seldom seen in the real world:

  • To be able to say with contentment and satisfaction in one’s impoverished old age, “What fun I had when I was young!”

In theory, this could happen if when young, one had a unique opportunity for a wonderful experience—an opportunity that is very rare, worth sacrificing for later on. Another way it could happen is if one simply cared more in general about what happened in one’s youth than about what happened in one’s old age.

Tax increases and government spending cuts are painful. Running up the national debt concentrates and intensifies that pain in the future. Since our budget deficits are not giving us a uniquely wonderful experience now, to justify running up debt, that debt should be either (i) necessary to avoid great pain now, or (ii) necessary to make the future better in a big enough way to make up for the extra debt burden. The idea that running up debt is the only way to stimulate an economic recovery when interest rates are near zero is exactly what I question… If reforming the way we handle paper currency made it clear that running up the debt is not necessary to stimulate the economy, what else could justify increasing our national debt? In that case, only true investments in the future would justify more debt: things like roads, bridges, and scientific knowledge that would still be there in the future yielding benefits—benefits for which our children and we ourselves in the future will be glad to shoulder the burden of debt.

National Lines of Credit: I write about the importance of stabilization policy that can be applied technocratically, without getting tangled up in politics in the context of my other main proposal for stabilization policy: National Lines of Credit (or equivalently “Federal Lines of Credit”). The key post there is "Preventing Recession-Fighting from Becoming a Political Football." In any case, I think National Lines of Credit would get less tangled up in politics than regular traditional fiscal policy, but it would also be possible to set them up so that they were initiated in an explicitly technocratic way. Here is the relevant passage from my working paper "Getting the Biggest Bang for the Buck in Fiscal Policy":

The lack of legal authority for central banks to issue national lines of credit is not set in stone. Indeed, for the sake of speed in reacting to threatened recessions, it could be quite valuable to have legislation setting out many of the details of national lines of credit but then authorizing the central bank to choose the timing and (up to some limit) the magnitude of issuance. Even when the Fed funds rate or its equivalent is far from its zero lower bound at the beginning of a recession, the effects of monetary policy take place with a significant lag (partly because of the time it takes to adjust investment plans), while there is reason to think that consumption could be stimulated quickly through the issuance of national lines of credit. Reflecting the fact that national lines of credit lie between traditional monetary and traditional fiscal policy, the rest of the government would still have a role both in establishing the magnitude of this authority and perhaps in mandating the issuance of additional lines of credit over the central bank’s objection (with the overruled central bank free to use contractionary monetary policy for a countervailing effect on aggregate demand).

Though not as good as monetary stimulus, National Lines of Credit are also much better than traditional fiscal policy in yielding a high ratio of stimulus to the amount ultimately added to the national debt.

National Rainy Day Accounts. There is a related mode of stabilization policy that I consider superior to National Lines of Credit. The National Rainy Day Accounts described in this passage of my working paper "Getting the Biggest Bang for the Buck in Fiscal Policy" would not add to the national debt at all: 

It is also worth pointing out that, in principle, national lines of credit in times of low demand could be superseded in the long run (at least in part) by a modest level of forced saving in times of high demand,  with the funds from these “national rainy day accounts” released to households in time of recession (and also perhaps in the case of one of a well-defined list of documentable personal financial emergencies).

The National Rainy Day Accounts also have household finance benefits for people who have difficulty saving for emergencies without some external discipline. The main limitations of National Rainy Day Accounts as stabilization policy is (a) that they require advance preparation and (b) the resources of National Rainy Day Accounts might sometimes be exhausted before getting enough stimulus. 

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Quartz #25—>Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data?

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Link to the Column on Quartz

Here is the full text of my 25th Quartz column, that I coauthored with Yichuan Wang, "Autopsy: Economists looked even closer at Reinhart and Rogoff’s data—and the results might surprise you." It is now brought home to supplysideliberal.com (and soon to Yichuan’s Synthenomics). It was first published on May 14, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© June 12, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

(Yichuan has agreed to extend permission on the same terms that I do.)

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In order to predict the future, the ancient Romans would often sacrifice an animal, open up its guts and look closely at its entrails. Since the discovery of an Excel spreadsheet error in Carmen Reinhart and Ken Rogoff’s analysis of debt and growth by University of Massachusetts at Amherst graduate student Thomas Herndon and his professors Michael Ash and Robert Pollin, many economists have taken a cue from the Romans with the Reinhart and Rogoff data to see if there is any hint of an effect of high levels of national debt on economic growth. The two of us gave our first take in analyzing the Reinhart and Rogoff data in our May 29, 2013 column. We wrote that “…we could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

Our further analysis since then (here, and here), and University of Massachusetts at Amherst Professor Arindrajit Dube’s analysis since then and full release of his previous work (herehere, and here) in response to our column have only confirmed that view. (Links to other reactions to our earlier column can be found here.) Indeed, although we have found no shred of evidence for a negative effect of government debt on growth in the Reinhart and Rogoff data, the two of us have found at least a mirage of a positive effect of debt on growth, as shown in the graph above.

The point of the graph at the top is to find out if the ratio of debt has any relationship to GDP growth, after isolating the part of GDP growth that can’t be predicted by past GDP growth alone. Let us give two examples of why it might be important to adjust for past growth rates when looking at the effect of debt on growth. First, if a country is run badly in other ways, is likely to grow slowly whatever its level of debt. In order to see if debt makes things worse, it is crucial to adjust for the fact that it was growing slowly to begin with. Second, if a country is run well, it is likely to grow fast while it is in the “catch-up” phase of copying proven techniques from other countries. Then as it gets closer to the technological frontier, its growth will naturally slow down. If getting richer in this way also tends to lead through typical political dynamics to a larger welfare state with higher levels of debt, one would see high levels of debt during that later mature phase of slower growth. This is not debt causing slow growth, but economic development having two separate effects: the slowdown in growth as a country nears the technological frontier, and the development of a welfare state. Adjusting for past growth helps us adjust for how far along a country is in its growth trajectory.

In the graph, if “GDP Growth Relative to Par” is positive, it means GDP growth is higher in the next 10 years than would be predicted by past GDP growth alone. If “GDP Growth Relative to Par” is negative, it means GDP growth is lower in the next 10 years than would be predicted by past GDP growth. (Here, in accounting for the effect of past GDP growth, we use data on the most recent five past years individually, and the average growth rate over the period from 10 years in the past to five years in the past.) The thick red line shows that, overall, high debt is associated with GDP growth just a little higher than what one would guess from looking at the past record of GDP growth alone. The thick blue curve gives more detail by showing in a flexible way what levels of debt are associated with above par growth and what levels of debt are associated with below par growth. We generated it with standard scatterplot smoothing techniques. The thick blue curve shows that, in particular, GDP growth seems surprisingly high in the range from debt about 60% of GDP to debt about 120% of GDP. Higher and lower debt levels are associated with future growth that is somewhat lower than would be predicted by looking at past growth alone. Interestingly, debt at 90% of GDP, instead of being a cliff beyond which the growth performance looks much worse, looks like the top of a gently rounded hill. If one took the tiny bit of evidence here much, much more seriously than we do, it would suggest that debt below 90% of GDP is just as bad as debt above 90% of GDP, but that neither is very bad.

Where does the evidence of above par growth in the range from 60% to 120% of GDP come from? Part of the answer is Ireland. In particular, all but one of the cases when GDP growth was more than 2.5% per year above what would be expected from looking at past growth occurred in a 10-year period after Ireland had a debt to GDP ratio in the range from 60% to 120% of GDP. It is well-known that Ireland has recently gotten into trouble because of its debt, but what does the overall picture of its growth performance over the last few decades look like? Here is a graph of Ireland’s per capita GDP from the Federal Reserve Bank of St. Louis data base:

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The consequences of debt have reversed some of Ireland’s previous growth, but it is still a growth success story, despite the high levels of debt it had in the 1980s and ’90s.

In addition to Ireland, a bit of the evidence for good growth performance following high levels of debt comes from Greece. As the graph below shows, Greece has had more impressive growth in the last two decades than many people realize, despite the hit it has taken recently because of its debt troubles.

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We did a simple exercise to see if the bump up in the thick blue curve in the graph at the top is entirely due to Ireland’s and Greece’s growth that has been reversed recently because of their debt troubles.  To be sure that the bad consequences of Ireland’s and Greece’s debt for GDP in the last few years were accounted for when looking at the effect of debt on growth, we pretended that the recent declines in GDP had been spread out as a drag on growth over the period from 1990 to 2007 instead of happening in the last few years. Then we redid our analysis. Making this adjustment to the growth data is a simple, if ad hoc, way of trying to make sure that the consequences of Irish and Greek debt are not missed by the analysis.

Imagining slower growth earlier on to account for Ireland’s and Greece’s recent GDP declines makes the performance of Ireland and Greece in that period from 1990 to 2007 look less stellar. The key effect is on the thick blue curve estimating the effect of debt on growth. Looking closely at the graph below after adjusting Ireland’s and Greece’s growth rates, you can see that the bump up in the thick blue curve in the range where debt is between 60% and 120% of GDP has been cut down to size, but it is still there. So the bump cannot be attributed entirely to Ireland and Greece “stealing growth from the future” with their high levels of debt.

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We want to stress that there is no real justification for making the adjustment for Ireland and Greece that we made except as a way of showing that the argument that Ireland and Greece had high growth in the 1990s and early 2000s, but now have had to pay the piper is not enough to turn the story about the effects of debt on growth around.

There are three broader points to make from this discussion of Ireland and Greece.

  • We still don’t recommend taking the upward bump in growth predicted by the thick blue curves in the 60% to 120% ranges for debt seriously.
  • The fact that looking at the experience of two countries in two decades can account for a good share of the bump up in the 60% to 120% ranges illustrates just how little there is to go on from the Reinhart and Rogoff data set. Our scatter plots with the thick blue curves give the impression of more than there really is, because we have dots for growth from 1970 to 1980 and 1971 to 1981 and 1972 to 1982, and so on. And there is no way to escape this kind of issue when the economic forces one is interested have both short-run and long-run effects, and change as slowly over time as levels of national debt do. There are advanced statistical methods for correcting for such issues; the corrections almost always go in the direction of saying that there is less evidence in a set of data than it might seem. Even without being experts ourselves in making those statistical corrections, we feel reasonably confident in saying that the Reinhart and Rogoff data speak very softly about any positive or negative effect of debt on growth at all: barely a whisper.
  • Third, the inclusion of Ireland and Greece and the fact that the basic story survives after pretending their GDP declines were a drag on growth earlier contradicts to some extent the claim of economics blogger and blog critic Paul Andrews in his post “None the Wiser After Reinhart, Rogoff, et al.” that Reinhart and Rogoff’s data focus on “20 or so of the most healthy economies the world has ever seen.” After adjusting for the hit their economies have taken recently, the inclusion of Ireland and Greece gives some perspective on the effects of debt on the growth of economies that havesubsequently had problems paying for their debt. There could certainly be other economies whose growth is more vulnerable to debt than Ireland and Greece, but to us these seem like exactly the kinds of cases people would have in mind when they argue that one should expect debt to have a negative effect on growth.

Understanding all of this matters because, as Mark Gongloff of Huffington Postwrites:

Reinhart and Rogoff’s 2010 paper, “Growth in a Time of Debt,” … has been used to justify austerity programs around the world. In that paper, and inmany other papers, op-ed pieces and congressional testimony over the years, Reinhart and Rogoff have warned that high debt slows down growth, making it a huge problem to be dealt with immediately. The human costs of this error have been enormous.

Even though there are many effective ways to stimulate economies without adding much to their national debt, the primary remedies for sluggish economies that are actually on the table politically are those that do increase national debt, so it matters whether people think debt is damning or think debt is just debt.  It is painful enough that debt has to be paid back (with some combination of interest and principal), and high levels of debt may help cause debt crises like those we have seen for Ireland and Greece. But the bottom line from our examination of the entrails is that the omens and portents in the Reinhart and Rogoff data do not back up the argument that debt has a negative effect on economic growth.

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Quartz #24—>After Crunching Reinhart and Rogoff’s Data, We Found No Evidence High Debt Slows Growth

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Link to the Column on Quartz

Here is the full text of my 24th Quartz column, that I coauthored with Yichuan Wang, "After crunching Reinhart and Rogoff’s data, we’ve concluded that high debt does not slow growth." It is now brought home to supplysideliberal.com (and soon to Yichuan’s Synthenomics). It was first published on May 14, 2013. Links to all my other columns can be found here.

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© May 29, 2013: Miles Kimball and Yichuan Wang, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

(Yichuan has agreed to extend permission on the same terms that I do.)

This column had a strong response. I have included the text of my companion column, with links to many of the responses after the text of the column itself. (For the comments attached to that companion post, you will still have to go to the original posting.) Other followup posts can be found in my "Short-Run Fiscal Policy" sub-blog.  

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Leaving aside monetary policy, the textbook Keynesian remedy for recession is to increase government spending or cut taxes. The obvious problem with that is that higher government spending and lower taxes tend to put the government deeper in debt. So the announcement on April 15, 2013 by University of Massachusetts at Amherst economists Thomas Herndon, Michael Ash and Robert Pollin that Carmen Reinhart and Ken Rogoff had made a mistake in their analysis claiming that debt leads to lower economic growth has been big news. Remarkably for a story so wonkish, the tale of Reinhart and Rogoff’s errors even made it onto the Colbert Report. Six weeks later, discussions of Herndon, Ash and Pollin’s challenge to Reinhart and Rogoff continue in earnest in the economics blogosphere, in the Wall Street Journal, and in the New York Times.

In defending the main conclusions of their work, while conceding some errors,Reinhart and Rogoff point out that even after the errors are corrected, there is a substantial negative correlation between debt levels and economic growth. That is a fair description of what Herndon, Ash and Pollin find, as discussed in an earlier Quartz column, “An Economist’s Mea Culpa: I relied on Reinhardt and Rogoff.” But, as mentioned there, and as Reinhart and Rogoff point out in their response to Herndon, Ash and Pollin, there is a key remaining issue of what causes what. It is well known among economists that low growth leads to extra debt because tax revenues go down and spending goes up in a recession. But does debt also cause low growth in a vicious cycle? That is the question.

We wanted to see for ourselves what Reinhart and Rogoff’s data could say about whether high national debt seems to cause low growth. In particular, we wanted to separate the effect of low growth in causing higher debt from any effect of higher debt in causing low growth. There is no way to do this perfectly. But we wanted to make the attempt. We had one key difference in our approach from many of the other analyses of Reinhart and Rogoff’s data: we decided to focus only on long-run effects. This is a way to avoid getting confused by the effects of business cycles such as the Great Recession that we are still recovering from. But one limitation of focusing on long-run effects is that it might leave out one of the more obvious problems with debt: the bond markets might at any time refuse to continue lending except at punitively high interest rates, causing debt crises like that have been faced by Greece, Ireland, and Cyprus, and to a lesser degree Spain and Italy. So far, debt crises like this have been rare for countries that have borrowed in their own currency, but are a serious danger for countries that borrow in a foreign currency or share a currency with many other countries in the euro zone.

Here is what we did to focus on long-run effects: to avoid being confused by business-cycle effects, we looked at the relationship between national debt and growth in the period of time from five to 10 years later. In their paper “Debt Overhangs, Past and Present,” Carmen Reinhart and Ken Rogoff, along with Vincent Reinhart, emphasize that most episodes of high national debt last a long time. That means that if high debt really causes low growth in a slow, corrosive way, we should be able to see high debt now associated with low growth far into the future for the simple reason that high debt now tends to be associated with high debt for quite some time into the future.

Here is the bottom line. Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

The graphs at the top show show our first take at analyzing the Reinhardt and Rogoff data. This first take seemed to indicate a large effect of low economic growth in the past in raising debt combined with a smaller, but still very important effect of high debt in lowering later economic growth. On the right panel of the graph above, you can see the strong downward slope that indicates a strong correlation between low growth rates in the period from ten years ago to five years ago with more debt, suggesting that low growth in the past causes high debt. On the left panel of the graph above, you can see the mild downward slope that indicates a weaker correlation between debt and lower growth in the period from five years later to ten years later, suggesting that debt might have some negative effect on growth in the long run. In order to avoid overstating the amount of data available, these graphs have only one dot for each five-year period in the data set. If our further analysis had confirmed these results, we were prepared to argue that the evidence suggested a serious worry about the effects of debt on growth. But the story the graphs above seem to tell dissolves on closer examination.

Given the strong effect past low growth seemed to have on debt, we felt that we needed to take into account the effect of past economic growth rates on debt more carefully when trying to tease out the effects in the other direction, of debt on later growth. Economists often use a technique called multiple regression analysis (or “ordinary least squares”) to take into account the effect of one thing when looking at the effect of something else. Here we are doing something that is quite close both in spirit and the numbers it generates for our analysis, but allows us to use graphs to show what is going on a little better.

The effects of low economic growth in the past may not all come from business cycle effects. It is possible that there are political effects as well, in which a slowly growing pie to be divided makes it harder for different political factions to agree, resulting in deficits. Low growth in the past may also be a sign that a government is incompetent or dysfunctional in some other way that also causes high debt. So the way we took into account the effects of economic growth in the past on debt—and the effects on debt of the level of government competence that past growth may signify—was to look at what level of debt could be predicted by knowing the rates of economic growth from the past year, and in the three-year periods from 10 to 7 years ago, 7 to 4 years ago and 4 to 1 years ago. The graph below, labeled “Prediction of Debt Based on Past Growth” shows that knowing these various economic growth rates over the past 10 years helps a lot in predicting how high the ratio of national debt to GDP will be on a year by year basis. (Doing things on a year by year basis gives the best prediction, but means the graph has five times as many dots as the other scatter plots.) The “Prediction of Debt Based on Past Growth” graph shows that some countries, at some times, have debt above what one would expect based on past growth and some countries have debt below what one would expect based on past growth. If higher debt causes lower growth, then national debt beyond what could be predicted by past economic growth should be bad for future growth.

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Our next graph below, labeled “Relationship Between Future Growth and Excess Debt to GDP” shows the relationship between a debt to GDP ratio beyond what would be predicted by past growth and economic growth 5 to 10 years later. Here there is no downward slope at all. In fact there is a small upward slope. This was surprising enough that we asked others we knew to see what they found when trying our basic approach. They bear no responsibility for our interpretation of the analysis here, but Owen Zidar, an economics graduate student at the University of California, Berkeley, and Daniel Weagley, graduate student in finance at the University of Michigan were generous enough to analyze the data from our angle to help alert us if they found we were dramatically off course and to suggest various ways to handle details. (In addition, Yu She, a student in the master’s of applied economics program at the University of Michigan proofread our computer code.)  We have no doubt that someone could use a slightly different data set or tweak the analysis enough to make the small upward slope into a small downward slope. But the fact that we got a small upward slope so easily (on our first try with this approach of controlling for past growth more carefully) means that there is no robust evidence in the Reinhart and Rogoff data set for a negative long-run effect of debt on future growth once the effects of past growth on debt are taken into account. (We still get an upward slope when we do things on a year-by-year basis instead of looking at non-overlapping five-year growth periods.)

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Daniel Weagley raised a very interesting issue that the very slight upward slope shown for the “Relationship Between Future Growth and Excess Debt to GDP” is composed of two different kinds of evidence. Times when countries in the data set, on average, have higher debt than would be predicted tend to be associated with higher growth in the period from five to 10 years later. But at any time, countries that have debt that is unexpectedly high not only compared to their own past growth, but also compared to the unexpected debt of other countries at that time, do indeed tend to have lower growth five to 10 years later. It is only speculating, but this is what one might expect if the main mechanism for long-run effects of debt on growth is more of the short-run effect we mentioned above: the danger that the “bond market vigilantes” will start demanding high interest rates. It is hard for the bond market vigilantes to take their money out of all government bonds everywhere in the world, so having debt that looks high compared to other countries at any given time might be what matters most.

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Our view is that evidence from trends in the average level of debt around the world over time are just as instructive as evidence from the cross-national evidence from debt in one country being higher than in other countries at a given time. Our last graph (just above) shows what the evidence from trends in average levels over time looks like. High debt levels in the late 1940s and the 1950s were followed five to 10 years later with relatively high growth.  Low debt levels in the 1960s and 1970s were followed five to 10 years later by relatively low growth. High debt levels in the 1980s and 1990s were followed five to 10 years later by relatively high growth. If anyone can come up with a good argument for why this evidence from trends in the average levels over time should be dismissed, then only the cross-national evidence about debt in one country compared to another would remain, which by itself makes debt look bad for growth. But we argue that there is not enough justification to say that special occurrences each year make the evidence from trends in the average levels over time worthless. (Technically, we don’t think it is appropriate to use “year fixed effects” to soak up and throw away evidence from those trends over time in the average level of debt around the world.)

We don’t want anyone to take away the message that high levels of national debt are a matter of no concern. As discussed in “Why Austerity Budgets Won’t Save Your Economy,” the big problem with debt is that the only ways to avoid paying it back or paying interest on it forever are national bankruptcy or hyper-inflation. And unless the borrowed money is spent in ways that foster economic growth in a big way, paying it back or paying interest on it forever will mean future pain in the form of higher taxes or lower spending.

There is very little evidence that spending borrowed money on conventional Keynesian stimulus—spent in the ways dictated by what has become normal politics in the US, Europe and Japan—(or the kinds of tax cuts typically proposed) can stimulate the economy enough to avoid having to raise taxes or cut spending in the future to pay the debt back. There are three main ways to use debt to increase growth enough to avoid having to raise taxes or cut spending later:

1. Spending on national investments that have a very high return, such as in scientific research, fixing roads or bridges that have been sorely neglected.
2. Using government support to catalyze private borrowing by firms and households, such as government support for student loans, and temporary investment tax credits or Federal Lines of Credit to households used as a stimulus measure.
3. Issuing debt to create a sovereign wealth fund—that is, putting the money into the corporate stock and bond markets instead of spending it, as discussed in “Why the US needs its own sovereign wealth fund.” For anyone who thinks government debt is important as a form of collateral for private firms (see “How a US Sovereign Wealth Fund Can Alleviate a Scarcity of Safe Assets”), this is the way to get those benefits of debt, while earning more interest and dividends for tax payers than the extra debt costs. And a sovereign wealth fund (like breaking through the zero lower bound with electronic money) makes the tilt of governments toward short-term financing caused by current quantitative easing policies unnecessary.

But even if debt is used in ways that do require higher taxes or lower spending in the future, it may sometimes be worth it. If a country has its own currency, and borrows using appropriate long-term debt (so it only has to refinance a small fraction of the debt each year) the danger from bond market vigilantes can be kept to a minimum. And other than the danger from bond market vigilantes, we find no persuasive evidence from Reinhart and Rogoff’s data set to worry about anything but the higher future taxes or lower future spending needed to pay for that long-term debt. We look forward to further evidence and further thinking on the effects of debt. But our bottom line from this analysis, and the thinking we have been able to articulate above, is this: Done carefully, debt is not damning. Debt is just debt.

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Companion Post:

Read more …

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Instrumental Tools for Debt and Growth

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A Joint Post by Miles Kimball and Yichuan Wang

Yichuan (see photo above) and I talked through the analysis and ideas for this post together, but the words and the particulars of the graphs are all his. I find what he has done here very impressive. On his blog, where this post first appeared on June 4, 2013, the last two graphs are dynamic and show more information when you hover over what you are interested in. This post is a good complement to our analysis in our second joint Quartz column: "Autopsy: Economists looked even closer at Reinhart and Rogoff’s data—and the results might surprise you," which pushes a little further along the lines we laid out in "For Sussing Out Whether Debt Affects Future Growth, the Key is Carefully Taking Into Account Past Growth." 

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In a recent Quartz column, we found that high levels of debt do not appear to affect future rates of growth. In the Reinhart and Rogoff (henceforth RR) data set on debt and growth for a group of 20 advanced economies in the post WW-II period, high levels of debt to GDP did not predict lower levels of growth 5 to 10 years in the future. Notably, after controlling for various intervals of past growth, we found that there was a mild positive correlation between debt to GDP and future GDP growth.

In a companion post, we address some of the time window issues with some plots how adjusting for past growth can reverse any observed negative correlation between debt and future growth. In this post, we want to address the possibility that future growth can lead to high debt, and explain our use of instrumental variables to control for this possibility.
One major possibility for this relationship is that policy makers are forward looking, and base their decisions on whether to have high or low debt based on their expectations of future events. For example, if policy makers know that a recession is coming, they may increase deficit spending to mitigate the upcoming negative shock to growth. Even though debt may have increased growth, this would have been observed as lower growth following high debt.On the other hand, perhaps expectations of high future growth make policy makers believe that the government can afford to increase debt right now. Even if debt had a negative effect on growth, the data would show a rapid rise in GDP growth following the increase in debt.

Apart from government tax and spending decisions informed by forecasts of future growth, there are other mechanical relationships between debt and growth that are not what one should be looking for when asking whether debt has a negative effect on growth. For example a war can increase debt, but the ramp of the war makes growth high then and predictably lower after the ramp up is done and predictably lower still when the war winds down. So there is an increase in debt coupled with predictions for GDP growth different from non-war situations. None of this has to do with debt itself causing a different growth rate, so we would like to abstract from it. 

To do so, we need to extract the part of the debt to GDP statistic that is based on whether the country runs a long term high debt policy, and to ignore the high debt that arises because of changes in expected future outcomes or because of relatively mechanical short-run aggregate demand effects of government purchases as a component of GDP. Econometrically, this approach is called instrumental variables, and would involve using a set of variables, called instruments, that are uncorrelated with future outcomes to predict current debt.

Since we are considering future outcomes, a natural choice for instrument would be the lagged value of the debt to GDP ratio. As can be seen below, debt to GDP does not jump around very much. If debt is high today, it likely will also be high tomorrow. Thus lagged debt can predict future debt. Also, since economic growth is notoriously difficult to forecast, the lagged debt variable should no longer reflect expectations about future
economic growth.   
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By using lagged debt and growth as instruments, we isolate the part of current debt that reflects debt from a long term high debt policy, and not by short run forecasts or other mechanical pressures. We plot the resulting slopes on debt to GDP in the charts below, for both future growth in years 0-5 and for future years 5-10. For the raw data and computations, consult the public dropbox folder.

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imageFrom these graphs, we can make some observations.


First, almost all the coefficients, across all the different lags and fixed effects, are positive. Since these results are small, we should not put too much weight on statistical significance. However, it should be noted that the plain results, OLS and IV, for both growth periods are all statistically significant at at least the 95% confidence level, and the IV estimates for the 5-10 year period in particular are significant at the 99% confidence level.


The one negative estimate, OLS estimate with country fixed effects, has a standard error with absolute size twice as large as the actual slope estimate.Moreover, country fixed effects are difficult to interpret because they pivot the analysis from looking at high debt versus low debt countries towards analyzing a country’s indebtedness relative to its long run average.

These results are striking considering therobustness with which Reinhart and Rogoff present the argument thatdebt causes low growth in their 2012 JEP article.Yet instead of finding a weaker negative correlation, aftercontrolling for past growth, we find that the estimated relationship between current debt and future growth is weakly positive instead. 

Second, when taking out year fixed effects, there is almost no effect of debt and future . Econometrically, year fixed effects takes out the average debt levelin every year, which leaves us analyzing whether being more heavilyindebted relative to a country’s peers in that year has an additional effect on growth. Because this component isconsistently smaller than the regular IV coefficient, this suggests,for the advanced countries in the sample, it’s absolute, not relative, debt that matters.

This should be no surprise. As most recently articulated in RR’s open letter to Paul Krugman, much of the argument against high debt levels relies on a fear that a heavily indebted country becomes “suddenly unable to borrow from international capital markets because its public and/or private debts that are a contingent public liability are deemed unsustainable.” The credit crunch stifles growth and governments are forced to engage in self-destructive cutbacks just in order to pay the bills. At its core, this is a story about whether the government can pay back the liabilities. But whether or not liabilities are sustainable should depend on the absolute size of the liabilities, not just whether the liabilities are large relative to their peers.

Now,our conclusion is not without limitations. As Paul Andrew notes,the RR data set used focuses on “20 or so of the most healthy economies the world has ever seen,” thus potentially adding a high level of selection bias.

Additionally, we have restricted ourselves to the RR data set of advanced countries in the post WW-II period. The 2012 Reinhart and Rogoff paper considered episodes of debt overhangs from the 1800’s, and thus the results are likely very different. However, it is likely that prewar government policies, such the gold standard and the lack of independent monetary authorities, contributed to the pain of debt crises. Thus our timescale does not detract from the implication that debt has a limited effect on future growth in modern advanced economies.

In their New York Times response to Herndon et. al., Reinhart and Rogoff “reiterate that the frontier question for research is the issue of causality”. And at this frontier, our Quartz column, Dube’s work on varying regression time frames, and these companion posts all suggest that causality from debt to growth is much smaller than previously thought.

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Examining the Entrails: Is There Any Evidence for an Effect of Debt on Growth in the Reinhart and Rogoff Data?

Here is a link to my 25th column on Quartz, written with Yichuan Wang: "Autopsy: Economists looked even closer at Reinhart and Rogoff’s data—and the results might surprise you." 

Yichuan recently finished his first year as an undergraduate at the University of Michigan. His blog is Synthenomics. You can find Yichuan on Twitter here.  

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An Independent Blog

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A recent picture of Miles

I was pleased that Brian Milner of the Globe and Mail found his way to my blog post "After Crunching Reinhart and Rogoff’s Data, We Found No Evidence That High Debt Slows Growth," and in his article and in "Rogoff-Reinhart put cart before the horse" quotes my sentence: 
What I find remarkable is that despite the likely negative effect of debt on growth from refinancing difficulties, we found no overall negative effect of debt on growth.
But Brian was inaccurate when he followed that quotation with the attribution 
 
…Mr. Kimball wrote in a blog post at Quartz.
Brian didn’t realize that supplysideliberal.com is an independent blog.
Though I love my editors at Quartz, I have fiercely guarded the principle of the independence of supplysideliberal.com itself. As I said in my anniversary post "A Year in the Life of a Supply-Side Liberal," it means a lot to me that I can say here anything that I think needs to be said on my own account without asking anyone’s permission. 

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For Sussing Out Whether Debt Affects Future Growth, the Key is Carefully Taking into Account Past Growth

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A Joint Post by Miles Kimball and Yichuan Wang

We are very pleased with the response to our May 29, 2013 Quartz column, “After crunching Reinhart and Rogoff’s data, we concluded that high debt does not slow growth.” Miles gives links to some of the online reactions in his (more accurately titled) companion blog post the next day, “After Crunching Reinhart and Rogoff’s Data, We Found No Evidence That High Debt Slows Growth.” The one reaction that called for another full post was Arindrajit Dube’s post “Dube on Growth, Debt and Past Versus Future Windows.”  Arindrajit suggests in that post that in his working paper "A Note on Debt, Growth and Causality," he had actually explored the variations that the two of us focus on, but we want to argue here that we did one important thing that Arindrajit did not try in his working paper: controlling for ten years worth of data on past growth, as we did in our Quartz column. In this post, we argue that controlling for ten years worth of data on past growth is the key to getting positive slopes for the partial correlation between debt and future growth. We were surprised to find that controlling for ten years of past GDP growth makes the partial correlation between debt and near future growth in future years 0 to 5 positive (as well as the further future growth in future years 5 to 10).The graph at the top shows our main message. Since this is a long post, let us give the bottom line here and return to it below:

The two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth for either growth either in the short run (the next five years) or in the long run (as indicated by growth from five to ten years later).   

The most important proviso in this statement is the clause “in the Reinhart and Rogoff data.” 

Yichuan has placed our programs in a public dropbox folder. Also, on Yichuan’s blog Synthenomics, we have an additional companion post, "Instrumental Tools for Debt and Growth," showing that instrumenting the debt to GDP ratio by the past debt to GDP ratio in order to isolate high debt and low debt policies from high or low debt caused by recent events makes the relationship between debt and future growth more positive. (This is mainly due to evidence from movements of debt in tandem across countries over time rather than movements in debt that distinguish one country from another at a give time.) 

Why it matters: Why does it matter whether the seeming effect of debt on future growth is a small positive number or a small negative number? Let us illustrate. Brad DeLong says (and Paul Krugman quotes Brad DeLong saying):

…an increase in debt from 50% of a year’s GDP to 150% is associated with a reduction in growth rates of 0.1%/year over the subsequent five years…

The first thing to say about this is that some of the estimates for going from 0 debt to a 50% debt to GDP ratio are bigger negative numbers. As Miles wrote in the companion post “After crunching Reinhart and Rogoff’s Data, We Found No Evidence That High Debt Slows Growth”:

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if I were convinced Arin Dube’s left graph were causal, the left graph seems to suggest that higher debt causes low growth in a very important way, though of course not in as big a way as slow growth causes higher debt. If it were causal, the left graph suggests it is the first 30% on the debt to GDP ratio that has the biggest effect on growth, not any 90% threshold.

The second thing to say is that reducing the growth rate .1% per year adds up. After five years, GDP would be .5% lower. Since the extra debt going from 50% to 150% is a year’s GDP, that is like a .5% per year addition to the interest on that extra debt, except that people throughout the economy experience the cost rather than the government alone. And if the effect on the path of GDP is permanent, that annual cost might not go away even when the debt is later repaid.

So we think it matters whether the best evidence points to what looks like a small positive slope or what looks like a small negative slope. And given how important the issues are, the Bayesian updating from results that are statistically insignificant at conventional levels of significance can have substantial practical importance.

Ten years worth of past GDP growth data are significantly better at predicting future GDP growth than five years worth of past GDP growth data.

There is a wide range of growth rates in the data. Even within a given country, growth rates can be very different over the many decades of time represented in the Reinhart and Rogoff data. So it should not be surprising that it is helpful to use data on many years of past growth in order to predict past growth. Define time t as the year in which the debt/GDP ratio is measured. Then what we focus on is the difference between predicting future real GDP growth based on only the growth rates from t-5 to t-4, t-4 to t-3, t-3 to t-2, t-2 to t-1, and t-1 to t, and adding to those five most recent past annual growth rates the average growth rate from t-10 to t-5.  The graph immediately below shows that there is, indeed, variation in the growth rate from t-10 to t-5 that can’t be predicted by the most recent past five annual growth rates of GDP.   

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The next graph shows that the average growth rate from t-10 to t-5 does, indeed, help in predicting the future growth rate of GDP from t to t+5:

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Here, “Excess Growth from Past Years 10-5” just means growth in past years 10 to 5 beyond what one could have guessed from knowing the most recent past five annual growth rates. In the multiple regression of future growth from t to t+5 on past growth, the t-statistic on “deep past” growth from t-10 to t-5 is 3.75, and so meets a very high standard of statistical significance.  

One way to think of why growth from t-10 to t-5 might help in predicting future growth is that it might help indicate the pace of growth to which growth will tend to mean revert after short-run dynamics play themselves out. But one would expect that there is a limit to the extent to which more and more growth data from the past will help. We find that growth from t-10 to t-5 does not help much in predicting growth in the five-year period fifteen years later from t+5 to t+10, as can be seen in the following graph:

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What would we have found if we had neglected to control for growth in past years 10 to 5? 

To illustrate the importance of carefully taking into account the predictive value of many past years of growth for future growth, let us show first what we would have gotten if we had only controlled for the most recent five annual growth rates of GDP.  

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Here we get a small downward slope. But we don’t believe this small downward slope is causal, since it doesn’t adequately control for all the things other than debt that make both past and future growth tend to be higher or that make both past and future growth tend to be low, and as a byproduct, also have an effect on debt. 

Looking at further future growth in future years 5 to 10, we see a positive relationship between excess debt and further future GDP growth. 

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THE MAIN EVENT: THE RELATIONSHIP BETWEEN DEBT AND FUTURE GROWTH AFTER CONTROLLING FOR TEN YEARS OF PAST GROWTH.

Someone might object that after controlling for a full ten years of past GDP growth (the most recent five years of annual growth, plus the average growth rate in past years 10 to 5), there wouldn’t be much independent variation in debt left with which to identify the effects of debt, but that is not so. The following graph shows that some country-years have higher debt than would be predicted by ten years of past growth and some have lower debt than would be predicted by ten years of past growth. 

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We call the difference between actual debt and what could have been predicted by ten years of past growth is “excess debt.” (It is important to understand that this is only of interest as a statistical object.) As can be seen in the graph immediately below (identical to the graph at the top of the post), debt above what could have been predicted by ten years of past growth has a positive relationship to future growth in the five years after the year when the debt to GDP ratio is measured.  

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Looking further into the future, to average GDP growth in future years 5 to 10, the relationship between excess debt and further growth looks more strongly positive. 

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Year Fixed Effects: How much of the evidence is from movements in average debt across all countries over time and how much is from movements of debt in one country relative to another? 

In our Quartz column“After crunching Reinhart and Rogoff’s data, we concluded that high debt does not slow growth,” we mentioned, but did not show, what happens when time fixed effects are included in order to isolate what part of the evidence depends on distinct movements in different countries as opposed to movement of debt in many different countries in tandem over time. Surprisingly, with the specification here, even with year fixed effects, we find a positive partial correlation between debt and future growth, for both GDP growth in future years 0 to 5 and GDP growth in future years 5 to 10. (See the two graphs immediately below.) These positive slopes are smaller, however, reflecting the subtraction of the evidence from movements of debt in many different countries in tandem over time.   

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The bottom line is that the only time we ever found a negative partial correlation between debt and future growth—that is, the only time we found a relationship between excess debt and future growth that would result in a negative coefficient in a multiple regression—was when we only controlled for five years of growth when looking at debt and near future growth in future years 0 to 5. When we control for a full ten years of past growth, we get a positive relationship between debt and future growth in both future growth windows and both with and without year fixed effects.

In our Quartz column “After crunching Reinhart and Rogoff’s data, we concluded that high debt does not slow growth,” we wrote 

…the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth.

There, we meant, we could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth in the long run, as indicated by GDP growth from five to ten years later. Now let us amplify our statement to say, as we did at the top:

The two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth for either growth either in the short run (the next five years) or in the long run (as indicated by growth from five to ten years later).   

The most important proviso in this statement is the clause “in the Reinhart and Rogoff data.” 

A key limitation of our analysis: the Reinhart-Rogoff data set may undersample troubled countries. 

In his post “None the Wiser After Reinhart, Rogoff, et al.,” Paul Andrews argues: 

What has not been highlighted though is that the Reinhart and Rogoff correlation as it stands now is potentially massively understated. Why? Due to selection bias, and the lack of a proper treatment of the nastiest effects of high debt: debt defaults and currency crises.

The Reinhart and Rogoff correlation is potentially artificially low due to selection bias. The core of their study focuses on 20 or so of the most healthy economies the world has ever seen. A random sampling of all economies would produce a more realistic correlation. Even this would entail a significant selection bias as there is likely to be a high correlation between countries who default on their debt and countries who fail to keep proper statistics.

Furthermore Reinhart and Rogoff’s study does not contain adjustments for debt defaults or currency crises.  Any examples of debt defaults just show in the data as reductions in debt. So, if a country ran up massive debt, could’t pay it back, and defaulted, no problem!  Debt goes to a lower figure, the ruinous effects of the run-up in debt is ignored. Any low growth ensuing from the default doesn’t look like it was caused by debt, because the debt no longer exists! 


In the light of Paul Andrews’s critique, we want to make it clear that our analysis is about the claim we felt Carmen Reinhart and Ken Rogoff seem to have been making that there might well be a negative effect of debt on growth even for countries that no doubts will repay their debts. That is, the question we are trying to answer is whether there is a negative effect of debt on growth other than the obvious effect that national bankruptcy or fears of national bankruptcy have. 

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