Misleading data on debts and growth

Feb. 17, 2010

Kenneth Rogoff of Harvard and Prof. Carmen Reinhart
have a new paper out that purports to show rising indebtedness above 90 % of the GDP impedes the rate of economic growth by 1 %. But the paper is less than convincing. In the first place in the developed world of advanced capitalism the number of data points of countries where debt levels exceed 90 %   for any prolonged period of time are rather limited. They have a large set of data over many years but most of it is for lower debt levels and much of it for less developed countries where a lot else is going on with respect to economic growth than simply public sector debt.

But in addition there is a bigger problem with their analysis as it is presented and commented upon by Martin Wolf in the FT today. There is no discussion of causality. There may well be a correlation between slower growth and rising debt beyond 90 % of the GDP but which causes which ?

Almost always , particularly in monetarist policy oriented central banks interest rates are raised before a recession sets in. So slower growth is no surprise . It is a result of interest rate rise induced recession. Given the slower growth, debt levels inevitably rise because that is how the fiscal system of the advanced western countries is designed.There is no surprise here. But the cure to these higher debt levels is the restoration of growth and lower unemployment. So Rogoff and Reinhart because they do not, at least in the version of the paper that is posted on line(a link is provided in Martin Wolf's column in the FT on walking the fiscal tightrope), discuss this issue of causation have not demonstrated the conclusions they claim.

Rather than some arbitrary policy rule about debt to GDP, I prefer the following formulation which I have written about in the past. Responsible fiscal policy budgeting entails separating out investments in human capital and other capital account expenditures from the current expenditure budget, lowering the rate of unemployment to a consensually arrived at target range(below 5 % for the U.S. and Canada, ensuring that infrastructure is on a sustainable path through appropriate investment in it, and then and only then balance the current expenditure budget.