DEBUNKING REINHART & ROGOFF

I am not sure if one single paper has ever received so much press as the Reinhart & Rogoff paper that concluded that the 90% threshold for public sector debt:GDP was the death knell for growth.  They also co-authored a book called “This Time Is Different” which had the same conclusions.  There are some basic misunderstandings of the monetary system that are clearly evident in the research.  The apples to oranges comparisons between the USA and Europe are most evident and renders the paper highly flawed in my opinion.  Additionally, this research has been debunked by Randall Wray and Yeva Nersisyan, but just yesterday Robert Shiller of Yale decided to take a crack at them also (via Project Syndicate):

“A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90% of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.

One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The fundamental problem that much of the world faces today is that investors are overreacting to debt-to-GDP ratios, fearful of some magic threshold, and demanding fiscal-austerity programs too soon. They are asking governments to cut expenditure while their economies are still vulnerable. Households are running scared, so they cut expenditures as well, and businesses are being dissuaded from borrowing to finance capital expenditures.

The lesson is simple: We should worry less about debt ratios and thresholds, and more about our inability to see these indicators for the artificial – and often irrelevant – constructs that they are.”

So it appears the 90% figure is a nice piece of datamining and it makes for even better TV (and political theater), but we have to be more careful drawing our conclusions from such data before allowing it to influence public policy and the direction of the discourse.  It appears to me that this research has garnered an unjust amount of attention.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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