Start Making Sense

“You may find yourself living in a shotgun shack
You may find yourself in another part of the world
You may find yourself behind the wheel of a large automobile
You may find yourself in a beautiful house with a beautiful wife
You may ask yourself, well, how did I get here?” — From Once in a Lifetime by Talking Heads

Kenneth Rogoff and Carmen Reinhart (RR) in the latest exchange of fire with Paul Krugman

The Herndon, Ash and Pollin paper, using a different methodology, reinforces our core result that high levels of debt are associated with lower growth. This fact has been hidden in the tabloid media and blogosphere discourse, but this point is made plain by even a cursory look at the full set of results reported in the very paper they critique. More importantly, the result was prominently featured in our 2012 Journal of Economic Perspectives paper with Vincent Reinhart on Debt Overhangs, which they do not cite. The main point of our 2012 paper is that while the difference in annual GDP growth between high and lower debt cases is about one percent a year, debt overhang episodes last on average 23 years. Thus, the cumulative effect on income levels over time is significant.

Third, the debate of the last few weeks does not change the fact that debt levels above 90% (even if one entirely rejects this marker for gross central government debt as a common cross-country “threshold”) are very rare altogether and even rarer in peacetime. From 1955 until right before the recent crisis, advanced economies spent less than 10% of those years at a debt/GDP ratio of higher than 90%; only about two percent of the years are above 120% debt/GDP. If governments thought high debt was a riskless proposition, why did they avoid it so consistently

Note the interesting tension between the two points that RR make. High debt episodes are both vary rare and very long. RR’s interpretation of this is that governments can and have gone to great lengths to avoid being in high debt states.

There’s a complementary interpretation which is that we shouldn’t be talking about various levels of debt in terms of the choice about which one to have. Instead, high debt is a syndrome, a fundamentally different state of affairs from medium or low levels of debt. And furthermore that countries may not have a lot of control in ending up with high debt (as indeed the RR financial crises book implies). In other words, by the time Ireland and Iceland and Cyprus and perhaps Spain and Slovenia were asking the “How did we get here” question about their fiscal crises, it was far too late to do anything about it.

From this perspective, arguing about the exact size of fiscal stance — 1-2 percent of GDP more or less from one year to the next — is somewhat beside the point for countries hit by a financial tidal wave. Now they’re at the point of, er, into the blue again after the money’s gone, and the question is what to do. Or put in RR terms, the question is whether it’s realistic to expect high debt countries to wait 23 years to exit that state?

One thought on “Start Making Sense

  1. “RR’s interpretation of this is that governments can and have gone to great lengths to avoid being in high debt states.”

    There is also the point that, when a government tries to stop the growth of debt, it is forced to employ contractionary policies, which will slow growth.

    From this point of view it is possible that high debt is correlated with low growth precisely because government fear the high debt.

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