Friday, April 19, 2013

The Reinhart – Rogoff Study Controversy

The Study and its Critics

By Pater Tenebrarum
In 2010, Carmen Reinhart and Kenneth Rogoff released an empirical study entitled 'Growth in a Time of Debt'. After crunching a long list of historical data series, they came to the conclusion that:
“..median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower." Countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate, in fact.”
Our first objection to the sentence above is that 'GDP' is a very poor 'measure' of economic growth in the first place. It omits the entire production structure preceding the final goods stage ex 'durable' capital investment; it uses 'hedonic indexing' in its calculation; and it actually counts government spending as contributing to 'growth'. A more useless economic statistic is really hard to imagine as far as we're concerned.
We suspect that in an unhampered free market economy no-one would get the absurd idea of going to the trouble of actually calculating it or something akin to it. The main reason why governments calculate such data is that they need a justification for meddling with the economy. Also, macro-economists need something to do. Again, in an unhampered free market economy many of today's macro-economists would have to compete in the private sector and offer skills to employers that are useful, or alternatively become entrepreneurs themselves and create products consumers actually want. It is a good bet very few consumers would be eager to purchase 'GDP' calculations.
It is quite different with the government – hence the intellectual output of most of today's economists, indeed of most intellectuals, is, to quote Hans-Hermann Hoppe, 'viciously statist'.
Reinhart and Rogoff are not outside of the mainstream – by dint of being monetarists, they are merely as close to free market thought as one is today 'allowed' to be by the establishment. In the 1940s, the Chicago School was regarded as part of the 'leftist fringe' (Hoppe), today they are considered the standard bearers of 'conservative economic thought', as evidenced by the fact that the Republican party cited their study frequently when urging to lower the deficit.
Now, we actually believe that Reinhart and Rogoff have detected a number of effects in their study that are very real and we also believe that cutting deficit spending would be an agreeable policy. In fact, doing away with the State altogether would be the most agreeable policy of all (it would be the very last act of 'public policy'), but let's not stray too far from the topic at hand.
Recently a number of economists based at the University of Massachusetts (a state that is incidentally also known by the nickname 'Taxachusetts') have taken a closer look at the study and discovered a few spreadsheet errors, weighting biases and coding errors (apparently nothing major that would actually invalidate the study's main conclusions, as the response of Reinhart and Rogoff indicates). In the wake of this discovery,  the 'howling of the Keynesians' immediately ensued. Even an at first glance fairly objective report on the errors discovered at the 'Roosevelt Institute' exudes, as a friend of ours put it, a 'strong Keynesian smell' – as evidenced by quotes such as this one:
 “The debt needs to be thought of as a response to the contigent circumstances we find ourselves in, with mass unemployment, a Federal Reserve desperately trying to gain traction at the zero lower bound, and a gap between what we could be producing and what we are. The past guides us, but so far it has failed to provide an emergency cliff. In fact, it tells us that a larger deficit right now would help us greatly.”
If one simply googles the term 'Reinhart-Rogoff study' one is greeted with links to a plethora of articles from an assortment of the usual suspects who are practically foaming at the mouth with the opportunity to argue for more government. That is after all what increased deficit spending amounts to in the end: more government.
In that sense it is quite unfortunate that they made these errors. We're not big fans of the Republican party and we think the only reason why it has rediscovered its inner fiscal conservative at all is the fact that the administration is run by a Democrat. No Republican administration has ever missed an opportunity to increase the deficit be leaps and bounds after all. However, things are what they are now, and the study provided deficit hawks with useful ammunition. This weapon has now been blunted.
Economic History vs. Economic Theory
Economics is a social science, not a natural one. That does not mean that there are no economic laws, only that economic history – which is what all such empirical studies actually examine – is subject to so many different variables that no economic laws can be derived from it. On the contrary, the proper approach is the other way around: one first needs to construct a rational, logically sound economic theory which one can then employ to parse the events of economic history.
Historicists have denied that there exist any time-invariant, universally valid economic laws at all. According to them,  economic laws are different from one historical epoch to the next, as well as between different cultures. They never provided any details as to how and why economic laws were precisely changing  and the starting point of their deliberations was always the collective, not the individual. They imbued the collective with a 'will', as though it were an independent, thinking entity, existing apart from its constituents.
Their ideological cousins of the Marxist persuasion even denied that there exists a single type of human reason or logic: according to Marx, there is 'proletarian logic' and the logic of the 'exploiters'. Marxists also believe (or believed at any rate) that history is predetermined, guided by the Hegelian 'Weltgeist' and striving toward the 'end of history' when communism would be established worldwide as the inevitable end point. No further improvement would be possible.
Economics is the study of human action – as such it is a branch of what Mises called 'praxeology'. Unless one believes what the historicists believed, or what the Marxians say about logic, it should be clear that deductive reasoning is how  economic laws can be discovered. There is not a single statement in economic theory that cannot be formulated verbally. Mathematics and statistics are useful in the natural sciences, in the study of inanimate objects. Its popularity in economics nowadays is entirely misguided; it is an attempt to make economics more like physics and its proponents are mainly empiricists. In other words, they are putting the cart before the horse.
Econometricians insist that economics should be able to 'make predictions' and that this sought after predictive power should be discoverable by studying the economic data of the past. If e.g. 'after A happened, B happened', then it follows that, 'B follows A', or 'A must be the cause of B'. If one then, after observing A, forecasts that B will happen next and C happens instead, one merely needs to go back to the drawing board and give it another try. In the meantime though this should of course not detract from giving interventionist advice to 'policymakers' based on all these predictions that may or may not come true. By all appearances, many decades of utter failure have still not  managed to convince the proponents of such fallacies that this approach may actually be flawed. Just read the Fed minutes, which contain the 'staff reports' and the predictions derived from them that then inform the 'scientific' monetary policy of the central bank. As we have recently suggested, they would actually do better by simply analyzing their own laugh track and using it as a contrary indicator.
Our point is this: we think Reinhart and Rogoff have indeed discovered real effects, but it wouldn't have been necessary to engage in such a study in order to do so. When considering deficit spending and its effects, there are a number of things one can conclude without requiring a single shred of 'empirical evidence'.
For one thing, high deficit spending introduces a degree of 'regime uncertainty'.  Higher deficit spending is regarded as deferred taxation by actors in the private sector, and rightly so. It will therefore not prompt people to start to invest or spend. On the contrary, it will prompt them to become even more frugal until it is clear how repressive future rates of taxation will turn out to be. It seems hardly necessary to study the past of scores of countries to come to that conclusion, although as far as we are concerned, it should be no problem at all to find the empirical evidence if one is so inclined (a quick glance in the direction of Japan should be quite revealing in this context). This effect was very likely a major element of the high deficit spending/high public debt  episodes of the past R&R have looked at. They may well have detected this effect.
Furthermore, if one argues in favor of more deficit spending, one must not lose sight of a number of important facts:
1.     The government possesses no resources of its own. It must take every cent it spends from the private sector, whether by borrowing, taxation or inflation.
2.   Given the above fact, the question arises why anyone should believe  spending by government bureaucrats to be preferable over spending by private sector agents. The categories of profit and loss are meaningless for bureaucrats; not a single cent they spend is spent with opportunity costs taken into account. For the most part such spending is therefore a waste of scarce resources (empirical evidence for the latter assertion is so abundant and glaringly obvious, that it hardly seems to require a study either).
3.   Based on the second consideration, we can conclude: government spends according to political and not economic considerations (favored cronies are often recipients of its largesse, and often plainly uneconomic projects are subsidized).  Although contrary to what happens in a classical credit expansion process, deficit spending may not lead to an intertemporal distortion of the economy's production structure, the effect of such spending will still be to leave us with a production structure that is not in accordance with the wishes of consumers. It must ipso facto represent malinvestment of capital. That cannot possibly improve the economic situation.
Conclusion:
The critics of the  Reinhart-Rogoff study are barking up the wrong tree. There can be little doubt that the study contains the errors that its critical examination has recently revealed – after all, the authors of the study themselves don't deny it. However, it is incorrect to conclude that therefore, deficit spending is just fine, and we should thus have more of it. In order to determine what the critical flaws of deficit spending by government are, it is not necessary to pursue 'empirical studies'. Common sense and the application of causal-realist economic thought should suffice.
Addendum: Ludwig von Mises on Government Debt
And finally, here are a few words by Ludwig von Mises on the topic of government debt (from Human Action): 
“There are in this world no such things as stability and security and no human endeavors are powerful enough to bring them about. There is in the social system of the market society no other means of acquiring wealth and of preserving it than successful service to the consumers.
The state is, of course, in a position to exact payments from its subjects and to borrow funds. However, even the most ruthless government in the long run is not able to defy the laws determining human life and action. If the government uses the sums borrowed for investment in those lines in which they best serve the wants of the consumers, and if it succeeds in these entrepreneurial activities in free and equal competition with all private entrepreneurs, it is in the same position as any other businessman; it can pay interest because it has made surpluses.
But if the government invests funds unsuccessfully and no surplus results, or if it spends the money for current expenditure, the capital borrowed shrinks or disappears entirely, and no source is opened from which interest and principal could be paid. Then taxing the people is the only method available for complying with the articles of the credit contract. In asking taxes for such payments the government makes the citizens answerable for money squandered in the past. The taxes paid are not compensated by any present service rendered by the government's apparatus.
The government pays interest on capital which has been consumed and no longer exists. The treasury is burdened with the unfortunate results of past policies.”  

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