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The Chicken or the Egg?

Friday May 3rd, 2013   •   Posted by Craig Eyermann at 6:25am PDT   •  

We’re revisiting the academic furor of the Reinhart/Rogoff data controversy today because there has been some new analysis to come out of the debate that seeks to answer a good question: Does a high national debt burden lead to slower economic growth, or vice versa?

Arindrajit Dube of the University of Massachusetts, Amherst, a colleague of the authors of the paper identifying the errors in one of Reinhart and Rogoff’s datasets, took on this question using the repaired data.

With that data, he sought to answer a simple question: “Does a high debt-to-GDP ratio better predict future growth rates, or past ones?”

It’s kind of the economics version of which came first: the chicken or the egg!

Here, if a high national debt burden (national debt-to-GDP ratio) causes slower economic growth, then it would be a good “predictor” for future economic growth rates, which we would see in the form of a declining future GDP growth rates with respect to higher national debt burdens. If a high national debt burden is better at predicting past economic growth rates, then that would be a good indication that poor economic growth is a driving factor that causes a nation’s national debt burden to escalate.

The graphs below illustrate what he found. The chart on the left shows what the recorded range of inflation-adjusted economic growth rates typically were three years after a particular national debt burden was reached (answering the question of “how are future economic growth rates typically affected by high national debt burdens?”), while the chart on the right shows what they were in the three years before a particular national debt burden was reached (answering the question of “Do national debt burdens typically rise because of past poor economic growth?”):


Dube comments on his results:

As is evident, current period debt-to-GDP is a pretty poor predictor of future GDP growth at debt-to-GDP ratios of 30 or greater—the range where one might expect to find a tipping point dynamic. But it does a great job predicting past growth.

This pattern is a telltale sign of reverse causality. Why would this happen? Why would a fall in growth increase the debt-to-GDP ratio? One reason is just algebraic. The ratio has a numerator (debt) and denominator (GDP): any fall in GDP will mechanically boost the ratio. Even if GDP growth doesn’t become negative, continuous growth in debt coupled with a GDP growth slowdown will also lead to a rise in the debt-to-GDP ratio.

Besides, there is also a less mechanical story. A recession leads to increased spending through automatic stabilizers such as unemployment insurance. And governments usually finance these using greater borrowing, as undergraduate macro-economics textbooks tell us governments should do. This is what happened in the U.S. during the past recession. For all of these reasons, we should expect reverse causality to be a problem here, and these bivariate plots are consistent with such a story.

Now, here’s what Dube glosses over in his analysis. In showing the range of values associated with future real economic growth rates in the chart on the left, we observe that the average growth rate still follows a negative trend – for a higher national debt burden, we should still expect that future economic growth will still be slower than it would be than if a nation had a lower national debt burden. Even three years it first attained its high debt burden.

Dube’s analysis also doesn’t tell us what the secret is for getting good economic growth for the nations with high debt burdens that managed to achieve that feat after racking up such high debts. For all we know from the data presented, it could be a post-default recovery, much like what has occurred in Iceland. Or it could be the result of austerity done right, as in Estonia, which was heavily biased in favor of cutting government spending rather than imposing massive tax hikes.

And what caused the most negative post-three year reaction Dube indicates? Could it be the opposite of what has occurred in Iceland or in Estonia? Could government central bank-directed bailouts to stave off debt defaults or imposing massive tax hikes that dwarf any spending cuts (kind of like the tax-hike heavy “balanced” approach that President Obama favors for the United States) be what’s really behind the ongoing economic tragedies unfolding today in Europe’s most debt-ridden nations?

Finally, and perhaps most importantly, the ability of a nation to withstand or recover from a significant economic shock, as visualized by the range of historic real economic growth rates shown in the chart on the right, will depend greatly upon how large its national debt burden is when such a shock occurs. The nonpartisan e21 editorializes:

Higher debt levels increase the required level of future taxation, increase the probability of a financial crisis, and reduce governments’ flexibility to deal with future crises that may emerge. Higher expected future tax rates reduce incentives to invest today. The probability of a fiscal crisis makes investors seek liquidity and safety rather than productive investment. Both factors increase savings, reduce current spending, and slow growth rates. On the last point, it is important to recognize that TARP did not succeed because it was a genius plan with perfect execution. TARP succeeded because federal debt was just 36.5% of GDP at the start of 2008. Had the U.S. entered 2008 with today’s debt level, it is not clear the federal government would have had the capacity to backstop the banking sector. The result would have been a situation similar to the one in Europe, where the weakness of the sovereign and the banking system create a negative feedback loop that reduces credit availability and investment demand. Moreover, the higher the debt level, the more dependent the fiscal authority becomes on the central bank suppression of interest rates. At 1980s interest rates, it would cost more than 10% of GDP to service current federal debt.

That’s much like how an emergency reservoir acts as an important backstop in preventing a community from going up in flames after a massive wildfire breaks out. If a nation has already burned through much of its capacity to borrow at the time it faces an emergency, which is the case for nations with high national debt burdens, then it can reasonably expect to face a debt crisis on top of whatever other economic crisis it is facing.

If the U.S. budget sequester debate has taught us anything, it is that most people won’t even notice when government spending is reduced, a point that has only just recently dawned on the anti-government spending cut crowd.

And that’s why it’s time to go after the excessive government spending that supports the corrupt power structure in Washington D.C. Because no one else deserves to lose more than those people.

Featured Image:
Oak Ridge National Laboratory

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May 2013