What to Take Away From the Reinhart-Rogoff Debate
An academic tussle has rekindled debate over one of the most important economic questions of our time: Are the governments of the developed world -- and particularly the U.S. -- taking on too much debt? There’s no definitive answer, and we’re no fans of austerity in the current economic environment. But it doesn’t take a Nobel laureate to understand that we should be worried.
The controversy centers on work by the economists Carmen Reinhart and Kenneth Rogoff, who found that countries experience slower growth when government debt exceeds 90 percent of gross domestic product. Economists at the University of Massachusetts at Amherst pointed out flaws in one Reinhart-Rogoff paper, including a simple spreadsheet error that artificially made a result look stronger than it was. The critique has been cited as if it debunks the entire academic case for fiscal prudence.
This would be wrong. Whatever doubts one may have about the relationship between debt and growth, and the causal links between the two, the health of government finance is a much bigger issue. Let’s pretend for a moment that the Reinhart and Rogoff result doesn’t hold up. Would we still have reason to be concerned about government debt?
Financial crises, recessions, wars and other expensive events have added immensely to the obligations of rich-world governments over the past few decades. As of the end of 2012, the average gross government debt among advanced nations stood at 109 percent of gross domestic product, up from 60 percent in 1991, according to the International Monetary Fund.
In principle, governments can manage much larger burdens. As long as the interest rate on their debt equals the growth in the dollar value of economic output -- a relationship that tends to hold in the long run -- debt and GDP will increase at the same pace, leaving the ratio constant. All a government has to do is maintain a primary budget balance; that is, make sure its spending (excluding interest on debt) matches revenue. Because governments plan to be around forever, there isn’t necessarily a final due date by which they must pay back all the debt.
Problem is, when governments borrow a lot, the increased demand can push interest rates up. If the rate exceeds the pace of GDP growth, the level of debt becomes a concern.
Consider, for example, a differential of one percentage point. A country with a 50 percent debt-to-GDP ratio would have to run a primary budget surplus of 0.5 percent of GDP to keep its debt burden from rising -- well within what most governments have been able to achieve in the past. Raise the debt ratio to 200 percent, and the required primary surplus increases to 2 percent of GDP. That’s a level of belt-tightening the U.S. has achieved in only 25 of the past 200 years.
In a 2010 paper, a group of IMF economists sought to identify the thresholds -- or “debt limits” -- beyond which countries would have to engage in unprecedented austerity to keep the debt burden from getting out of control. They found that Greece and Portugal, which both had to accept bailouts, were well within the danger zone. They estimated the limit for the U.S. at 183 percent of GDP. The country’s gross general government debt, which includes states’ debts and money owed to the Social Security trust fund, currently stands at about 107 percent of GDP.
It’s best to stay well below the limit. The closer a country gets to that line, the greater the chance that markets will lose confidence in its creditworthiness. Such market concerns tend to become self-fulfilling as investors demand ever-higher interest rates to compensate for the risk, or even stop buying a government’s bonds altogether.
Countries such as the U.S. and the U.K. might have a bit more leeway, because they issue debt in currencies they control. If they printed more money, the resulting inflation would reduce their debt ratios by increasing the dollar value of GDP. Inflating away debts, though, works only to the extent that it surprises investors. As soon as bond buyers catch on, they’ll demand higher interest rates on new issues to compensate for the expected inflation.
In short, whether or not Reinhart and Rogoff are right in saying that high debt levels impede growth, the case for avoiding them remains strong.
This doesn’t mean that austerity is always the answer. Raising taxes and cutting spending in a deep recession tends to succeed only in raising the debt-to-GDP ratio, as some European countries are learning. Similarly, now would be an excellent time for the U.S. to make stimulative investments in education, research and public-works projects. With interest rates low and unemployment high, the added spending could boost the economy without increasing the government’s debt burden -- as explained in a 2012 paper by economists Bradford DeLong and Lawrence Summers.
Short-term stimulus would present a threat only if it undermined market confidence in the government’s ability to manage its debts in the long term. To that end, it’s crucial that the U.S. present a credible plan to close the large gap between its projected spending -- mainly on Medicare and Social Security -- and the tax revenue it can reasonably expect to receive. So far, Congress has been doing precisely the opposite, imposing immediate cuts in discretionary spending while failing to address the country’s long-term fiscal gap.
May wiser minds prevail before we reach the point where government debt becomes a serious problem. It’s hard to know exactly where that point is, and vital that we never find out.
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