Governor Cuomo's "Tax-Free New York" Would Come at a High Cost

Jun 13, 2013Richard Kirsch

Eliminating taxes in college communities won't improve the economy, but it will undermine our public institutions.

Eliminating taxes in college communities won't improve the economy, but it will undermine our public institutions.

The decade-long conservative campaign for lower taxes and limited government has hit a wall of public outrage over the unfairness of the American tax system. But while lower taxes for the wealthy and corporations may not be popular, there is still huge public skepticism about how tax dollars can be put to work creating jobs or improving people’s daily lives. Fueling that skepticism are campaigns like that being run now by New York Governor Andrew Cuomo, who is aggressively promoting the idea that we can promote prosperity by lowering taxes.

Governor Cuomo has been racing around New York, with six appearances around the state in less than two weeks, to promote a plan he calls “Tax-Free NY.” Just the name alone should be enough to alarm anyone who understands what society, citizenship. and civilization is all about or what is needed to create broadly shared prosperity. One of a governor’s fundamental jobs is to spend tax dollars wisely, to put the public’s resources to work educating our children, protecting the health of our air and water, building the roads and mass transit systems that allow us to get to work, enjoy community life. and get their goods to market. Taxes pay for public safety and courts that safeguard the rule of law. A “tax-free NY” would be a New York of anarchy, dire poverty, and hopelessness.

Of course, the governor is not really proposing to get rid of all taxes in New York. Instead he would eliminate all taxes – property, personal income, sales, and business – in new tax-free zones established in and around public and private colleges and universities in the state. Every one of these institutions of higher education are supported heavily by taxes in a host of ways: for their very existence and operations in the case of public colleges, and through research grants and government-provided or -guaranteed student grants and loans to private colleges. 

If there is an idea behind the governor’s program, it is that the researchers and thinkers who work in higher education have long made university communities incubators of new businesses. Creating tax-free zones around New York universities is somehow supposed to make them more attractive to business innovation. But Governor Cuomo has this totally backwards. Universities are business innovators because of the creative people who work there. Eliminating taxes around a community college or university does not make the people who teach and do research more creative or innovative. Businesses don’t start in university communities because of low taxes. Businesses are started in university communities because of the quality of the researchers and intellectual richness of the faculty. Attracting and supporting them takes money – from taxes!

As part of Governor Cuomo’s push, I have received two emails from his campaign touting “Tax-Free NY.” The emails are full of quotes from the super-rich promoting the governor’s proposal, including Goldman Sachs CEO Lloyd Blankfein and Jamie Dimon, CEO of JPMorgan Chase. My favorite is from Kenneth Langone, one of the billionaires who tried to defeat President Obama last year: “States need to begin helping businesses by lifting the tax burden and also creating an environment in which employees want to raise their families.” The Blankfeins and Dimons and Langones of this world may live in gated communities, use private education, pay for private health care (at the Langone NYU Medical Center), and enjoy lavish retirements without Social Security, but most other New Yorkers rely on taxes and public programs to help them raise their families.

Of course, Langone – who made his fortune from Home Depot – and the rest of Cuomo’s tycoons would never have become rich without all the public structures that support their businesses and employees. In his advocacy for “Tax-Free NY,” the Governor is encouraging people and businesses to shirk their responsibilities and deny their obligations. The businesses and employees who benefit from the richness of a university community, often marked by excellent schools and libraries and good public services, have a basic responsibility to help pay for the benefits that give them that opportunity.

Building an America that works for all us, with broadly based prosperity, will take leaders who can tell a different story about America – the true story about the great American middle class built by decisions the country made, through our government, to invest in public education, a legal system that protects private initiative, labor laws that protect workers from exploitation, and investment in public infrastructure. That, Governor Cuomo, is also what built New York as the Empire State. 

Richard Kirsch is a Senior Fellow at the Roosevelt Institute, a Senior Adviser to USAction, and the author of Fighting for Our Health. He was National Campaign Manager of Health Care for America Now during the legislative battle to pass reform

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Europe's Austerity Backlash: History Repeats Itself

Jun 11, 2013Mariam Tabatadze

Austerity's failure in Europe was easy to predict, even if politicians and economists didn't see it coming.

Austerity's failure in Europe was easy to predict, even if politicians and economists didn't see it coming.

A few weeks ago we saw an interesting debate unfold in Europe: European Commission President José Manuel Barroso said that austerity in Europe had reached its limit, and a few days later, the German Finance Minister Wolfgang Schaeuble responded, “somebody should tell Barroso” that strict budget rules are not the main issue in the eurozone. Though some politicians are stubbornly refusing to admit that the default policy in Europe for the past three years has been a devastating force, most policymakers and influential leaders are already changing their tunes. The most salient example of this is the IMF, whose Managing Director, Christine Lagarde, has been toning down her austerity recommendations and calling for more gradual reforms. Most recently, she supported the Spanish government’s decision to ease austerity policies and focus on decreasing the alarmingly high unemployment rate (especially among young people, for whom it reaches over 50 percent).

The fact that European leaders are seeing the light of day and turning their backs on austerity is a welcomed development. Perhaps the eurozone has a chance to grow now that governments have stopped purposely crippling themselves. But why was austerity the default policy, and why weren’t its devastating effects foreseen? Since 2010, various European nations have been following the policy prescriptions of right-wing economic thought, and the reality illustrates a strikingly different result than what was expected. Greece’s debt-to-GDP ratio rose from 144.6 percent in 2010 to 170.7 percent in 2012. Austerity, which set out to restore confidence, help economies flourish, and most importantly, reduce debt, has failed to accomplish all of the above so far. In fact, the eurozone as a whole contracted for the first time ever in 2012, two years after austerity policies were implemented.

Ideologically, austerity policies come from a familiar place – most individuals are intuitively aware that one should spend less than one earns. Furthermore, one does not cure sickness with more sickness, and it is simple to make the argument that debt cannot be cured by more debt. While it is true that fiscal responsibility is important, there are other aspects of austerity worth considering.

First, spending cuts often affect the layers of society that are most vulnerable, because they were already more dependent on government support. Impoverishing the poor and lower middle class is not synonymous with promoting entrepreneurship and dynamism of the private sector. The lower layers of society end up suffering and bearing the burden of an economic crisis caused by members of the upper levels of society, whether they are bankers or politicians.

Second, it makes no sense to cut spending across the board on an entire interconnected continent. Austerity is supposed to restore competitiveness and promote exports through efforts like reducing domestic wages, but who will spend the necessary funds to consume those exports if every country is cutting budgets and focusing on saving? It seems common sense that not all nations within the eurozone can run surpluses; it is equally obvious that not all countries can be export-led, the way Germany is.

Third, and most important, is the glaring problem in the set of assumptions behind austerity. The first is human rationality. According to this line of thought, economic stimulus will provide a net effect of zero because consumers are smart enough to factor rising government debt into their calculations and therefore will save today in order to prepare for rising taxes in the future. On the other hand, spending cuts signal to these (largely imagined) rational, calculating economic actors that their income will be higher in the future due to lowered taxes and lowered debt. Thus, they will be more comfortable spending in the present, and voila, demand has been boosted. Except, there is one problem: Homo economicus has very little in common with Homo sapiens, in that actual living humans are not rational and not nearly as farsighted as most economists would like you to believe. If, in the midst of an economic crisis and austerity policies, your neighbor gets fired and your newly graduated son is having a hard time finding a job, you are not likely to spend more money now because you anticipate your taxes being lower one day.

Despite overwhelming evidence, politicians and economists alike are still convinced that austerity works. Historical examples like the austerity policies put in place before Roosevelt’s famous New Deal leave little doubt that “expansionary contraction” is not beneficial during economic downturns. Even so-called austerity success stories with supposed applicability to the eurozone have been called into question: Australia and Denmark, regarded as model austerity countries, fell into crises after two years of implementing austerity policies. The only real success stories of reductions in debt have not been during downturns, but during periods of economic growth. The United States, for example, succeeded in reducing the deficit significantly under Bill Clinton, and Sweden reduced its fiscal deficit from 1994-1998 during a period of rapid GDP growth.

The bottom line is simple: none of what is going on in Europe after adopting austerity policies should be a surprise. It is just inexplicable that we have to keep reinventing the wheel and rediscovering the adverse effects of austerity in a struggle to recover from a crisis. Why can’t we tell austerity (in the words of Kelis), “might trick me once, I won’t let you trick me twice”?

Mariam Tabatadze is a a member of the Roosevelt Institute | Campus Network and a recent graduate of Connecticut College with a double major in Economics and International Relations. She is interning at the Institute for New Economic Thinking this summer. Click here to read her full paper on the eurozone crisis.

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When a Surplus is Really a Deficit

Jun 3, 2013Elizabeth Pearson

States are showing budget surpluses, but that doesn't mean that everything has been fixed post-recession.

States are showing budget surpluses, but that doesn't mean that everything has been fixed post-recession.

News of surging income-tax revenues and surprise budget surpluses has brightened statehouses over the past few weeks, but it’s worth asking whether we should be thinking of these revised fiscal projections as surpluses at all. After all, current state surpluses are the product of deep cuts to higher education, delayed repair to basic infrastructure, and unfunded pension liabilities — in fact, these surpluses are better viewed as evidence of serious, structural budget deficits.

For one thing, welcome news from the states comes with the disclaimer that much of the revenue surge prompting headlines is due to one-time revenues caused by taxpayers with capital gains and other types of non-withheld income accelerating income into the 2012 tax year as they anticipated higher federal income-tax rates in 2013.

But the larger cause of current budget surpluses is the deep cuts state governments imposed during the recent recession. For instance, states are now spending 28 percent less per student on higher education compared to when the recession began in 2008. The recession also produced more dramatic losses in state government jobs than in any other downturn over the past fifty years. State-government spending cuts and job losses have dragged down the economy, slowing recovery and prolonging the jobs crisis.

States (with the exception of Vermont) have legal requirements to balance their budgets each fiscal year, and therefore do not have recourse to deficit spending. One reason recent cuts were so deep is that states relied disproportionately on spending cuts rather than revenue increases to balance their budgets during the recession — and because federal recovery aid to states expired in mid-2011 even as states struggled to cope with increased obligations due to the economic collapse.

As states cut to the bone to survive the recession, prolonged under-investment eventually produces misleading surpluses. Meanwhile, it is perversely harder to actually see the budget gaps that states grapple with each year. At the federal level, recessions produce annual deficits and increase the size of the federal debt, prompting political wrangling over sustainable solutions. As ideologically charged as these debates can be, they at least engage a visible target: no matter whether the federal books balance in any given year, we still confront the costs of past wars and economic downturns in arguments over the size of the public debt.

But, because states don’t have the option of deficit spending, budget gaps at the state level are effectively internalized through cutting services, laying off employees, and delaying improvements. Each year’s painful shortfalls are solved through cuts that swiftly and quietly become a “new normal.” With no mounting debt to remind us of these structural imbalances, past years’ debts seem to disappear — but in fact they are leaving lasting impacts on states’ abilities to underwrite economic growth in the long term.

Hollow as they are, today’s surpluses are being cited in states like Wisconsin to call for permanent tax cuts that will start the austerity cycle anew by generating future shortfalls that can then be “solved” by new cuts. Such efforts come on the heels of attempts in several states to abolish income taxes during the past legislative session — and fly in the face of the simple fact that, while state tax revenues now have three years of growth under their belt, they still have not surpassed their pre-recession levels. Advocating tax cuts when state revenue remains below pre-recession levels would be laughable if it were not so dangerous. This recession has impacted state tax collections far worse than in past recessions, and even if current revenue growth rates continue it could take years for revenues to catch up to pre-recession levels, adjusted for population growth and inflation.

More responsible discussion of revenue increases and “surpluses” has revolved around whether funds should be set aside in state rainy-day funds or used now to restore services. These are important conversations to pursue. But we must also consider a broader conversation about state budgets as a reflection of our public priorities. As states rebuild in the wake of the recession, which public investments will support economic growth and meet fundamental needs for safe infrastructure, quality education, and services for vulnerable citizens? Viewed in this light, today’s improving bottom line is a step in the right direction but still falls far short of both pre-recession goals and our broader common priorities. In other words, we are still faced with severe deficits.

Seizing on recent changes in state tax collection is the wrong place to focus these broader discussions. Instead, we need to be talking about revenue increases and much-need tax-system modernization like extending the sales tax to services and digital goods. Revenue increases have always been part of the state government toolkit when it comes to balancing budgets — Republican and Democratic policymakers alike recognized this fact as recently as the 1960s and 1970s when they repeatedly adopted major new taxes to invest in their states. Remembering this bipartisan legacy can be an important part of making the case for responsible tax reform at the state level.

When surpluses are the result of dramatic cuts to services and unprecedented job losses, they shouldn’t be considered surpluses at all. We can cheer the good news of growing state tax collections while pursuing broader measures of fiscal health, most notably a budget that balances with our priorities.

Elizabeth Pearson is a Roosevelt Institute | Pipeline Fellow and a PhD candidate at UC Berkeley.

 

Money in vise image via Shutterstock.com

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Guest Post: Dube on Growth, Debt and Past versus Future Windows

Jun 1, 2013Arindrajit Dube

Windows into the Past and the Future:  A Visual Elaboration

Arindrajit Dube

Recently, we have seen a number of explorations of the timing of growth around episodes of high debt as a way to discern the likely direction of causality in that relationship.  This is important, because we do observe that there is a negative correlation between contemporaneous debt and growth. For instance, this is true when using the corrected data from Reinhart and Rogoff, and equal weighting of country-year observations. Although there is no evidence of tipping points, a negative relationship remains.

In a blog post in April, I showed that the timing of this negative relationship went against an interpretation where high debt caused low growth.  I showed that relationship between contemporaneous debt with future growth is much weaker than that with past growth—which is suggestive of reverse causality.  I used a 3-year window for this exercise. In other words, if we label current year as “0” I took the average growth rates in years 1,2 and 3.  In a more recent column at Quartz, Kimball and Wang’s follow-up analysis showed the relationship using a window between years 5-10.  In a working paper I that I wrote based on my blog post—but posted online after Kimball and Wang’s column—I followed the recent literature in taking a 5-year forward average growth rate, i.e., average growth taken over years 1-5.

The general tenor of these findings is that the further into the future that the window stretches, the more attenuated the debt-growth relationship seems to be. However, the same does not appear to be true when considering windows stretching backwards in time: current debt is indeed strongly associated with past growth. 

But how sensitive are these results to specific window lengths? More generally, as suggested by Evan Soltas, how do these results look when using windows of alternative lengths? That’s exactly what I’ll do here, by plotting the coefficients and confidence bounds for bivariate regressions of growth from alternative windows on contemporaneous debt. For example, the window labeled -2 uses average growth rates from dates -2 and -1. Similarly, the window labeled 3 uses growth rates from dates 1, 2 and 3.

The results are stark, and confirm what we have already seen. The bivariate regression of current growth on current debt is around -0.018, meaning a 10 percentage point higher debt ratio (e.g., 110 versus 100) is associated with a lower growth by 0.18 percentage points.  This relationship is statistically significant at conventional levels using country-clustered standard errors. However, a 10 point higher debt ratio is associated with an even lower average growth 3, 5, or 10 years back, and this apparently spurious relationship appears stronger the further we roll back our window, clocking lower growths by 0.25 points or more in magnitude.

In contrast, the further forward we roll our window, the weaker the relationship appears to be, falling roughly by 1/3 when we merely consider the growth rate in the next year. And it attenuates further when we take future rates: a 10 point higher debt ratio is associated with merely a 0.05 point lower growth in the next 10 years, which is statistically indistinguishable from zero.

There is, however, a complication when doing this type of analysis. Namely, we should be mindful of the following possibility. Perhaps today’s high debt is not negatively correlated with the growth rate averaged over the next 10 years because the average debt level in the next 10 years is also not particularly high as compared to today.  (In statistical parlance, perhaps debt is strongly mean reverting.)  This can be checked: we can current debt on the average debt levels in the past and future windows in an analogous fashion as before.

Reassuringly, a 10 point greater debt ratio today is associated with a 7 point or greater debt ratio over the next 10 years.  So this cannot be an explanation for the  near disappearance of the negative debt-growth relationship when taking forward averaged growth rates.  Similarly, there is a roughly symmetric relationship with past debt ratios which means that the highly asymmetric debt-growth relationship in the future versus past cannot be due to a similarly asymmetric relationship of current debt with future versus past debt.

I mentioned the issues of serial correlation of debt and growth levels in passing in my original blog post, which is why I also showed the results with distributed lags, which explicitly controls for the past and future debt levels in the regression. While those fully account for the issues raised here, I think the analysis here showing the serial correlation in debt visually more informative about the patterns in the data.

Of course, there are numerous ways to account for the reverse causality patterns, besides just considering forward-averaged growth rates. One strategy is to explicitly include past growth rates as a control. I did this in my blog post (see the last figure there), as well as in working paper.  This is also exactly what Kimball and Wang do in showing the “excess growth” over and beyond what is predicted by past growth.  However, I think their graphical approach in actually computing the predicted and excess growth rates based on past growth rates was a very nice way to make the point. At any rate, all these results all suggest effectively no relationship between debt and growth in the post-war sample of advanced industrialized countries that we analyzed.

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Windows into the Past and the Future:  A Visual Elaboration

Arindrajit Dube

Recently, we have seen a number of explorations of the timing of growth around episodes of high debt as a way to discern the likely direction of causality in that relationship.  This is important, because we do observe that there is a negative correlation between contemporaneous debt and growth. For instance, this is true when using the corrected data from Reinhart and Rogoff, and equal weighting of country-year observations. Although there is no evidence of tipping points, a negative relationship remains.

In a blog post in April, I showed that the timing of this negative relationship went against an interpretation where high debt caused low growth.  I showed that relationship between contemporaneous debt with future growth is much weaker than that with past growth—which is suggestive of reverse causality.  I used a 3-year window for this exercise. In other words, if we label current year as “0” I took the average growth rates in years 1,2 and 3.  In a more recent column at Quartz, Kimball and Wang’s follow-up analysis showed the relationship using a window between years 5-10.  In a working paper I that I wrote based on my blog post—but posted online after Kimball and Wang’s column—I followed the recent literature in taking a 5-year forward average growth rate, i.e., average growth taken over years 1-5.

The general tenor of these findings is that the further into the future that the window stretches, the more attenuated the debt-growth relationship seems to be. However, the same does not appear to be true when considering windows stretching backwards in time: current debt is indeed strongly associated with past growth. 

But how sensitive are these results to specific window lengths? More generally, as suggested by Evan Soltas, how do these results look when using windows of alternative lengths? That’s exactly what I’ll do here, by plotting the coefficients and confidence bounds for bivariate regressions of growth from alternative windows on contemporaneous debt. For example, the window labeled -2 uses average growth rates from dates -2 and -1. Similarly, the window labeled 3 uses growth rates from dates 1, 2 and 3.

The results are stark, and confirm what we have already seen. The bivariate regression of current growth on current debt is around -0.018, meaning a 10 percentage point higher debt ratio (e.g., 110 versus 100) is associated with a lower growth by 0.18 percentage points.  This relationship is statistically significant at conventional levels using country-clustered standard errors. However, a 10 point higher debt ratio is associated with an even lower average growth 3, 5, or 10 years back, and this apparently spurious relationship appears stronger the further we roll back our window, clocking lower growths by 0.25 points or more in magnitude.

In contrast, the further forward we roll our window, the weaker the relationship appears to be, falling roughly by 1/3 when we merely consider the growth rate in the next year. And it attenuates further when we take future rates: a 10 point higher debt ratio is associated with merely a 0.05 point lower growth in the next 10 years, which is statistically indistinguishable from zero.

There is, however, a complication when doing this type of analysis. Namely, we should be mindful of the following possibility. Perhaps today’s high debt is not negatively correlated with the growth rate averaged over the next 10 years because the average debt level in the next 10 years is also not particularly high as compared to today.  (In statistical parlance, perhaps debt is strongly mean reverting.)  This can be checked: we can current debt on the average debt levels in the past and future windows in an analogous fashion as before.

Reassuringly, a 10 point greater debt ratio today is associated with a 7 point or greater debt ratio over the next 10 years.  So this cannot be an explanation for the  near disappearance of the negative debt-growth relationship when taking forward averaged growth rates.  Similarly, there is a roughly symmetric relationship with past debt ratios which means that the highly asymmetric debt-growth relationship in the future versus past cannot be due to a similarly asymmetric relationship of current debt with future versus past debt.

I mentioned the issues of serial correlation of debt and growth levels in passing in my original blog post, which is why I also showed the results with distributed lags, which explicitly controls for the past and future debt levels in the regression. While those fully account for the issues raised here, I think the analysis here showing the serial correlation in debt visually more informative about the patterns in the data.

Of course, there are numerous ways to account for the reverse causality patterns, besides just considering forward-averaged growth rates. One strategy is to explicitly include past growth rates as a control. I did this in my blog post (see the last figure there), as well as in working paper.  This is also exactly what Kimball and Wang do in showing the “excess growth” over and beyond what is predicted by past growth.  However, I think their graphical approach in actually computing the predicted and excess growth rates based on past growth rates was a very nice way to make the point. At any rate, all these results all suggest effectively no relationship between debt and growth in the post-war sample of advanced industrialized countries that we analyzed.

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Dube, Kimball, and Wang, All on Reinhart/Rogoff

May 31, 2013Mike Konczal

Two excellent new additions to the debate over what the link is between high debt loads and growth came out in the past 24 hours.

The first is by Arindrajit Dube, "A Note on Debt, Growth and Causality": "This note documents the timing in the relationship between the debt-to-GDP ratio and real GDP growth in advanced economies during the post World War II period using the dataset from Carmen Reinhart and Ken Rogoff. I first show that the debt ratio is more clearly associated with the 5-year past average growth rate, rather than the 5-year forward average growth rate–indicating a problem of reverse causality. Indeed, there is little evidence of a lower growth rate above the 90 percent threshold when using the 5-year forward average growth rate....non- and semi-parametric plots provide visual confirmation that the relationship between debt-to-GDP ratio and growth is essentially flat for debt ratios exceeding 30 percent when we (1) use forward growth rates, (2) control for past GDP growth, or both."

This short paper formalizes a recent post Dube wrote at this blog, extending his semi-parametric analysis out to five years. It also provides all the equations, as well as some of the literature on this debate. It's an important piece, dismantling the arguments that debt leads to lower growth.

The second is by Miles Kimball and Yichuan Wang at Quartz. "Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth."

Using different ranges (including 5-10 years out) and different techniques, Kimball and Wang can't find any evidence for the Reinhart and Rogoff thesis that high debt loads are correlated with lower growth. It's a remarkable post, where you can read them become surprised at what they are and are not seeing, and how they take pains to make sure they aren't missing something.

Now where are the posts arguing the opposite? The literature hasn't addressed this well at all. Indeed, in their recent letter to Paul Krugman, Reinhart and Rogoff argued that the "repeatedly-expressed view that slow growth causes high debt but not visa-versa, is hardly supported by the recent literature on the subject."  They suggest checking out their appendix to their New York Times piece for more info, which tells us to check out the World Economic Outlook.

But even the Outlook warns us on causation (in the paragraph immediately after the one they cite, no less): "But there are limits to empirical studies on the economic effects of debt overhangs. For example, countries that have high debt levels may have low growth for other reasons that typically are not captured in the econometric models. In fact, some studies find no causal relationship between high debt and lower growth. The October 2012 Global Financial Stability Report finds that countries with debt above 100 percent of GDP experience lower growth, but it also finds that countries with high but falling debt ratios grew faster than countries with lower but increasing debt ratios."

Straightforward checks for casuality are missing from these previous studies. I'm not sure why, but now that people are looking at these issues with fresh eyes, it is suddenly much more difficult to make the statements about high debt leading to low growth with any certainty, much less the one that has dominated the converation during the turn to austerity after 2010.

Follow or contact the Rortybomb blog:

  

 

Two excellent new additions to the debate over what the link is between high debt loads and growth came out in the past 24 hours.

The first is by Arindrajit Dube, "A Note on Debt, Growth and Causality": "This note documents the timing in the relationship between the debt-to-GDP ratio and real GDP growth in advanced economies during the post World War II period using the dataset from Carmen Reinhart and Ken Rogoff. I first show that the debt ratio is more clearly associated with the 5-year past average growth rate, rather than the 5-year forward average growth rate–indicating a problem of reverse causality. Indeed, there is little evidence of a lower growth rate above the 90 percent threshold when using the 5-year forward average growth rate....non- and semi-parametric plots provide visual confirmation that the relationship between debt-to-GDP ratio and growth is essentially flat for debt ratios exceeding 30 percent when we (1) use forward growth rates, (2) control for past GDP growth, or both."

This short paper formalizes a recent post Dube wrote at this blog, extending his semi-parametric analysis out to five years. It also provides all the equations, as well as some of the literature on this debate. It's an important piece, dismantling the arguments that debt leads to lower growth.

The second is by Miles Kimball and Yichuan Wang at Quartz. "Based on economic theory, it would be surprising indeed if high levels of national debt didn’t have at least some slow, corrosive negative effect on economic growth. And we still worry about the effects of debt. But the two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth."

Using different ranges (including 5-10 years out) and different techniques, Kimball and Wang can't find any evidence for the Reinhart and Rogoff thesis that high debt loads are correlated with lower growth. It's a remarkable post, where you can read them become surprised at what they are and are not seeing, and how they take pains to make sure they aren't missing something.

Now where are the posts arguing the opposite? The literature hasn't addressed this well at all. Indeed, in their recent letter to Paul Krugman, Reinhart and Rogoff argued that the "repeatedly-expressed view that slow growth causes high debt but not visa-versa, is hardly supported by the recent literature on the subject."  They suggest checking out their appendix to their New York Times piece for more info, which tells us to check out the World Economic Outlook.

But even the Outlook warns us on causation (in the paragraph immediately after the one they cite, no less): "But there are limits to empirical studies on the economic effects of debt overhangs. For example, countries that have high debt levels may have low growth for other reasons that typically are not captured in the econometric models. In fact, some studies find no causal relationship between high debt and lower growth. The October 2012 Global Financial Stability Report finds that countries with debt above 100 percent of GDP experience lower growth, but it also finds that countries with high but falling debt ratios grew faster than countries with lower but increasing debt ratios."

Straightforward checks for casuality are missing from these previous studies. I'm not sure why, but now that people are looking at these issues with fresh eyes, it is suddenly much more difficult to make the statements about high debt leading to low growth with any certainty, much less the one that has dominated the converation during the turn to austerity after 2010.

Follow or contact the Rortybomb blog:

  

 

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Michael Kinsley Gets It Wrong On "Austerians"

May 23, 2013Mike Konczal

While I was on vacation, the Internet exploded over a column by Michael Kinsley beefing with Paul Krugman and his follow-up response. The biggest problem with his attempt to reclaim the word “austerians” from its detractors is that he doesn’t provide a working definition, an argument, or even specific people or proposals for what he has in mind. He apparently takes “austerian” to mean “anti-Krugman,” and since Kinsley and others feels that they don’t line up with Krugman, they must all be austerians.

This leads into the second biggest problem with Kinsley’s posts: he concludes that everyone is basically on the same page. It’s just a matter of how you weigh your priorities and concerns. Kinsley writes that “Krugman now says that what he is against is ‘premature’ fiscal austerity. So is everybody. They just disagree on what is ‘premature.’” Also that “[y]ou can be a right-wing Austerian, a left-wing Austerian, a right-wing Keynesian, or a left-wing Keynesian. And (as I also noted last week) the differences are not so great.” (My underlines.)

This is wrong. I’ll quickly summarize three different approaches to the deficit, trying hard to not make straw men of them. There’s (1) Team Keynesian, which thinks that the government should increase the short-term deficit, full-stop. Extend the payroll tax cut for two years. Invest in an infrastructure bank. Mail people checks. Get to the point where the Federal Reserve has traction again on the economy before worrying about the debt.

People in this category are all for ways to deal with the long-term deficit. But they realize that: (a) Medicare is the major driver of those costs, Obamacare needs a chance to deal with this, and it may even be working already; (b) reducing the long-term deficit should require a combination of taxes and spending, and the GOP will refuse any and all tax increases, making a deal impossible; and (c) the GOP wants to privatize Social Security and Medicare rather than bring them into a healthy long-term financial situation, so not everyone is even on the same page.

However, people in (2) Team Barbell think that stimulus must be paired with long-term deficit reduction at the same time. For an example, there’s the original Domenici-Rivlin Restoring America's Future plan: "First, we must recover from the deep recession that has thrown millions out of work... Second, we must take immediate steps to reduce the unsustainable debt... These two challenges must be addressed at the same time, not sequentially."

I assume when Kinsley references needing to eat spinach along with dessert as macroeconomic policy he’s referring to a need for both stimulus and deficit reduction to complement each other. Sadly for him, there’s never been a clear economic case for why these should be addressed together, and plenty of evidence that addressing the second will do little for the first.

(Noah Smith started a conversation recently about whether elites want a slower recovery in order to do structural reform. The original Domenici-Rivlin reform quoted above basically said, “We know unemployment is devastating, and we know more upfront stimulus will help. However, we are going to need you to turn Medicare into a giant Groupon system in order to get it.”)

These two approaches are very different than the arguments for (3) Team Austerity. The argument here is that, if done right, austerity will have a negligible effect on the economy and could even increase prosperity by restoring confidence to private capital. This is not a strawman; it’s the economic plan the GOP put forward when they took the House in 2011, which they got from AEI, which they got from Alberto Alesina and Silvia Ardagna of Harvard.

The 2011 GOP plan also noted, “Analyzing 20 developed countries between 1946 and 2009, Reinhart and Rogoff found a distinct threshold for gross government debt equal to 90 percent of GDP.” They believed action was needed to avoid crossing this threshold, even if it might be painful. (Thankfully, it wouldn’t be according this argument.)

No Pain, No Gain?

Kinsley’s misdiagnosis that the policy disagreements are all a matter of relative priorities then leads him to believe that more weight on short-term pain will lead to better long-term conclusions: “I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be...The problem is the great, deluded middle class—subsidized by government and coddled by politicians.”

This set the Internet on fire. I’m genuinely not sure what he’s referencing here when he mentions the middle-class. Is Kinsley at the point where he doesn’t get editors? I’m going to rewrite this for him: “During the 2000s, the middle class borrowed way too much, speculating on housing and using fake home equity to go on a spending spree. Now that this bubble has burst, the middle class needs to spend less and save more. There will be, yes, suffering, but they should have been saving more all along. Americans didn’t save enough, and now they have to save more and work off all the bad debts.”

And here’s how I would have responded to that better argument: “Yes, but two things. The first is that everyone can’t all save at the same time. If everyone is saving, nobody is spending, and we start to hit some major problems. Second, the bad debts to be worked off aren’t set in stone. If unemployment is higher, or wage growth slower, or inflation is under-target, that means the pile of bad debts is even greater. Since they are greater, people save more, and then there are even more problems. So even if you have a strongly moralistic tone about what needs to be done, or read this as a pox on our middle class, stimulus in the short term is crucial.”

Because austerity won’t even do the job Kinsley is proposing it will do. In 1933, John Maynard Keynes said, “You will never balance the Budget through measures which reduce the national income.” He argued this because he was a childless gay hedonist saw that austerity won’t even function to reduce the debt load, because a weaker GDP will eliminate any debt savings. This is precisely what is happening in Europe, and it could happen here if we suffocate the recovery too early.

 

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While I was on vacation, the Internet exploded over a column by Michael Kinsley beefing with Paul Krugman and his follow-up response. The biggest problem with his attempt to reclaim the word “austerians” from its detractors is that he doesn’t provide a working definition, an argument, or even specific people or proposals for what he has in mind. He apparently takes “austerian” to mean “anti-Krugman,” and since Kinsley and others feels that they don’t line up with Krugman, they must all be austerians.

This leads into the second biggest problem with Kinsley’s posts: he concludes that everyone is basically on the same page. It’s just a matter of how you weigh your priorities and concerns. Kinsley writes that “Krugman now says that what he is against is ‘premature’ fiscal austerity. So is everybody. They just disagree on what is ‘premature.’” Also that “[y]ou can be a right-wing Austerian, a left-wing Austerian, a right-wing Keynesian, or a left-wing Keynesian. And (as I also noted last week) the differences are not so great.” (My underlines.)

This is wrong. I’ll quickly summarize three different approaches to the deficit, trying hard to not make straw men of them. There’s (1) Team Keynesian, which thinks that the government should increase the short-term deficit, full-stop. Extend the payroll tax cut for two years. Invest in an infrastructure bank. Mail people checks. Get to the point where the Federal Reserve has traction again on the economy before worrying about the debt.

People in this category are all for ways to deal with the long-term deficit. But they realize that: (a) Medicare is the major driver of those costs, Obamacare needs a chance to deal with this, and it may even be working already; (b) reducing the long-term deficit should require a combination of taxes and spending, and the GOP will refuse any and all tax increases, making a deal impossible; and (c) the GOP wants to privatize Social Security and Medicare rather than bring them into a healthy long-term financial situation, so not everyone is even on the same page.

However, people in (2) Team Barbell think that stimulus must be paired with long-term deficit reduction at the same time. For an example, there’s the original Domenici-Rivlin Restoring America's Future plan: "First, we must recover from the deep recession that has thrown millions out of work... Second, we must take immediate steps to reduce the unsustainable debt... These two challenges must be addressed at the same time, not sequentially."

I assume when Kinsley references needing to eat spinach along with dessert as macroeconomic policy he’s referring to a need for both stimulus and deficit reduction to complement each other. Sadly for him, there’s never been a clear economic case for why these should be addressed together, and plenty of evidence that addressing the second will do little for the first.

(Noah Smith started a conversation recently about whether elites want a slower recovery in order to do structural reform. The original Domenici-Rivlin reform quoted above basically said, “We know unemployment is devastating, and we know more upfront stimulus will help. However, we are going to need you to turn Medicare into a giant Groupon system in order to get it.”)

These two approaches are very different than the arguments for (3) Team Austerity. The argument here is that, if done right, austerity will have a negligible effect on the economy and could even increase prosperity by restoring confidence to private capital. This is not a strawman; it’s the economic plan the GOP put forward when they took the House in 2011, which they got from AEI, which they got from Alberto Alesina and Silvia Ardagna of Harvard.

The 2011 GOP plan also noted, “Analyzing 20 developed countries between 1946 and 2009, Reinhart and Rogoff found a distinct threshold for gross government debt equal to 90 percent of GDP.” They believed action was needed to avoid crossing this threshold, even if it might be painful. (Thankfully, it wouldn’t be according this argument.)

No Pain, No Gain?

Kinsley’s misdiagnosis that the policy disagreements are all a matter of relative priorities then leads him to believe that more weight on short-term pain will lead to better long-term conclusions: “I don’t think suffering is good, but I do believe that we have to pay a price for past sins, and the longer we put it off, the higher the price will be...The problem is the great, deluded middle class—subsidized by government and coddled by politicians.”

This set the Internet on fire. I’m genuinely not sure what he’s referencing here when he mentions the middle-class. Is Kinsley at the point where he doesn’t get editors? I’m going to rewrite this for him: “During the 2000s, the middle class borrowed way too much, speculating on housing and using fake home equity to go on a spending spree. Now that this bubble has burst, the middle class needs to spend less and save more. There will be, yes, suffering, but they should have been saving more all along. Americans didn’t save enough, and now they have to save more and work off all the bad debts.”

And here’s how I would have responded to that better argument: “Yes, but two things. The first is that everyone can’t all save at the same time. If everyone is saving, nobody is spending, and we start to hit some major problems. Second, the bad debts to be worked off aren’t set in stone. If unemployment is higher, or wage growth slower, or inflation is under-target, that means the pile of bad debts is even greater. Since they are greater, people save more, and then there are even more problems. So even if you have a strongly moralistic tone about what needs to be done, or read this as a pox on our middle class, stimulus in the short term is crucial.”

Because austerity won’t even do the job Kinsley is proposing it will do. In 1933, John Maynard Keynes said, “You will never balance the Budget through measures which reduce the national income.” He argued this because he was a childless gay hedonist saw that austerity won’t even function to reduce the debt load, because a weaker GDP will eliminate any debt savings. This is precisely what is happening in Europe, and it could happen here if we suffocate the recovery too early.

 

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The Ongoing Crisis Demands Jobs, Not Deficit Reduction

May 16, 2013David B. Woolner

Today's leaders must recognize that job creation is the key to boosting revenues for the government and the people.

Today's leaders must recognize that job creation is the key to boosting revenues for the government and the people.

Now, the rise and fall of national income—since they tell the story of how much you and I and everybody else are making—are an index of the rise and fall of national prosperity. They are also an index of the prosperity of your Government. The money to run the Government comes from taxes; and the tax revenue in turn depends for its size on the size of the national income. When the incomes and the values and transactions of the country are on the down-grade, then tax receipts go on the down-grade too. If the national income continues to decline, then the Government cannot run without going into the red. The only way to keep the Government out of the red is to keep the people out of the red. And so we had to balance the budget of the American people before we could balance the budget of the national Government.Franklin D. Roosevelt, 1936

The news that the nation added 165,000 jobs in April and that the unemployment rate has dipped to 7.5 percent—its lowest since December 2008—is of course welcome. It has eased the fears of many economists that recent cuts in federal spending might stall our somewhat anemic recovery, helped boost the stock market to record levels, and has been cited by Alan Krueger, the Chairman of the President’s Economic Advisors, as “further evidence that the U.S. economy is continuing to recover from the worst downturn since the Great Depression.”

But as many economists have also reported, the April rate of job growth is still far too low to bring about the level of re-employment needed to bring us back to full employment, and, worse still, the slight improvement in the overall unemployment rate masks a good many far more disturbing statistics. Many of the jobs acquired in April are low-skill and low-paying. Some of the drop in the unemployment rate can be attributed to the fact that millions of Americans have stopped looking for work and have dropped out of the work force all together—496,000 people in March 2013 alone. Then there are the under-employed, who also rank in the millions. If we add their ranks to those who are unemployed or have dropped out of the work force altogether, we arrive at an overall “underemployment rate” of 13.9 percent, up from the previous month’s rate of 13.8 percent. Taken together this means that roughly 22 million Americans are either unemployed or under-employed—a staggering figure, which after four years of so-called “recovery” has some economists predicting that long-term un-and under-employment may now be a permanent fixture of the American landscape.

What is even more shocking, however, is that in spite of all of these grim statistics, grim statistics that reflect the hardship and pain of millions, much of the political discourse in Washington—and in the media—remains fixated on the debt and deficit and the Republican demand for a balanced budget. It is almost as if Washington has all but given up on trying to take direct action to bring about a better employment picture. This realization is perhaps best evidenced by the fact that one of the more significant contributors to our persistently high unemployment rate in the past year has been public sector layoffs. 

Calls for the federal government to balance its books are not new, of course. Thanks to the extremely effective public persuasion campaign of the conservative right, we have heard this refrain time and time again. It has now become de rigueur for most politicians— no matter what their party—to pay lip service to the need to get “our house in order” and cut the deficit no matter what the consequences for the average American.

It wasn’t always this way, however. In the mid-1930s, when faced with a similar economic crisis and similar calls for cuts in federal spending, Franklin Roosevelt took an entirely different tack. He insisted that in the midst of a crisis where—much like today—we faced both declining federal revenues and increasing unemployment, “a national choice had to be made” between those who argued that the government should do nothing and “let Nature take its course” and those who argued for federal intervention in the economy, even if it meant running a deficit. As FDR saw it, what stood between his administration and a balanced budget were “millions of needy Americans, denied the promise of a decent American life.” In light of this, he argued that “to balance our budget in 1933 or 1934 or 1935 would have been a crime against the American people,” which would have required either “a capital levy that would have been confiscatory” or accepting “human suffering with callous indifference." "When Americans suffered,” he went on, “we refused to pass by on the other side. Humanity came first.”

And so the Roosevelt Administration launched programs like the Works Progress Administration that built much of the infrastructure we still enjoy today and which gave millions of Americans, from common laborers to structural engineers, the joy and dignity of work. FDR admitted that “this cost money”—and the American people understood that this would continue to cost money “for several years to come.” But given the dire state of the economy and the lack of demand in the private sector, the American people understood that it was the right thing to do.

Unlike today’s politicians, however, FDR refused to pander to the sky-is-falling rhetoric of the conservative right on the disastrous consequences that would accrue to the country by running a deficit in the midst of an economic crisis. For them FDR had a simple answer. He flat out rejected “this foolish fear about the crushing load the debt will impose upon your children and mine.” On the contrary, he went on:

This debt is not going to be paid by oppressive taxation on future generations. It is not going to be paid by taking away the hard-won savings of the present generation. It is going to be paid out of an increased national income and increased individual incomes produced by increasing national prosperity.

In other words, FDR understood that the real crisis the country faced in the Great Depression was an employment crisis—not a deficit crisis—and that in the long run the “only way to keep the Government out of the red” was, as he said, “to keep the people out of the red.” And so he set his priority on the one thing he knew would help bolster the revenue of both the American people and their government: millions upon millions of jobs.

Unfortunately, much of our leadership in Washington today seems to have lost sight of this fact, and instead of taking meaningful action to help grow the economy and alleviate the suffering of the millions of unemployed, would prefer to cut spending and engage in another endless round of bickering about the debt and deficit. Such “callous indifference” to the plight of millions of Americans is no way to bring about an end to the current crisis or build a better future for our children.

David Woolner is a Senior Fellow and Hyde Park Resident Historian for the Roosevelt Institute. He is currently writing a book entitled Cordell Hull, Anthony Eden and the Search for Anglo-American Cooperation, 1933-1938.

For more on solutions to the ongoing unemployment crisis, join the Roosevelt Institute in Washington, D.C. on June 4th for A Bold Approach to the Jobs Emergency: Setting the Political Agenda for 2014 and 2016.

 

Unemployment line image via Shutterstock.com.

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Audacity, Audacity, Always Audacity: Why Obama and Baucus Should Push for a Carbon Tax

Apr 29, 2013Bo Cutter

A carbon tax would bring long-term rewards, but it will take leaders willing to make short-term sacrifices.

We are at an unacknowledged turning point for the economy and the environment. We could, right now, substantially reduce our debt and deficit projections, take a major step toward a better environment, create a simpler and fairer tax system, make job creation easier, and raise economic growth a bit. For all of these reasons, we could and should adopt a carbon tax.

A carbon tax would bring long-term rewards, but it will take leaders willing to make short-term sacrifices.

We are at an unacknowledged turning point for the economy and the environment. We could, right now, substantially reduce our debt and deficit projections, take a major step toward a better environment, create a simpler and fairer tax system, make job creation easier, and raise economic growth a bit. For all of these reasons, we could and should adopt a carbon tax.

Taking this step depends on two men: President Obama and Senator Max Baucus, chair of the Senate Finance Committee. Both men want to leave an important legacy, and both are in a unique political position: they still possess real political power, but neither will ever face another election. (Obama, of course, is limited to two terms, and Baucus has just announced that he will retire.) Acting together, the two of them could completely change the odds of enacting a carbon tax this year.

Right now, if you ask around, as I have, there are many across the ideological spectrum who agree that a carbon tax would help us solve a lot of problems, but they won't take a public step because they see no leadership support. My own gut feeling is that there would even be energy industry support for a carbon tax. President Obama and Senator Baucus could change this picture by making a carbon tax a priority and building bipartisan support for the project.

Why should we care? Let's look at four issues: federal revenues, the tax system, jobs, and – oh, yeah – the environment.

First, a carbon tax of $20 a ton would raise about $120 billion a year, or $1.2 trillion over a decade. Right now, everyone anywhere near the budget debates is in a convenient and delusional state of mind about revenues. The conventional wisdom is that we either do not need more revenues or they are easy to find. So here are some counter-assertions: (1) despite the right’s imaginations, we are not going to cope with the retirement of the boomers, the doubling of folks on Medicare, and our need for fundamental infrastructure investment without new revenues; (2) despite the speeches the left makes to itself, the problem won't be solved by taxing whomever the left decides is rich; (3) we aren't going to end the home mortgage and charitable deductions. There will come a point when $1 trillion in new revenue over the next decade that actually makes the economy and the world a little better will look pretty interesting, so why not try for it now?

Second, the tax system is a mess and more caught in a state of political gridlock than even the rest of the federal budget. The system is far too complicated, and it probably lowers economic growth and job creation. More practically, raising new revenues from this structure is next to impossible; the 40-year strategy of broadening the base and lowering rates (a strategy I agree with) has played itself out. With the carbon tax's $1 trillion, you could exempt low-income families, reduce the payroll tax, lower overall tax rates, and still bring down the debt and deficit. Sure, there would be fights about how to use the extra revenue, but those are fights the political system is supposed to have.

Third, jobs. We rely way too much on payroll taxes. They are very, very inefficient, and they directly and visibly add to the costs of job creation. Back when the U.S. economy was an unstoppable job machine, these taxes looked as though they were cost-free. Not anymore. I am optimistic about our long-term economic prospects, but I also think the jobs of the future will require much more education and training content than the jobs of the past, and therefore employers will be much more sensitive to other costs, i.e., taxes. Anything sensible we can do to make job creation easier and less costly is a step we should take.

Finally, the environment. A lot has been published recently about climate change and its sensitivity to greenhouse gases. Cutting through all of the models and the uncertainties, the net conclusion is that warming is probably a small bit less sensitive to greenhouse gases than we have thought. Climate change deniers have used this for the obvious purposes. But the actual end conclusions haven't changed much. At current rates, we will put half a trillion more tons of carbon into the atmosphere by 2045 and 1 trillion more by 2080. Because of this the Earth's temperature will probably warm about three-quarters of a degree in the next 30 years and 1.5 degrees over the next 50. (30 years may seem a long time to some of you; from my perspective, it's a blink of an eye away.) And the math keeps suggesting that the earth's sensitivity to extreme events is increasing more rapidly than global warming. So the future may be less hot but more dangerous.

Isn't it worth a small amount of political difficulty and a fairly small tax now to slow down these trends? Everyone in politics talks a lot about political courage – mostly their own. As far as I can tell, political courage normally consists of doing something your supporters love and your opponents hate and then bragging about it. But maybe the two leaders I mentioned at the start will realize that they can afford to change that definition and leave a real legacy.

Roosevelt Institute Senior Fellow Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team. He has also served in senior roles in the White Houses of two Democratic Presidents.

 

Melting Earth image via Shutterstock.com

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Reinhart-Rogoff a Week Later: Why Does This Matter?

Apr 24, 2013Mike Konczal

Retreat!

Well this is progress. We are seeing distancing by conservative writers on the Reinhart/Rogoff thesis. In Feburary, Douglas Holtz-Eakin wrote, “The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth. Granted, the research is not yet robust enough to say exactly when and how a crisis will engulf the US, but there is no reason to believe that America is somehow immune." (h/t QZ.)

Today, Holtz-Eakin writes about Reinhart and Rogoff in National Review, but drops the "canonical" status. Now they are just two random people with some common sense the left is beating up. "In order to distract from the dismal state of analytic and actual economic affairs, the latest tactic is to blame...two researchers, Carmen Reinhardt and Kenneth Rogoff, who made the reasonable observation that ever-larger amounts of debt must eventually be associated with bad economic news."

That's not actually what they said, and if you read Holtz-Eakin in February Reinhart-Rogoff is sufficient evidence to enact the specific plans he wants. Now there's no defense of the "danger zone" argument; just the idea that the stimulus failed. Retreat!

This is getting a bigger audience. (If you haven't seen The Colbert Report on the Reinhart/Rogoff issue, it's fantastic.) But going foward, plan beats no plan. And a critique isn't a plan. So what should we conclude about Reinhart-Rogoff a week later, now that the critique seems to have won? How should the government approach the debt?

Cliffs and Tradeoffs

One thing about the "cliff" metaphor is that there's no tradeoff that would make it acceptable. If you are driving, there are all kinds of tradeoffs you make with your route, but you'd never agree to a tradeoff that has you driving off a cliff. There were numerous other ways of describing this scenario, either the technical "nonlinearities" or the "danger zone" of Eakin just a few months ago.

With the danger zone metaphor now out of play, perhaps economists can see the relevant tradeoffs more clearly. Reinhart-Rogoff stand with a small negative relationship between debt and growth, one that is likely driven by low growth rather than high debt. And despite what you've heard, there's no literature that shows the casuation in the other direction.

But let's say they found it. Well, what's the relevant tradeoff? If there's even a basic fiscal multipler at work, the upside more than compensates for the downside. As Brad DeLong notes, if you consider a multipler of 1.5 and a marginal tax share of 1/3, the small correlation people are finding - Delong uses 0.006 percent from an in-house estimate - are more than canceled. Spending 2 percent more causes a bump of 3 percent of GDP, while debt goes up 1 percent of GDP. As Delong notes, "3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?"

And as the IMF noted recently, "Studies suggest that fiscal multipliers are currently high in many advanced economies. One important implication is that fiscal tightening could raise the debt ratio in the short term, as fiscal gains are partly wiped out by the decline in output." Now is the time to move away from austerity and towards more expansion. There are costs (though debt servicing is at a historic low), but the benefits outweight them.
 
Right now people are debating what level of debt-to-GDP we should level out at and how quickly that debt should begin to come down. There's also the debt ceiling battle coming at the end of the summer. This new information will influence all these conversations.
 
Was it Important?
 
Meanwhile, Ryan Avent at The Economist's Free Exchange writes about Reinhart-Rogoff here. To address one of his points, Avent also thinks that the Reinhart-Rogoff cliff results are overplayed as something that actually impacted policy. This is always a tricky question to answer, but Reinhart-Rogoff certainly dominated the sensible, mainstream conversation over the deficit and was a favorite go-to for conservatives in particular. I also think it was popular among journalists, because it was a straight-line number that was supposed to not require complicated modelng. Media Matters put together this video of people discussing the Reinhart-Rogoff cutoff:

(Bonus fun: in the video, at the 1m20s, Niall Ferguson refers to the 90 percent result as "the law of finance.")

I think the ideas matter. (Why else would we do this?) I think it's important to understand this revelation in light of other players moving against austerity, including both the IMF and the financial industry. As people reposition themselves, understanding that one of the core old ideas is now out of play allows a different reconfiguration of power. Also, it's worth repeating, it's becoming harder to pretend that austerity hasn't failed. It didn't even do the actual goal, which was reduce the debt-to-GDP ratios of the countries that were being targeted.

Citizens across the world who were normally indifferent are realizing that they were sold a bad bag of goods when it came to austerity and belt-tightening. They are now trying to figure out what happened, and how things could be done differently. As these are such critical issues, this examination is important. It's great we are having it.

Follow or contact the Rortybomb blog:

  

 

Retreat!

Well this is progress. We are seeing distancing by conservative writers on the Reinhart/Rogoff thesis. In Feburary, Douglas Holtz-Eakin wrote, “The debt hurts the economy already. The canonical work of Carmen Reinhart and Kenneth Rogoff and its successors carry a clear message: countries that have gross government debt in excess of 90% of Gross Domestic Product (GDP) are in the debt danger zone. Entering the zone means slower economic growth. Granted, the research is not yet robust enough to say exactly when and how a crisis will engulf the US, but there is no reason to believe that America is somehow immune." (h/t QZ.)

Today, Holtz-Eakin writes about Reinhart and Rogoff in National Review, but drops the "canonical" status. Now they are just two random people with some common sense the left is beating up. "In order to distract from the dismal state of analytic and actual economic affairs, the latest tactic is to blame...two researchers, Carmen Reinhardt and Kenneth Rogoff, who made the reasonable observation that ever-larger amounts of debt must eventually be associated with bad economic news."

That's not actually what they said, and if you read Holtz-Eakin in February Reinhart-Rogoff is sufficient evidence to enact the specific plans he wants. Now there's no defense of the "danger zone" argument; just the idea that the stimulus failed. Retreat!

This is getting a bigger audience. (If you haven't seen The Colbert Report on the Reinhart/Rogoff issue, it's fantastic.) But going foward, plan beats no plan. And a critique isn't a plan. So what should we conclude about Reinhart-Rogoff a week later, now that the critique seems to have won? How should the government approach the debt?

Cliffs and Tradeoffs

One thing about the "cliff" metaphor is that there's no tradeoff that would make it acceptable. If you are driving, there are all kinds of tradeoffs you make with your route, but you'd never agree to a tradeoff that has you driving off a cliff. There were numerous other ways of describing this scenario, either the technical "nonlinearities" or the "danger zone" of Eakin just a few months ago.

With the danger zone metaphor now out of play, perhaps economists can see the relevant tradeoffs more clearly. Reinhart-Rogoff stand with a small negative relationship between debt and growth, one that is likely driven by low growth rather than high debt. And despite what you've heard, there's no literature that shows the casuation in the other direction.

But let's say they found it. Well, what's the relevant tradeoff? If there's even a basic fiscal multipler at work, the upside more than compensates for the downside. As Brad DeLong notes, if you consider a multipler of 1.5 and a marginal tax share of 1/3, the small correlation people are finding - Delong uses 0.006 percent from an in-house estimate - are more than canceled. Spending 2 percent more causes a bump of 3 percent of GDP, while debt goes up 1 percent of GDP. As Delong notes, "3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?"

And as the IMF noted recently, "Studies suggest that fiscal multipliers are currently high in many advanced economies. One important implication is that fiscal tightening could raise the debt ratio in the short term, as fiscal gains are partly wiped out by the decline in output." Now is the time to move away from austerity and towards more expansion. There are costs (though debt servicing is at a historic low), but the benefits outweight them.
 
Right now people are debating what level of debt-to-GDP we should level out at and how quickly that debt should begin to come down. There's also the debt ceiling battle coming at the end of the summer. This new information will influence all these conversations.
 
Was it Important?
 
Meanwhile, Ryan Avent at The Economist's Free Exchange writes about Reinhart-Rogoff here. To address one of his points, Avent also thinks that the Reinhart-Rogoff cliff results are overplayed as something that actually impacted policy. This is always a tricky question to answer, but Reinhart-Rogoff certainly dominated the sensible, mainstream conversation over the deficit and was a favorite go-to for conservatives in particular. I also think it was popular among journalists, because it was a straight-line number that was supposed to not require complicated modelng. Media Matters put together this video of people discussing the Reinhart-Rogoff cutoff:

(Bonus fun: in the video, at the 1m20s, Niall Ferguson refers to the 90 percent result as "the law of finance.")

I think the ideas matter. (Why else would we do this?) I think it's important to understand this revelation in light of other players moving against austerity, including both the IMF and the financial industry. As people reposition themselves, understanding that one of the core old ideas is now out of play allows a different reconfiguration of power. Also, it's worth repeating, it's becoming harder to pretend that austerity hasn't failed. It didn't even do the actual goal, which was reduce the debt-to-GDP ratios of the countries that were being targeted.

Citizens across the world who were normally indifferent are realizing that they were sold a bad bag of goods when it came to austerity and belt-tightening. They are now trying to figure out what happened, and how things could be done differently. As these are such critical issues, this examination is important. It's great we are having it.

Follow or contact the Rortybomb blog:

  

 

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Guest Post: The Time Series of High Debt and Growth in Italy, Japan, and the United States

Apr 22, 2013Deepankar Basu

Mike Konczal here. In light of the collapse of the argument for a "cliff" in debt-to-GDP ratio, the most pressing issue to figure out is what to make of any minor relationship between debt and GDP. Which way does the causation work? Arin Dube wrote about this last week. Today, Deepankar Basu, assistant professor of economics at the University of Massachusetts-Amherst, takes a deep dive into this data using time series methods. Though this will involve some complicated techniques and charts, this work is crucial for understanding the current situation. I hope you check it out!

Public Debt and Economic Growth in the Postwar U.S., Italian and Japanese Economies

Deepankar Basu

A recent paper by Thomas Herndon, Michael Ash, and Robert Pollin (HAP) has effectively refuted one of the most frequently cited stats of recent years: countries with public debt above 90 percent of GDP experience sharp drop offs in economic growth. This “90 percent” result was put into circulation in 2010 by a paper written by Carmen Reinhart and Kenneth Rogoff (RR) and was heavily circulated by conservative policymakers, commentators, and economists.

I think the most important issue in the subsequent discussion in blogs and newspaper op-eds (for a quick rundown see here) is the question of causality. Does the negative correlation between public debt and economic growth rest on high levels of public debt causing low economic growth, as RR and other “austerians” claim (we borrow this term from Jim Crotty)? Or is the causation the reverse of what the austerians say, meaning low economic growth causes higher public debt? Using the HAP data set for 20 OECD countries, economist Arindrajit Dube of University of Massachusetts-Amherst has shown that (a) the negative relationship between public debt and growth is much stronger at low levels of growth, and (b) the association between past economic growth and current debt levels is much stronger than the association between current levels of debt and future economic growth. This is strong evidence for the second causation argument, where low growth leads to high debt.

While Dube has worked in a single equation framework with a panel data set, in this article, I change gears and ask a time series question instead: what useful information, if any, can one extract about the relationship between public debt and economic growth from historical data for individual countries? In particular, I ask the following question: can data on historical coevolution of public debt and economic growth in the postwar U.S., Italian and Japanese economies tell us anything useful about possible causal relationships among these two variables? To briefly summarize the results, I find that the time series pattern of the dynamic relationship between public debt and economic growth in the postwar U.S., Italian, and Japanese economies is consistent with low growth causing high debt rather than high debt causing low growth.

Why I Chose the U.S., Italy, and Japan

As reported in Table A-1 of the HAP paper, there are only 10 countries in the sample of advanced economies from 1946-2009 that witnessed debt-to-GDP ratios above 90. These countries generally experienced years with debt/GDP above 90 consecutively, so they form easily observable episodes. However, in the postwar period very few of these episodes exhibit notably slow growth. The U.S. from 1946-2009 has already been explained in detail here as being caused by the reduction in government spending due to demobilization from World War II.

Mike Konczal here. In light of the collapse of the argument for a "cliff" in debt-to-GDP ratio, the most pressing issue to figure out is what to make of any minor relationship between debt and GDP. Which way does the causation work? Arin Dube wrote about this last week. Today, Deepankar Basu, assistant professor of economics at the University of Massachusetts-Amherst, takes a deep dive into this data using time series methods. Though this will involve some complicated techniques and charts, this work is crucial for understanding the current situation. I hope you check it out!

Public Debt and Economic Growth in the Postwar U.S., Italian and Japanese Economies

Deepankar Basu

A recent paper by Thomas Herndon, Michael Ash, and Robert Pollin (HAP) has effectively refuted one of the most frequently cited stats of recent years: countries with public debt above 90 percent of GDP experience sharp drop offs in economic growth. This “90 percent” result was put into circulation in 2010 by a paper written by Carmen Reinhart and Kenneth Rogoff (RR) and was heavily circulated by conservative policymakers, commentators, and economists.

I think the most important issue in the subsequent discussion in blogs and newspaper op-eds (for a quick rundown see here) is the question of causality. Does the negative correlation between public debt and economic growth rest on high levels of public debt causing low economic growth, as RR and other “austerians” claim (we borrow this term from Jim Crotty)? Or is the causation the reverse of what the austerians say, meaning low economic growth causes higher public debt? Using the HAP data set for 20 OECD countries, economist Arindrajit Dube of University of Massachusetts-Amherst has shown that (a) the negative relationship between public debt and growth is much stronger at low levels of growth, and (b) the association between past economic growth and current debt levels is much stronger than the association between current levels of debt and future economic growth. This is strong evidence for the second causation argument, where low growth leads to high debt.

While Dube has worked in a single equation framework with a panel data set, in this article, I change gears and ask a time series question instead: what useful information, if any, can one extract about the relationship between public debt and economic growth from historical data for individual countries? In particular, I ask the following question: can data on historical coevolution of public debt and economic growth in the postwar U.S., Italian and Japanese economies tell us anything useful about possible causal relationships among these two variables? To briefly summarize the results, I find that the time series pattern of the dynamic relationship between public debt and economic growth in the postwar U.S., Italian, and Japanese economies is consistent with low growth causing high debt rather than high debt causing low growth.

Why I Chose the U.S., Italy, and Japan

As reported in Table A-1 of the HAP paper, there are only 10 countries in the sample of advanced economies from 1946-2009 that witnessed debt-to-GDP ratios above 90. These countries generally experienced years with debt/GDP above 90 consecutively, so they form easily observable episodes. However, in the postwar period very few of these episodes exhibit notably slow growth. The U.S. from 1946-2009 has already been explained in detail here as being caused by the reduction in government spending due to demobilization from World War II.

Other than the U.S., the only two countries with debt-to-GDP above 90 percent and average growth below 2 percent are Italy and Japan, with 1 percent and 0.7 percent respectively. With the inclusion of the earlier years from 1946-1949, New Zealand’s average growth increases from RR’s reported -7.6 percent to 2.6 percent. That is why I chose to focus in this article on U.S., Italy and Japan.

For the U.S. economy, federal debt declined from its high value (more than 100 percent of GDP) in the immediate postwar years to its lowest level in the mid-1970s (less than 25 percent of GDP), thereafter increasing till the mid-1990s and falling again over the next decade or so before picking up again with the onset of the global financial and economic crisis in 2007. The growth rate of real GDP has fluctuated a lot in the postwar period, with average values being higher in the two decades after the end of WWII than after the 1980s.

The Italian economy has experienced a different pattern: low levels of public debt till the early 1970s followed by a three-decade-long increase, with contemporary debt levels remaining at historical highs. Japan witnessed a very similar pattern: low levels of public debt till the mid-1970s followed by four decades of steady increase, with contemporary levels of debt hovering at historical highs. In terms of economic growth, both Italy and Japan witnessed a gradual slowdown, even as growth fluctuated at business cycle frequencies, over the entire postwar period. Thus, for all the three countries, there is large variation over time in both the variables (public debt and economic growth), which can be exploited to investigate their dynamic interrelationships. 

To motivate the analysis, in Figures 1.1, 1.2, and 1.3, I give time series plots of public debt and economic growth (year-on-year change in real GDP) for the three economies that I have chosen for this analysis: the U.S. economy between 1946 and 2012, the Italian economy between 1951 and 2009, and the Japanese economy between 1956 and 2009.

FIGURE 1.1  (USA): Time Series plots, for the period 1946-2012, of (a) federal debt held by public as a share of GDP (top panel), and (b) year-on-year change in real GDP (bottom panel). Source: data for debt is from Table B-78, Economic Report of the President, 2013; data for growth is from NIPA Table 1.1.1 

FIGURE 1.2  (ITALY): Time Series plots, for the period 1946-2012, of (a) federal debt held by public as a share of GDP (top panel), and (b) year-on-year change in real GDP (bottom panel). Source: Herndorn, Ash and Pollin (2013).

FIGURE 1.3  (JAPAN): Time Series plots, for the period 1946-2012, of (a) federal debt held by public as a share of GDP (top panel), and (b) year-on-year change in real GDP (bottom panel). Source: Herndorn, Ash and Pollin (2013). 

Why Use a Time Series Framework

Why do I adopt a time series framework? Adopting a time series lens allows one to use a vector autoregression (VAR) analysis, a popular time series methodology that is especially suitable for studying rich dynamic interactions among a group of time series variables. The pattern of dynamic interactions (allowing for complex lagged effects) can be nicely summarized through plots of orthogonalized impulse response functions, which trace out the effect of an unexpected change in a variable on the time paths of all the variables in the system (orthogonalizing the error makes sure that the effect of impulses to one error is not contaminated by cross correlation with other errors in the system).  In other words, this allows a researcher to address the following question: how would the variables in the VAR evolve over time when impacted by an unexpected change in one of the variables, holding other things constant? The key phrases here are “unexpected change in one of the variable” and “holding other things constant.” How do we interpret these key phrases?

Recall that in a VAR, every variable is explained by its past values and by past values of the other variables in the system. Each equation also has an unexplained part, the random error term. Thus an impulse imparted to the error (i.e., the unexplained part) in one of the equations in the VAR, can be understood as an “unexpected change,” or change in the variable that is not explained by its own past values and past values of the other variables in the VAR. Orthogonalizing the errors, on the other hand, implies that a change in one error is uncorrelated by changes in other errors in the system. Hence, when the researcher traces out the impact of an impulse to one error, she is confident that it is not picking up effects of changes in the other errors. This is a clear advantage over cross sectional analysis of correlations among variables, where distinguishing the effects of changes in one variable from the other might be difficult.  

In addition, a VAR allows each variable to be endogenous; i.e., it not only allows for lagged but also contemporaneous interaction among the variables. Thus, the researcher is not forced to take an a priori stand on whether a variable is exogenous (or not) as in a single equation estimation framework (where the dependent variable is, by assumption, endogenous, and some of the independent variables are exogenous).

Of course, a VAR will not, by itself, address the issue of causality; one needs to impose additional restrictions to distinguish causality from correlation (i.e., to tackle the so-called identification problem). A common identification strategy is to adopt a “causal ordering” of the variables in the VAR, which is a way to restrict some of the contemporaneous effects among the variables. If a variable is causally prior to another, this means that changes in the second variable cannot have any contemporaneous impacts on the first. In a two-variable vector autoregression (VAR), there are only two possible orderings: the first variable can be assumed to be causally prior to the second, or vice versa.

So, one can use both orderings (instead of taking a stand on which is the correct structural relationship) and see if the shape of the impulse response functions change according to the ordering adopted. If it does not, then the pattern of dynamic interaction captured by impulse response functions can be thought of as a reasonable approximation of underlying structural relationships. The point is this: if the impulse response functions display qualitatively similar shapes in both ordering of variables (and remember there are only two possibilities here), then the dynamic patterns of interaction are independent of the ordering. Either of them can be used to address the question: how does the system react to an unexpected change in one variable? This is a common empirical strategy in the time series literature, and as such we adopt it here. (This strategy becomes difficult to implement and interpret when there are more than two variables in the system, in which case theoretically motivated restrictions are imposed to get identification.)

Two-Variable VAR Analysis for Individual Countries

To investigate the debt-growth relationship, I estimate a two-variable VAR with an optimal number of lags (where public debt as a share of GDP and year-over-year change in real GDP are the two variables) for each of the three countries separately: the U.S. economy for the period 1946-2012, the Italian economy over 1951-2009, and the Japanese economy over the period 1956-2009. (I choose the “optimal” number of lags using the Akaike Information Criterion.) I find three interesting results.

First, the contemporaneous correlation between the errors in the two equations of the VAR is negative for each of the three countries (-0.56 for the U.S., -0.54 for Italy, and -0.30 for Japan). This suggests that unexpected changes in debt and economic growth move in the opposite direction in each of these countries. This finding is in line with existing results, both of Reinhart-Rogoff and their critics.

Second, I conduct Granger non-causality tests to understand lags of which of the two variables in the VAR better helps in predicting the other. Table 1 summarizes Granger non-causality test results for the three countries. The first column in Table 1 tests whether debt does not Granger-cause growth; i.e., the null hypothesis that all lags of debt enter the growth equation with zero coefficients. A high p-value indicates that the null hypothesis cannot be rejected; i.e., lags of debt do not help in predicting growth. The entries in the first column are all relatively large and show that lags of debt do not help in predicting growth with high levels of statistical significance. This is true for all three economies, and especially for Italy (which has a p-value of 0.81).

The second column in Table 1 tests for the opposite direction of predictability: it tests whether growth does not Granger-cause debt; i.e., the null hypothesis that all lags of growth enter the debt equation with zero coefficients. A low p-value indicates that the null hypothesis can be strongly rejected; i.e., lags of growth do help in predicting debt. The entries in column 2 are all relatively small and show that lags of growth help in strongly predicting debt for all three countries (both U.S. and Italy have p-values of 0, and Japan has a p-value of 0.04).

This finding about Granger non-causality is in line with similar results reported in 2010 by Josh Bivens and John Irons for the U.S. economy. The fact that similar results hold for Italy and Japan, which have been witnessing relatively higher levels of public debt in the past few decades, is indeed a strong rebuttal of austerian claims. It demonstrates that low growth leading to (or helping to predict) high debt is more consistent with the time series data than high debt leading to (or helping to predict) low growth. Moreover, this is true not only for the U.S. economy but also for Italy and Japan. 

Third, I analyze plots of impulse response functions (IRF) to decipher possible directions of effects running between debt and growth for all three countries for the two possible “orderings” of the variables. Figure 2.1, 2.2, and 2.3 display the orthogonalized IRFs with the first “ordering,” where debt is assumed to be “causally prior” to growth (meaning changes in debt can have a contemporaneous impact on growth but not the other way around). Figure 3.1, 3.2, and 3.3 display the orthogonalized IRFs with the alternative ordering, where growth is assumed to be “causally prior” to debt (meaning changes in growth can have a contemporaneous impact on debt but not the other way around).

 

 

FIGURE 2.1. (USA): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the U.S. economy for the period 1946- 2012 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Debt is causally prior to growth.

FIGURE 2.2. (ITALY): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the Italian economy for the period 1951- 2009 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Debt is causally prior to growth.

FIGURE 2.3. (JAPAN): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the Japanese economy for the period 1956- 2009 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Debt is causally prior to growth.

Impulse Response Function: Impact of Debt on Growth

Let us start with the first ordering. In the top panel (right) of Figure 2.1 (USA), a one standard deviation positive impulse to the debt shock (i.e., the error in the equation that predicts debt) reduces growth contemporaneously, but growth returns back to zero within a year and stays there after that. In the top (right) panel of Figure 2.2 (ITALY), a similar impulse to the debt shock reduces growth contemporaneously, and growth returns back to zero within the next two years and stays there after that (notice that the 90 percent confidence interval includes zero). In the top panel (right) of Figure 2.3 (JAPAN), a one standard deviation impulse to the debt shock reduces growth contemporaneously, but growth returns back to zero within a year and gradually falls over the next several years (though here, too, the 90 percent confidence interval includes zero).

What story do these pictures tell us? If debt has a contemporaneous effect on growth (but not the other way round), then an unexpected increase in the level of debt in any year (due, for instance, to an increase in the deficit of a government that has given a tax break) will reduce economic growth in that year, but the negative impact will be washed out relatively quickly. The system will return back to its original growth path within the next few years. The speed with which the system reverts back to its original state is quickest for the U.S, slower for Japan, and slowest for Italy.  

FIGURE 3.1. (USA): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the U.S. economy for the period 1946- 2012 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Growth is causally prior to debt.

FIGURE 3.2. (ITALY): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the Italian economy for the period 1951- 2009 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Growth is causally prior to debt.

FIGURE 3.3. (JAPAN): Orthogonalized impulse response functions using a Cholesky decomposition for a 2 variable VAR (debt and growth) with optimal number of lags (chosen with AIC). The recursive VAR is estimated with annual data for the Japanese economy for the period 1956- 2009 and 90 percent bootstrapped confidence intervals are included in the IRF plots. Ordering: Growth is causally prior to debt.

Let us now turn to the second ordering. In the top panel (right) of Figure 3.1 (USA), a one standard deviation impulse to the debt shock has no contemporaneous effect on growth, but there is a positive effect on growth for the next two years. In the top panel (right) of Figure 3.2 (ITALY), a one standard deviation impulse to the debt shock has no contemporaneous effect on growth, and a fluctuating (negative and positive) impact on growth which is not very precisely estimated (the 90 percent confidence interval includes zero). In the top panel (right) of Figure 3.3 (JAPAN), a one standard deviation impulse to the debt shock has no contemporaneous effect on growth, but growth experiences a positive impact for the next three years, after which it starts falling – all of which is estimated pretty imprecisely (the 90 percent confidence interval includes zero).

How should we interpret these pictures? In this case, only Italy displays a negative impact of debt on growth; both Japan and the U.S. show mildly positive impacts of unexpected changes in debt levels (though the effects are estimated pretty imprecisely). Thus, if it were the case that the contemporaneous effect between debt and growth runs from the latter to the former (as the second ordering assumes), then increases in levels of public debt might even have a positive impact on economic growth, as witnessed in the U.S. and Japan. Why might this be the case? This might be reflecting the positive multiplier effect on output growth of a boost to aggregate demand coming from an increase in the government’s deficit. Evidence for the U.S. and Japan suggests that this effect might be non-zero, at least in the short run.

Thus, for all three countries and in both orderings, an unexpected increase in debt in any year does not have any statistically significant negative effect on economic growth in future years. When I allow the contemporaneous effect to run from growth to debt, the short- to medium-term impact is positive for the U.S. and Japan, though the effects are not very precisely estimated. This evidence is contrary to RR’s claim that high debt leads to low growth.   

Impulse Response Function: Impact of Growth on Debt

Once again, let us start with the first ordering. In the bottom panel (left) of Figures 2.1 (USA), 2.2 (ITALY), and 2.3 (JAPAN), a one standard deviation impulse to the growth shock reduces debt unambiguously in the short and medium term. While debt starts returning to its initial level in the case of the U.S. economy after about five to six years, it keeps declining in the Italian and Japanese economies. (This seems to suggest that the impact of economic growth on debt levels is longer lasting in Italy and Japan than in the U.S.) The bottom panels (left) of Figures 3.1 (USA), 3.2 (ITALY), and 3.3 (JAPAN) display impulse response plots for a one standard deviation impulse to the growth shock for the second ordering. They paint a qualitatively similar picture to that seen for the first ordering.

So, what do these figures tell us? They show that an unexpected increase in economic growth (for instance, due to an increase in aggregate demand caused by expanding exports) will be associated with a decrease in levels of public debt. Hence, we can turn this picture around and infer the following: when there is an unexpected decrease in economic growth, it will be associated with an increase in the levels of public debt over the next several years. This is true for all the three countries and for both orderings of the variables in the VAR.

Moreover, unlike the effect of debt on growth (which we saw in the top panels of the figures), the effects of unexpected changes in growth on future debt levels are statistically significant (though imprecisely measured) up to about 10 years in the future. This evidence clearly supports the anti-austerian position that low growth leads to higher public debt.

Summary

To summarize, I find that the time series pattern of the dynamic relationship between public debt and economic growth in the postwar U.S., Italian, and Japanese economies is consistent with low growth causing high debt rather than the high debt causing low growth. I draw this conclusion from two types of analyses: Granger non-causality tests and an investigation of impulse response function plots.

Granger non-causality tests allow one to ask the following questions: (a) do debt levels in the past help in better predicting current economic growth, and (b) does economic growth in the past help in improving predictions of current debt levels? The evidence suggests that for the U.S., Italy, and Japan, the answer to the first question is a NO and the answer to the second is a YES.

Impulse response analysis allows one to address the following questions: (a) what is the impact of an unexpected increase in current debt levels on the future time path of economic growth, and (b) how does an unexpected decline in economic growth affect future levels of debt? The data suggests that an unexpected increase in debt levels has only a small effect on future economic growth but an unexpected decline in economic growth is associated with large and long-lasting increases in public debt levels.     

Thus, empirical evidence from time series analysis of the U.S., Italian, and Japanese economies seems to bolster the critique presented by our colleagues Herndon, Ash, and Pollin, as well as Dube and others, of the Reinhart-Rogoff claim that high public debt leads to low economic growth. If anything, the evidence supports causality running in the opposite direction: low growth causes higher public debt.

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