An American economist looks at Europe
By Pedro Schwart
Economists,
especially in Europe, seem to be divided into two irreconcilable camps over the
question of 'growth versus austerity'. From 2008 to 2012, the
talk was all of consolidating public budgets, increasing taxes, closing down or
merging unsafe banks, selling their assets at fire-sale prices, cutting down on
pension and health entitlements, firing public employees, reducing trade union
privileges and opening labor markets to competition—the classic panoply of
measures the IMF used to demand of Third World countries when it moved in to
rescue them. This time and for the Eurozone, the IMF was content to play second
fiddle: the rescuers were Germany and other northern and central European
countries; the peccant countries they had to rescue were those on the outer
fringes of the Eurozone. The expectation was that this hard medicine would bear
fruit at the latest in 2013 and bring renewed growth and employment after four
years of contraction. Unexpectedly, and for reasons we hope to discover
someday, there was a second dip in the recession. Public opinion, especially in
countries suffering from high unemployment, became restless. In despair many
Europeans leaders turned their eyes towards the United States, hoping to learn
the lessons of its money-printing Federal Reserve and bond-issuing Treasury.
The European Central Bank chief Signor Draghi promised to do "whatever it
takes" to save the euro; Signor Monti was dealt a sharp lesson by Italian
voters; the French President and the Spanish Prime Minister demanded
growth-fostering measures to ease public deficit reduction; the European Council
set in progress a program to help employ young people; and the European
Community as a whole launched a plan to better rail and road transport on the
Continent. Frau Merkel was cast into the role of a Dickensian Gradgrind who
wanted everybody to stick to "Facts! Facts! Facts!" The policy
climate had changed.
These moves were
dictated by political convenience, but the change in policy direction was
reinforced by the effect of a scientific dispute that reverberated beyond the
confines of Academia; an econometric mistake committed by Harvard economists
Carmen Reinhart and Ken Rogoff seemed to put the austerity camp in disarray. At
least this is how Paul Krugman, in line with many others, presented his case
for a deficit financed stimulus.
The
Reinhart-Rogoff slip-up
The controversy
went like this. Reinhart and Rogoff (2010) had come to the not-so-surprising
conclusion that an excessive accumulation of public debt tended to reduce the
rate of growth of a country. They went further. They thought they could see a
threshold in the historical series of their sample of countries, whereby a debt
equivalent to more than 60% of GDP in developing economies and of 90% for
advanced economies was accompanied by a non-linear reduction in growth. Though
Reinhart and Rogoff in their paper (2010) allowed for the possibility that the
causation could go from low growth to high debt due to falls in tax revenues,
the implication was that it was debt that led to lower growth when it went over
the threshold of 60% and 90%. This is how, in discussions about austerity versus stimulus,
I myself, along with many others, understood the results.
Three young
economists from the University of Massachusetts, Drs. Herndon, Ash and Pollin
(2013), criticized the Reinhart and Rogoff results regarding debt and growth by
pointing out a number of statistical mistakes which led them to conclude that
"when properly calculated, the average real GDP growth rate for countries
carrying a public debt-to-GDP ratio of over 90 percent is actually 2.2 percent,
not -0.1percent" as Reinhart and Rogoff claimed. More importantly for the
case in hand, "average GDP growth at public debt/GDP ratios over 90
percent is not dramatically different than when public debt/GDP ratios are
lower". (2013, Introduction) The three critics underlined that this took
much of the sting from the arguments (which I used abundantly) against
increasing public debt in a crisis.
As is often the
case, Reinhart and Rogoff were not really the out-and-out defenders of
austerity that they were represented to be. One of the conclusions of their
deservedly famous book This Time is Different (2009) was that
financial crises were always followed by an "explosion" of public
debt mainly due to falling tax revenues, but they did not proceed to link
public debt causally with lower growth. They simply noted that full recovery
from financial upheavals of the kind the advanced world was now suffering
usually took pretty long to arrive.1
Ken Rogoff in fact
was not remiss to call for extraordinary remedies for the recession following
the present crisis. Thus, in December 2008 he prescribed a short burst of
inflation, on the order of 6% for two years, as "extremely helpful in
unwinding today's epic debt morass".2 I personally
would be a much more single-minded budget cutter than Rogoff and less indulgent
with bursts of inflation.3
Enter Paul Krugman
In April 2013
Krugman published an article in theNew York Review of Books with
the title "How the case for Austerity has crumbled". He wanted to put
the last nail in the budget cutters' coffin by pointing to the mistakes of the
Reinhart and Rogoff 2010 article on debt and growth, an article he added with
some exaggeration that "may have had more immediate influence on public
debate than any previous paper in the history of economics". The mistakes
discovered by Hendon, Ash and Pollin seemed to have destroyed the whole case
for austerity as the way to solve the debt crisis. The only means to restart
growth and reduce the weight of the debt accumulated during the crisis was to
finance public expenditure indiscriminately with debt. Krugman also unfairly
accused Reinhart and Rogoff of stark disregard for research ethics for not
sharing their data. I find it difficult to see how Hendon, Ash and Pollin could
have built their case without the Reinhart and Rogoff data. It is a long time
since Krugman gave up research for sensational journalism.
The Reinhart and
Rogoff reply, apart from the polemical fireworks, is interesting in that it
revisits some points from their 2009 book. Number one, recoveries from deep
systemic financial crises "are long, slow and painful". Two,
post-crisis circumstances dictate that debt must be dealt with, but not too
fast. Three, the real danger is not a spike in debt over the 90% threshold, but
in the possibility of "debt overhang". Ironically, it was Krugman who
in 1988 invented the notion of 'debt overhang' as that which a country suffers
when its debt is so large that all the proceeds from national investment are
appropriated by debt-holders. Krugman also seemed to have passed over anEconomic
Perspectives article written by Reinhart and Rogoff with Reinhart's
husband (2012) in which attention was drawn to the fact that when public debt
stayed at levels above 90% of GDP for five years, the overhang phenomenon
lashed in and kept growth levels below the trend for at least ten years in a
majority of the 26 episodes in advanced economies since 1800.
Fallacies
regarding the public debt
The economist who
clarified the question of public debt more than any other was James Buchanan,the recently
deceased Nobel Prize laureate. We need his help to understand why the total
amount of public debt matters for the personal and constitutional welfare of
the residents of a country.
Buchanan's first
book, originally published in 1958 under the title Public Principles of
Public Debt has become a classic of financial theory. He there
overturned the orthodox view of public debt prevalent at the time and still
held by many fiscal theorists today. This orthodox and misguided view he summed
up in three mistaken propositions.
1. The creation of public debt does not involve any transfer of the primary real burden to future generations.
2. The analogy between individual or private debt and public debt is fallacious in all essential respects.
3. There is a sharp and important distinction between an internal and an external public debt. (Buchanan, page 5)
Now, I must be
frank with my readers. Until I carefully re-read Buchanan for this essay I was
one of those macroeconomists who held by these three tenets of fiscal
orthodoxy. I have proclaimed my adhesion to them even in print! I can see now
where the source of my mistake lay: I reasoned as if society was a sentient
being, whose national debt had to be seen as a mere transfer between different
parts and organs of a single entity, governed by an all seeing planner, whose
job is to maximize a social welfare function. Internal debt issues were simple
transfers of funds among parts of the national society. The debt only weighed
on the national welfare when it was due to foreigners.
The Ricardian
equivalence mistake
The first
proposition has the authority of David Ricardo (1817)
behind it. Under certain very strict assumptions, the national public debt is
discounted by individuals as if it were a tax. When individuals are supposed to
care for their descendants as much as for themselves, then it does not matter
whether a war or a public project is financed by taxes or by bonds. In so far
as individuals were rational and their time horizon was infinite, the bond
would be fully discounted by the buyer and equivalent to a tax on his wealth;
the tax-payer would save the full present value of the future service of the
bond. Ricardo himself said that this extreme conclusion was only partially
true, but for him financing a present expense with bonds on the whole did not
shift the burden to future generations.4 Ricardo's
main object was to decry public expenditure in all its shapes and forms, so he
wanted to underline that the way it was financed was of little import.
(Buchanan, 1999, page 81)
Buchanan then gave
an illuminating definition of what 'future generation' really meant.
I shall define a "future generation"as any set of individuals living in any time period following that in which the debt is created. [...] An individual living in the year t0 will normally be living in the year t1but he is a different individual in the two time periods. [...] I shall not be concerned whether a public debt burden is transferred to our children or grandchildren as such. I shall be concerned with whether or not the debt burden can be postponed. (Buchanan, page 28, paragraph 2.4.6.)
It is not how the
moneys are used that matters but the shifting of the burden from one 'generation'
to another. Buying a bond voluntarily is no sacrifice for an individual who
prefers to save a given sum rather than consume it. Neither is it a sacrifice
for the people enjoying the results of the public investment thus financed. The
sacrifice falls on the future 'generation' being taxed to return the funds to
the bond holder. This generation will be different from the original one which
received the benefits and was freed from the obligation to repay.
One conclusion of
this analysis is that the operations of privately and publicly indebting
oneself are strictly analogous except for the fact that in the case of public
debt the burden of repayment may fall on someone who did not have the full
enjoyment of those funds. Whether the funds are well employed or not is
immaterial.
External and
internal public loans
With the present
crisis, the conviction has spread among specialists that foreign debt is more
dangerous and less manageable than domestic loans. For those who conceive of
national societies as wholes, when there is no external creditor, debt is owed
by one part of the social body to another. Buchanan quoted Philip E. Taylor as
saying that
to the extent that public debt is held by citizens of the debtor government, "we owe it to ourselves." [...] If on the other hand the debt is owed to citizens or governments of other societies, payments on the debt represent deductions from national product.5
The question very
properly asked by Buchanan is who is part of the 'generation' having to service
an internal debt, and is he the same as the one who enjoyed the proceeds of the
loan? The fallacy stands out in another quotation of Buchanan's, this time a
passage from Arthur Pigou (1949).
"But interest and sinking funds on internal loans are
merely transfers from one set of people in the country to another set".6 Thank you
very much! Sets of citizens are interchangeable for the all-wise central
planner.
Daniel Gros of
CEPS has tried to show that, empirically speaking, foreign debt is quite
another proposition from domestic debt. As an explanation he adduces that
foreigners do not have the remedy of voting for "the higher taxes or lower
expenditure needed to service the debt." And he proceeds with the usual
remark that in the case of domestic debt "a higher interest rate or risk
premium just leads to more redistribution within the country (from taxpayers to
bond holders)". The case is different for debt owed outside the country;
"higher interest rates lead to a welfare loss for the country as a whole
because the government has to transfer resources abroad." (Gros, page 1)
These are well
rehearsed arguments based on the fallacious idea that it is the country as a
whole and not individuals who service public debts. Dr Gros' paper, however, is
more interesting than most because he has regressed sovereign debt spreads on
current account deficits. He has shown a remarkable correlation indicating that
investors are wary of nations with a high proportion of debt when it is foreign
owned and they show a large current account deficit. Inversely, he notes the
remarkable case of Belgium with public debt nearly equivalent to 100% of GDP
but low spreads throughout the crisis. Even more remarkable and well known is
the case of Japan with the highest public debt rate among advanced nations,
very low interest rates and no financial crisis—rather continuous immobility in
the doldrums.
By reducing the
service of domestic public debt to a question of redistribution between inert
taxpayers and bond holders, the real nature of the problem is hidden from view.
Individual taxpayers and bondholders vote according to their own personal
interest. In this case
... the community must compare one debt form which allows a higher income over future time periods but also involves an external drainage from such income streams with another form which reduces the disposable income over the future but creates no net claims against such income. [...] [With an] external loan [...] income in a future period would be higher than in the internal loan case by precisely the amount necessary to service the external loan. (Buchanan, pages 62-63, paragraph 2.6.15.)
The second case is
an accurate description of the Japanese plight over the last twenty years, with
extra low interest rates and spreads and very little growth.
How much public
debt
The amount of debt
a government will issue is of course related to how much public expenditure is
considered proper. This discussion does not properly belong in this essay,
except to say that the matter of what the state ought to do is usually
discussed from the outside, as if the community were an organic entity with a
single value scale embodied in a social welfare function. "...in this
case", says Buchanan, "the fiscal problem reduces to one of simple
maximization [...] by some omniscient decision maker". This cannot be the
case in a democracy where the process is king.
The task of the expert here becomes that of showing how the decision-making process itself might be improved, how information concerning alternatives can be increased, and how individuals can be presented with "fair" alternatives. (Buchanan, page 119, paragraph 2.12.10.)
We are still left
with the question of how much public debt an economy can sustain. Again the
combination of taxes, inflation and public debt is one to be decided in the
democratic process, with no expert presuming to "play God", as
Buchanan used to say.
We have seen the
extreme case of 'debt overhang'. There are earlier limits to deficits and debt
issue. When replying to Krugman, Reinhart and Rogoff 7 recalled
situations of "debt with drama" which we have witnessed in Europe,
when markets simply ceased to accept sovereign paper and the government found
itself incapable of supplying its services. Whatever Krugman may believe, debt
equivalent to 100% of GDP is in the end unsustainable. Even in the case of the
United States, which enjoys the privilege of being the world's banker, there
may come a moment when raising taxes will not be enough to defend the dollar
and singeing cuts in expenditure will have to be made. There is a limit to the
burden of pensions, health services, and public works that present generations
can leave for later taxpayers, who may refuse to pay the bill. In the end, a
debt is a debt is a debt.
References
Barro, Robert J.
(1974). "Are Government
Bonds Net Wealth?". Journal of Political
Economy, vol. 82, no. 6, pgs.1095-1117. PDF file.
Buchanan, James
(1999). Public Principles of
Public Debt.Liberty Fund, Inc. Online at the Library of Economics
and Liberty.
Gros, Daniel
(2013): The Austerity Debate is Beside the Point for Europe. CEPS
Commentary. Centre for European Policy Studies, Brussels (8 May).
Herndon, Thomas,
Ash, Michael and Pollin, Robert (2013): "Does High Public Debt
Consistently Stifle Growth? A Critique of Reinhart and Rogoff". Working
Paper Series nr. 322 (May). Political Economy Research Institute, University of
Massachusetts Amherst.
Krugman, Paul
(2013): "How the Case for Austerity Has Crumbled". New York
Review of Books (May).
Lerner, Abba P.
(1948): "The Burden of National Debt", in Lloyd A. Meltzer et
al.: Income, Employment and Public Policy. New York.
Pigou, A. C.
(1949): A Study in Public Finance. 3rd. edn., London.
Reinhart, Carmen
M. and Rogoff, Kenneth S. (2009): This Time is Different. Eight
Centuries of Financial Folly. Princeton.
Reinhart, Carmen
M. and Rogoff, Kenneth S. (2010): "Growth in a Time of Debt". American
Economic Review: Papers & Proceedings, nr. 100 (May).
Reinhart, Carmen
M. and Rogoff, Kenneth S. (2013): "Letter to PK" (May 25) Carmen M.
Reinhart Author Website.
Reinhart, Carmen
M., Vincent R. Reinhart, and Kenneth S. Rogoff (2012): "Public Debt
Overhangs: Advanced-Economy Episodes since 1800." Journal of
Economic Perspectives, 26(3): 69-86
Rogoff (2008):
"Inflation Now the Lesser Evil", Project Syndicate.
Footnotes
1. Reinhart and Rogoff (2009), Chapter 14 distill
the following recovery periods from a long history of financial crises. On
average, real housing prices tend to decline by 35% over six years; equity
prices, 56% over three and a half years; unemployment increases by 7% over four
years; output falls by more than 9% in two years; and after the financial
crises of the period after World War II government debt, helped by falling tax
revenues and calls on the public Treasury, tended "to explode" with
average rises of 86%.
2. Rogoff (2008), quoted by Warsh (May 2013).
3. Cf. David Warsh (2013) verdict on Rogoff.
4. This theorem was taken up by Barro (1974) to
show that issuing public debt to use the proceeds for anti-cyclical investment
was useless, since the amount borrowed and spent by the Government to revive a
depressed economy would be fully discounted by the purchaser of the bonds who
would not see them as wealth.
5. Philip E. Taylor, The Economics of
Public Finance (Rev. ed.; New York, 1953), p. 187, as quoted in
Buchanan (1958) page 59, paragraph 2.6.3.
7. Reinhart
and Rogoff (2013).
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