It Takes Two to Tango: A Look at the Numerator AND Denominator
This is a guest contribution by Marshall Auerback, Braintruster at the New Deal 2.0
by Marshall Auerback
A new book by Kenneth Rogoff and Carmen Reinhart, “This Time It’s Different: Eight Centuries of Financial Follies”, has occasioned much comment in the press and blogosphere (see here and here)
The book purports to show that once the gross debt to GDP ratio crosses the threshold of 90%, economic growth slows dramatically.
But that’s too simplistic: a ratio is just a number. Debt to GDP is a ratio and the ratio value is a function of both the numerator and denominator. The ratio can rise as a function of either an increase in debt or a decrease in GDP. So to blindly take a number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent work, is unduly simplistic. It appears that they looked at the ratio, assumed that its rise was due to an increase in debt, and then looked at GDP growth from that period forward assuming that weakness was caused by debt instead of that the rise in the ratio was caused by economic weakness. In other words, they have the causation backwards: Deficits go up as growth slows due to the automatic countercyclical stabilizers.They don’t cause the slow down, etc.
After the Second World War, the debt ratio came down rather rapidly—mostly not due to budget surpluses and debt retirement but rather due to rapid growth that raised the denominator of the debt ratio. By contrast, slower economic growth post 1973, accompanied by budget deficits, led to slow growth of the debt ratio until the Clinton boom (that saw growth return nearly to golden age rates) and budget surpluses lowered the ratio.
From 1991 through 2001 the growth of government debt had been falling and since then rising most recently at a faster pace. The raw data comes courtesy of the St. Louis Fed (and attached spreadsheet).
The Ratio of the rates of change of Debt / GDP is rising faster than the change in Debt indicating that both the increase in Debt and the fall in GDP are contributing to a rising Debt / GDP ratio. For policy makers who obsess about a rising Debt / GDP ratio, they fail to understand that austerity measures that cut GDP growth will cause a rise in the Debt to GDP ratio. Basically, it boils down to this simple observation: it is foolish, dangerous, and thoroughly counterproductive to treat fiscal balances in isolation. In particular, setting a fiscal deficit to GDP target equal to expected long run real GDP growth in order to hold public debt/GDP ratios at a completely arbitrary (indeed, literally pulled out of thin air) public debt to GDP ratio without for a moment considering what the means for the feasible range of current account and domestic private sector financial balance is utterly nonsensensical.
It is crucial that investors and policy makers recognize and learn to think coherently about the connectedness of the financial balances before they demand what is being currently called fiscal sustainability. As it turns out, pursuing fiscal sustainability as it is currently defined will in all likelihood just lead many nations to further private sector debt destabilization. To put it bluntly, if the private sector continues to pursue a high net saving/financial surplus position while fiscal retrenchment is attempted, unless some other bloc of nations becomes large net importers (and the BRICs are surely not there yet), nominal GDP will fall in the fiscally “sound” nations, the designated fiscal deficit targets WILL NEVER BE ACHIEVED (there can also be a paradox of public thrift), and private debt distress will simply escalate.
In fact, if austerity measures are based on measures of debt relative to economic growth there is a very real risk of a downward spiral where economic growth declines at a faster pace than government debt and the rising Debt / GDP ratio leads to ever greater austerity measures. At a minimum, focusing only on the debt side of the equation risks increasing the Debt / GDP ratio that is the object of purported concern is likely to lead to policy incoherence and HIGHER levels of debt as GDP plunges. The solution is to recognize that the increase in the ratio is in some fair measure the result of declining economic growth and that only by increasing economic growth will the ratio be brought down. This may cause an initial rise in the ratio because of debt financing of fiscal stimulus but if positive economic growth is achieved the problem should be temporary. The alternative is to risk a debt deflationary spiral that will be much more difficult (and costly) to reverse.
This article is crossposted with News N Economics
Let me ask the same question I asked at Worthwhile Canadian Initiative. Even assuming the household-government budget analogy, why worry about the debt/GDP ratio? Why not the interest_payments/GDP ratio? (Which is more like the householder’s rule of thumb.)
Marshall, point very well taken.
The need for pro-growth progressive policies is more dire than ever as we struggle to dig ourselves out after thirty years of faux-growth malfeasance. (Partially excepting six years or so under Clinton..)
Good to see Auerbach linked to over here. I’ve been hoping he, Randall Wray, Bill Mitchell, Warren Mosler or Scott Fullwiler would start getting some face time over here.
These are the guys that need to lead our economic discussions. Their clear headed, accounting based, non ideoogic analysis is just what is needed now.
Chartalism is what they study (neo chartalism maybe) and it needs to be understood by the AB crowd.
“So to blindly take a number, say, 90% debt to GDP as Rogoff and Reinhart have done in their recent work, is unduly simplistic.”
I would like very much to find Auerbach reliable, because I like his thesis. He shows himself to be unreliable, though, in the bit of salesmanship quoted above. Rogoff and Reinhart didn’t publish a WSJ-editorial length claim that 90% is a magic number. They wrote a book. They also wrote a paper by the same name on the same subject using much of the same material, published in 2008 – time enough for serious professional comment.
So, the point is, there wouldn’t be much need for the other 495 pages of the thing if all they had done was “blindly” and “simplisticly” tout a magic 90% number. In fact, they differentiate between advanced and not-so advanced economies, look at the impact of commodity price swings, note that the US seems to be a special (and perhaps more dangerous) case among OECD countries.
I really don’t know why people try to sell their own views by offering a pretense about the views of others. The 90% thingie is an empirical observation. Those of us who like to base our thinking on facts instead of adjectives and adverbs chosen for their damaging effect think empirical observations are good things.
I would urge Auerbach to criticize Rogoff and Reinhart on the same level that Rogoff and Reinhart have written. Look at the data, look at the methodology, and leave the clever, dismissive chat to trolls.
I havent read the book and I have no intention either but I do know that Rogoffs book can rightly be lumped in with other “deficit terrorists” who completely misunderstand (or sometimes intentionally obfuscate) what a govt debt is.
To call all govt debts of 90% the same is madness. If I have an economy with a gold standard and need to acquire gold in order to issue more currency I have an operational constraint that is real. No gold no currency. If I borrow under this system I damn well have to acquire some gold at some point in able to pay the loan back. Looking at an economy that needs to acquire gold either by trade or by mining it leads to some very real constraints on debt accumulation.
Pegging your currency to another (like Argentina did decades ago) gives you the same REAL operational constraints and puts a different light on debt accumulation. Being part of a currency union like the Euro nations are is just like being a state in the US. You have very real restraints because you cant simply issue the amount of currency you need.
Comparing any of these situations to the US, China, Japan, Canada, GB or Aust is not only wrong, its ridiculously wrong. That is EXACTLY what Rogoff is trying to do. He is saying essentially that all currency situations are exactly the same and operate under the exact same limits, according to HIS calculations, which is NONSENSE. Japans debt to GDP ratio has been over 90% for a long time.
I would urge you to look at a lot more of Marshall Auerbachs pieces before you call him unreliable.
You might find that Rogoff is the one that needs to be dismissed.
So, haven’t read the book, but you know it’s OK to lump Rogoff in with other “deficit terrorists”? I’m as likely to listen to your “urging” as I am to win the lottery.
Yes, to lump all countries with a 90% debt ratio together, for purposes other than launching into a more discrimating sort analysis, would be nuts. But, since you haven’t read the book, YOU DON’T EVEN KNOW IF THAT’S WHAT R/R DID! I might add that, since my point was entirely based on the assertion that R/R did not merely lump all 90% cases together, your response to me suggests that you not only failed to read R/R, but also failed to read what I wrote. Or failed to understand what you read.
Please, please don’t bother responding if you are going to stick to the “don’t know and don’t need to know” view of the facts. I’m trying to raise the standards around here.
I dont have to read his book to know that the whole premise of some sort of magic debt threshhold is specious. It doesnt exist. Looking at govt debt only is equivalent to you only looking at someones income only while trying to evaluate their net worth.
You do need to read more of Auerbach, Bill Mitchell, Randall Wray and Warren Mosler if you want to see why the Rogoffs should be (mostly) ignored. There is a lot of misinformation about govt debts out there and its not helping.
You started off by calling Auerbach un reliable when you know nothing of him. You acted as if the only proper critique to a 495 page book is another 495 page book.
PLEASE …… DO try and raise the standards here!!
Just to note. Debt to GDP is distorted by the fact that Social Security surpluses score as Public Debt. Even if the Bush tax cuts had not passed total Public Debt would have grown by $150 billion a year from Social Security surpluses alone. Off the top of my head this would not have actually made debt to GDP ratio still go up but the offset would have been substantial.
Under Social Security’s Low Cost Alternative the Trust Funds would due to cash surpluses and compound interest would by 2085 balloon to $110 trillion. Which under the rules in play would score as that same amount of Public Debt.
Only one of the paradoxes built into Social Security accounting, the up is down piece is often bewildering.
In 2000 Clinton ran a Unified Budget Surplus of (from memory) $235 billion. Yet total Public Debt subject to the limit went up. You could look it up.
Ah, the trick of conveniently missing the point. As I noted, If you didn’r read the book you don’t know if the accucation Auerback made is true. I, who have read it, am telling you it isn’t true. You then repeat, absent any knowledge whatsoever, that it is . What an idiot.
We don’t need to speculate on what Rogoff wrote in his book. Bill Mitchell read the book and clears it all up for us here. Greg’s right, as it turns out. http://bilbo.economicoutlook.net/blog/?p=8322