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Bad Results Follow Flawed Reasoning about the Debt-to-GDP Ratio

By       Message Seymour Patterson     Permalink
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When University of Massachusetts at Amherst graduate student Thomas Herndon discovered errors in a paper written by two Harvard economists entitled "Growth in a Time of Debt," the general reaction of dismay prompted the thought in some quarters that ideology runs roughshod over evidential findings. It was apparently very hard for some economists to accept that neoliberal thinking about deficits, as it applies to developing countries, Europe, and America, cannot demonstrate that austerity, Structural Adjustment Programs, or sequestration promote economic growth.

The authors of "Growth in a Time of Debt" are Harvard economists Carmen Reinhart and Ken Rogoff, former chief economist of the International Monetary Fund (IMF). A link to their paper can be found at Growth in a Time of Debt.

In fact, Reinhart's and Rogoff's paper made some commonsense observations that have been ignored in the media. One such observation is that the debt-to-GDP ratio rises quickly in the aftermath of a financial crisis. Policymakers, however, zeroed in on the idea that a debt-to-GDP ratio of 90 percent is detrimental to growth--that is, that it causes slow growth in developed economies. They also stressed the point made by Reinhart and Rogoff that a high debt burden leads to private sector deleveraging, which in turn causes a contraction of the economy.

Another idea picked up on from the Reinhart/Rogoff paper was that, as the economy contracts (a legacy of the 2007-2009 recession), the public debt rises sharply--in part to offset the contraction caused by private sector deleveraging. In turn, the increased public debt causes short-term interest rates to rise, which leads to a further contraction in growth.

Shortcomings in the Reinhart/Rogoff Analysis

In their analysis, Reinhart and Rogoff ignored the role of the Federal Reserve Bank in stabilizing the economy. The easy-money policy pursued by Chairman Ben Bernanke has had the effect of keeping interest rates on government securities low, though this has not translated into making credit readily available to potential borrowers. Two other points made by the Harvard economists are these: (1) "Seldom do countries 'grow' their way out of debt." And (2), there is a causal link between debt and financial crises in the form of a crisis in confidence.

With respect to the first point, it can be argued that it is in fact possible for a country to grow its way out of debt. This is not a frequent occurrence, however, because, over time, the demand for public goods increases. Vote-seeking politicians ignore this demand at their peril.

As to the second point, it might be noted that there is something circular about a financial crisis that causes the public debt to increase, which in turn leads to a crisis in confidence, which then leads to a financial crisis. This makes high debt-to-GDP ratios both the cause and the solution to financial crises. So, is it the high debt-to-GDP ratio, the crisis in confidence, or the financial crisis that causes slow growth? Or all of the above?

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The Major Flaw of "Growth in a Time of Debt"

In attempting to replicate the work of Reinhart and Rogoff, Herndon found that their case for promoting economic growth through spending cuts (deficit reduction) depended on the exclusion of countries that in fact showed rapid growth in the face of high debt. The exclusion might not have been intentional, and might even be excused because "everyone makes mistakes."

What is disturbing, however, is that people who welcomed the findings have an ideological ax to grind. The conclusion of "Growth in a Time of Debt" comports with the ideological prejudices of deficit hawks and confirms what they believe. It has given a certain momentum (enveloped in a patina of research) to the case for spending cuts as the pathway to growth. It should surprise no one that when the data exclusion error is removed, the thesis that countries with debt-to-GDP ratios in excess of 90 percent have negative economic growth falls apart.

Austerity in Europe

Accession to the EU sets the stage for promoting austerity. There are three criteria to join the EU: first, political, which includes democracy, respect for human rights and the protection of minorities; second, economic, i.e. operating a market economy; and third, acceptance of the Community acquis, or ability to assume the obligations of membership.

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There is another piece to EU accession that also merits mention. To become a member of the European Monetary Union (EMU), a country has to meet three criteria as they relate to inflation, government deficit, and government debt.

With respect to inflation, the first criterion the acceding country must meet is an inflation rate that is not more than 1.5 percentage points above that of the three EU members with the lowest inflation rates. The second criterion is that the deficit-to-GDP ratio cannot exceed three percent; and the third is that the debt-to-GDP ratio can be no more than 60 percent.

We know from the Greek experience that there are creative ways around these requirements. For instance, Goldman Sachs for a fee hid Greece's true debt--about 2.8 billion Euros of Greece's debt--by swapping foreign bonds into domestic debt. To do that, G-S used an entirely fictitious exchange rate that made Greece's debt seem less than it really was.

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Seymour Patterson received a Ph.D. in economics from the University of Oklahoma in 1980. He has taught courses and done research in international economics and economic development. He has been the recipient of two Fulbright awards--the first in (more...)
 

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