The bogus case for fiscal stimulus
A response to the critics of Reinhart and Rogoff’s theory on public debt and growth.
The amount of ink that has been shed on the so-called methodological errors and data omissions of Reinhart and Rogoff (R&R) is rather astounding. These two Harvard professors wrote a paper about two years ago equating higher levels of public debt with lower growth. They came up with an empirical threshold of 90 percent of GDP for public debt above which, growth drops precipitously. The big deal is that economic growth does not fall off the cliff once the public debt level reaches a threshold of 90 percent of GDP, as they had suggested. Apparently, they had made several errors – both in selective use of data and in their methodology. Some professors from the University of Massachusetts in Amherst have outed them thus.
It is, perhaps, an expression of schaudenfreude on the part of many that has found expression in their gleeful repudiation of the conclusion that R&R put out.
It is convenient that ‘Austerians’ is closer to ‘Austrian’, a school of economics that is anathema to the so-called mainstream economists because it challenges their assumptions and theories. Hence, an all-out attack on ‘Austerians’ gives the so-called pro-Keynesians an opportunity to have a go, indirectly, at the Austrian school too. Two birds in one stone!
Check out the critiques/articles:
The gentlemen who wrote the research paper, finding holes in R&R’ work, penned an Op-ed in the Financial Times: In fact, since 2009, the US government’s interest payments on debt have been at historically low levels, not historic highs, despite the government’s rising level of indebtedness. This is precisely because the US Treasury has been able to borrow at low rates throughout these high deficit years. We are not suggesting that governments should be free to borrow and spend profligately. But government deficit spending, pursued judiciously, remains the single most effective tool we have to fight against mass unemployment caused by severe recessions
In the Atlantic: But austerity doesn’t just have a math problem. It has an image problem too. Just a week ago, Reinhart and Rogoff’s work was the one commandment of austerity: Thou shall not run up debt in excess of 90 percent of GDP. Wisdom didn’t get more conventional…But now austerity doesn’t look so conventional. It looks like the punch line of a bad joke about Excel destroying the global economy. Maybe, just maybe, that will be enough to free us from some defunct economics.
Martin Wolf in the Financial Times: Stimulus is merely not always wrong, as “austerians” seem to believe…The issue here is not even the direction of causality, but rather the costs of trying to avoid high public debt in the aftermath of a financial crisis…Others with room for manoeuvre, such as the US and even the UK, could – and should – have taken a different course. Because they did not, recovery has been even weaker and so the long-run costs of the recession far greater than was necessary. This was a huge blunder. It is still not too late to reconsider. Surprisingly, “Free Exchange” in The Economist did not sound so triumphalist as one would have expected, given the blogger’s well-documented bias for stimulus and more of it and in all forms.
Gavyn Davies wrote the best comment on the entire controversy, in my view. He was far too reluctant to join the campaign of running down R&R.
Anders Aslund of the Peterson Institute defends R&R in the Financial Times. He correctly points out that the Professors at the University of Massachusetts do not repudiate the broader conclusions reached by R&R. Contrary to the dismissive criticism of such a defence, the conclusions broadly remain intact.
His colleague, Adam Posen, did little to conceal his contempt and glee in his Op-ed in the Financial Times. Consider a few gems from his piece: Certainly, academics who oversell their conclusions to get their lines into a speech or to come up with a rule that can be named after them can become disproportionately influential…Yet, eventually, the truth will out – as it did this week… High quality global journalism requires investment… Every time that the truth does emerge from the data, a few more researchers and officials find something lasting. This process of intellectual attrition took a long while to convince policy makers that trade protectionism is harmful, and that adherence to the gold standard is ill-advised. But we have now reached a state of public debate where only the obviously self-interested advocate the first and only the obviously loony defend the second.
Wolfgang Muenchau, in the Financial Times: The reduction of everything to a single number was followed by an exaggeration of the impact. Causation could go from high debt to low growth, as the authors suggest; or the other way round; or in both directions. Or the relation might be spurious. Or something altogether different might cause both. If causality is the other way round, the story is much less exciting for someone who peddles economic policies. You might as well say: people are poor because they have no money. If your growth is negative, your debt ratio rises for the simple reason that it is expressed in terms of nominal GDP.
There is another gloating article in the Washington Post about how austerians have always used bad data. The author makes no attempt to hide the political opponent he is aiming at, with his comment.
Now, let us respond to the critics of R&R.
One, regardless of whether R&R were correct, there is a need to balance short-term growth compulsions vs long-term costs of fiscal expansion. It is a burden, a legacy left for future generations. Hence, greater care and circumspection in advocating one or the other are required.
Two, it is important to determine, first, if growth slowdown was a consequence of a crisis or if the crisis merely exposed the unsustainability of the previous growth performance. If so, trying to restore status quo ante will make economies revisit the crisis again and again.
Three, the issue of causality is laughable. Yes, initially causality will run from slow growth to high debt. As growth slows, governments use fiscal policy, deficits are run and the stock of debt rises. Given the episodic nature of this relationship, the magnitude of causality that runs from slow growth to high debt might be stronger than the one that runs from high debt to lower growth later. Further, the causality might be strong from slowing growth to high debt but it does not take away the point that a high debt and the consequent fiscal drag reduce average growth rates over a longer period.
Four, R&R did not posit a theory. They documented an empirical fact that growth slows after public debt reaches a certain threshold. They might have said that it fell off the cliff. But, that is because, as the UMASS Amherst authors point out, they might have omitted some data from New Zealand in the 1940s. The interesting point is that, directionally, the Amherst professors do not find anything different. It is not as though growth accelerates. Growth does slow. The magnitude, while not so dramatic as originally suggested, is still sizable and significant. The Amherst (my alma mater) professors fail to acknowledge that.
Five, Northern Europe, led by Germany, was pre-disposed towards austerity because of German aversion to profligacy of either the monetary or fiscal variety. R&R might have provided them intellectual cover but they certainly were not the inspiration. Implied criticism that R&R put the world through an unnecessary and prolonged stagnation is utterly dishonest.
Six, Northern European countries like the Netherlands and Finland (and also France) were not subject to austerity conditions. Yet, their economies too have slowed. There is a general growth malaise because the growth rates of the 1990s and 2000s were built on debt, in large part. Other contributors were low-cost manufacturing from China, some delayed effects of advances in information technology made in the 1990s and lower commodity prices, particularly in the 1990s. Those drivers were exhausted and hence, the question is whether more fiscal stimulus would have simply amounted to pulling on a string.
Seven, Europe is ageing and, in some cases, as fast as Japan, if not faster. Hence, their potential growth will drop gradually over time. That will hurt tax revenues of the government. Government deficit and debt will be slow to come down. Risk premium might remain high and hence exert a drag on private activity. Thus, Europe, in particular, had valid reasons to set the bar higher, for engaging in fiscal stimulus.
Eight, regardless of whether it is public or private debt, the greater the stock of outstanding credit in the economy, the lower the output effect of a marginal unit of credit. China’s case is the classic example. Its successive credit injections have produced diminishing output gains. In general, fiscal policy is useful for influencing structural growth drivers while monetary policy is supposed to deal with short-run fluctuations in demand. When fiscal policy is called up on to address short-run growth constraints, one must be aware that one is using a blunt instrument. Nor will it be clear, until much later, as to how much shifts it happened in the behaviour, expectations and plans of the private sector. Simply put, it might have merely substituted for private sector.
Nine, of course, knives will be sharpened after reading the seventh point above. Critics would shoot back that the case for government stimulus exists only because the private sector is down and out. Yes, ‘animal spirits’ become weak. But, as history has demonstrated in the case of sovereigns and in the case of corporations, goading people into action depends on making them optimistic about future. That is not necessarily dependent on the government spending money. It has the potential to backfire too, if people worry about their future tax and other burdens. Inspiring leadership including setting personal examples can inspire people out of their stupor. The key is to stimulate economic activity. The key is not government spending.
Ten, fiscal policy being blunt, its impact will not be on the most affected and vulnerable sections of the public. Vocal and assertive interest groups will garner public resources even as they get away with destroying private shareholder wealth, creating a crisis in the first place. Fiscal stimulus is usually unaccompanied by fixing of responsibility and accountability. It has not happened in the US or in Europe, this time. One without the other is incomplete and distortionary. It distorts private incentives and penalties.
Eleven, recent history is that monetary stimulus is not fully withdrawn. Policy is asymmetrical. Rates are cut and monies are printed eagerly and easily but they are not withdrawn equally eagerly. Political and other pressures come in the way. No one wishes to spoil the party, even if the party has gone on for too long and has become wild, endangering the partying members themselves. There is no guarantee that a similar attitude will not be adopted in the case of fiscal stimulus.
Twelve, Japan might have been slow with monetary stimulus in the 1990s (it might not have mattered, even if monetary stimulus had been applied earlier) but it did spend government money generously. The Liberal Democratic Party (LDP) was known for that. They had very little to show for it, in the face of de-leveraging and then due to a steady to accelerating decline in the working age population. Hence, the record of Japan with fiscal stimulus is more relevant for Europe than the pro-stimulus camp would care to admit.
Thirteen, Fiscal austerity has not apparently resulted in a rise in government borrowing costs. Theorists should not only be intelligent but should also accept that their audience to be intelligent. The pro-stimulus folks do not remember both. If governments print money with one hand and buy their own bonds with the other hand, why should rates rise? It is a mockery of free market. Where such practices are not done and yet, where bond yields are dropping, then the question to ask if the deflationary impulse is too powerful to be resisted by wasting fiscal efforts. Let us also remember that intervention too has to be timed, to be effective. That is what Robert Rubin used to say about FX market interventions.
Fourteen, the pro-stimulus camp is also very disingenuous about the absence of inflation. It is everywhere except in the official CPI because, regardless of whether the public substitutes cheaper goods and services for expensive goods and services, statisticians assume that to be the case and adjust CPI down accordingly. Asset bubbles are nothing but inflation too. Is that good inflation and hence not considered as relevant? History – recent or distant – has shown them to be dangerous and undesirable.
Repeat after me: Stimulus measures have already produced the kind of inflation that history has shown to be dangerous and undesirable.
Moreover, there may not be inflation now because velocity of circulation of money might be low. When it picks up, the stock of money should be reduced proportionately. There are good chances that it won’t be. Particularly in the U.S. Inflation would then pick up. If one pours fiscal oil into the fire, then let us see how inflation flames leap up. It is too soon and too flawed to claim victory on the inflation front.
Fifteen, it is four years since unprecedented fiscal, monetary and accounting stimulus measures were unleashed in the Western world. If all that they have to show for these unconventional and unprecedented measures are asset bubbles and not economic and employment revival, intelligent, honest and humbler folks would question the medicine too as much as they advocate downing more of it into the patient.
Sixteen, on that medical note, one can simply state that a patient suffering from the after-effects of over-eating and indigestion is not given more food. He is asked to fast and given minimal nourishment to keep the body functioning. That is the equivalent of minimal, targeted stimulus while the necessary private sector adjustment happens simultaneously. Then, when he is ready to resume normal eating, the doctor advises him not to go back to his indiscriminate eating habits. That is the accountability part. The case for fiscal stimulus for the economy fulfills none of these above conditions. In short, fiscal stimulus should be limited, have an expiry date and targeted. It should allow real adjustment to be completed and not impede it.
And finally, an antidote for Mr Posen’s venom on the proponents of Gold Standard:
Discretionary policy-making was thoroughly discredited in 2007-08. Policymakers have either been influenced or corrupted or co-opted by special interests. There is no guarantee it won’t happen in future. It is a human failing and more acute, in the case of countries with fading fortunes. Everyone wants to loot the maximum for themselves because the pool of wealth is no longer growing but shrinking. That is why inequality widens. Hence, the call for a “gold standard” is a call for fetters on policymakers and their discretionary powers. It is a call for an alternative policy framework in which economies and systemic stability would not be captive to the tunnel vision and group think of academic-economists and their policy-making counterparts, focusing too narrowly on the discredited and abused consumer price index. It does not have to be the “Gold Standard” of yore but something that would keep hubristic policymakers and arrogant academic-economists leashed.
In the Indian context, the ‘crowing’ of the pro-stimulus camp could not have come at a worse time as the government prepares to unleash the Food Security Programme on the nation. The government could dismiss the 90 percent threshold (India’s gross public debt is very close to it, if not over it) as irrelevant and embrace fiscal stimulus in addition to its obsessive clamour for monetary stimulus. Election compulsions combined with defective economics could be very toxic for India.
Anantha Nageswaran is the Fellow for geo-economics at the Takshashila Institution.