econoblog101

There has been a discussion over the last few weeks about the results of the Reinhart/Rogoff (R-R) book This Time It’s different. Paul Krugman has attacked the result that there would be a 90% “border” of the debt/GDP ratio which, if you step over it, is harmful for growth. Let me just summarize this discussion. First, here is what R-R say in their first post on VoxEU:

The main findings of that study are:

First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP.¹ Above the threshold of 90%, median growth rates fall by 1%, and average growth falls considerably more. The threshold for public debt is similar in advanced and emerging economies and applies for both the post World War II period and as far back as the data permit (often well into the 1800s).

It should be no surprise then that the media mirrors this, like here (funny they don’t mention “Economist Reinhart”):

Economist Rogoff Breaks Down What Happens To Economies That Hit 90% Debt-To-GDP Ratio

Here’s the highlights:
* Less than 90% debt-to-GDP ratios have no significant impact on growth
* Above 90% ratios have a significant impact to growth — with
these countries averaging negative growth

Then, the WSJ interviews Carmen Reinhart and this is what she says (my highlighting):

WSJ: Your research shows that when public debt hits about 90% of GDP, that is almost like a threshold for slow growth. There is some
disagreement about where we are on that spectrum. If you take just
debt held by the public, it is in the 60s. But if you look at all
debt, gross debt, including debt held by government agencies like
Social Security, it’s much higher. Where are we on that spectrum?

REINHART: Debt is debt. We’re very close to that 90%. Other government agencies are holding government debt and netting that out, but in the end the federal government is going to be liable. And gross debt of the federal government still doesn’t take into account the massive guarantees (by government-owned Fannie Mae and Freddie Mac). If anything, 90% is a generous measure.

What the data seem to reveal is that at lower ranges of debt, you
really can’t make a link between debt and growth. But once you hit a
certain threshold, you hit a wall. You can pile on the debt for a
while, and you’re not seen as risky. You can accumulate a certain
amount of debt without a threat to your debt sustainability. But then
you reach a point where that debt sustainability is called into
question. It becomes an issue.

Now Paul Krugman enters the scene and complains about two things:

1. the US data is flawed in the sense that all data points with a debt/GDP ratio of above 90% are from the time just after WWII. This graph, posted at Krugman’s webpages, speaks for itself:

.

2. the international data consists of only three cases:

If I’m reading this right, then the postwar cases other than Japan — which I’ve argued looks like reverse causation — are Belgium, Ireland, and Italy. Are these cases enough to bear the weight now being placed on that supposed 90 percent red line? (source)

So, I think that economist’s should not take it for granted that increasing government debt above 90% has bad consequences for growth per se. Of course, this is just the opposite side of the medal that says: increasing government debt is not always good. However, nobody I have read is making this case.

The result of this discussion is a little bit tricky: increasing government debt can increase growth, if the money is invested well. If it is squandered by the government, stagnation will result. What makes this even more tricky is that even if the money is squandered, short-term growth will result. If lack of demand is the economic problem of the day, more spending will solve it and hopefully lead to a virtuous circle with prices rising and households, firms and governments able to repay what they owe. After all, the market doesn’t care who spends and how it is financed: if you have money, you can buy stuff.