These are beautiful times for philosophers of economics. The recent financial crisis has caused about as much turmoil in the economics profession as it has in the financial markets, the economy and government balance sheets. Last week we could learn that economists fail not only with respect to the theoretical, methodological and ethical foundations of their discipline, at least some of the discipline’s most prominent and influential members appear not to possess even the most basic epistemic integrity one would expect any scientist to have, much more scientists whose public policy recommendations have far reaching consequences for the welfare of millions of people.
To briefly recap the story (slightly more detailed ones here and here), it all started with a 2010 paper in which two Harvard economists, Carmen Reinhart and Kenneth Rogoff, purported show that a country’s level of debt and GDP growth are negatively correlated. Moreover, their evidence seemed to indicate an important non-linearity: ‘the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more’. 90 percent debt/GDP thus looked like a tipping point beyond which growth drops sharply.
In their paper, Reinhart and Rogoff were careful not to draw strong policy conclusions from their findings or to read them causally. But other statements lend themselves to causal interpretation (‘In a series of academic papers with Carmen Reinhart… we find that very high debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more’, see here), and they certainly regard the 90 percent threshold an important indicator for policy (e.g., ‘Our analysis, based on these cases and the 23 others we identify, suggests that the long term risks of high debt are real.’, NBER Working Paper 18015, p. 23).
The timing of this research could hardly have been better. Many governments ran huge budget deficits to finance fiscal stimulus packages in the aftermath of the recent financial crisis. As a consequence, public debt/GDP ratios soared all over the world between 2008 and 2012: from 64.8 to 101.6 in the US, 44.5-89.8 in the UK, 66.2-93.1 in the Eurozone, 64.9-81.6 in Germany, 105.4-161.6 in Greece. Alas, not all countries could handle the increased levels of debt equally well: the US steered dangerously close to a ‘fiscal cliff’, several European countries such as Greece and Cyprus had to be bailed out by IMF and the EFSF, and, probably, the best is yet to come. IMF and EFSF grant financial assistance only after a ‘country programme’ with the requesting government has been agreed on, and these programmes invariably contain numerous austerity measures. The Reinhart-Rogoff findings appear to justify austerity. Until an Amherst grad student cooked their goose.
Thomas Herndon tried to replicate the Reinhart-Rogoff findings as an exercise for a term paper in an econometrics class. But no matter what he tried, his results kept deviating from those published by the prominent economists. So he asked them for their spreadsheet, received it and found the sources of discrepancy: a stupid coding error, mysterious data exclusions and dubious methodological choices (download the paper, co-authored by Herndon’s supervisors, here). When corrected for the mistakes, growth remains slightly lower for countries with a debt/GDP ratio above 90 percent but the difference is not at all dramatic. I haven’t seen any evidence to the effect that Reinhart-Rogoff deliberately tweaked results. Thus far, they have admitted to the coding error but defended other aspects of their study. It is pretty clear, however, that the original analysis did not quite receive as much attention as it should have, especially considering the likely policy consequences of research of this kind.
And now? Two Harvard professors toppled from their pedestal, anti-austerity protests vindicated, a triumph of the left. The world makes sense again. At least if we are to trust the many commentators in the blogosphere.
The true scandal behind this episode in my view is that evidence of a negative correlation between the public debt/GDP ratio and growth should never have been taken to support austerity measures. Likewise, the absence of evidence for such a correlation does certainly not support public spending sprees.
As we all know, and as Paul Krugman reminds us (here), correlation does not imply causation. But this is an obvious and not very interesting point. My own main worry is that pooling data from many very heterogeneous countries and historical periods is likely to produce non-sensical results – or at least results that are not very useful for policy considerations.
Take an analogy. What determines whether additional debt is problematic in case of an individual? This will certainly depend on his or her existing level of indebtedness, whether collateral is available and of what quality it is, what his or her employment situation is currently and likely to be in the future, what the money will be spent on and so on. Since these factors differ from person to person, it would be silly to use a rule such as ‘Do not incur a debt greater than x times your annual income’. But this is exactly the kind of recommendation some economists and policy analysts seem to have taken from the Reinhart-Rogoff research.
Countries (or their governments) do not secure public debt with collateral. Their ability to raise money in capital markets depends mainly on their potential to tax their citizens in the future. And this potential in turn depends on factors such as population growth, median age, private debt and so on. (Would you rather loan money to a 25-year old or a 65-year old? To a double-income-no-kids household or to one that has a growing number of dependents, many of whom have either already left the labour market or may never enter it? To a household that is already much indebted or one that is not? Etc.)
With respect to these factors there are enormous differences among the countries and periods Reinhart-Rogoff pool, differences that should matter for the analysis. For instance, population growth in the U.S. is among the highest among industrialised countries, mainly due to high immigration. Immigrants are mostly young and keen to work. By contrast, Japan, Germany and most Eastern European countries have negative population growth (Slovenia, a likely candidate for EFSF assistance, shrinks by 0.2% per year, for instance). The median Japanese is 44.6, the German 43.7, the Greek 42.2. U.S. Americans are a lot younger at 36.9.
Differences over time matter too. In 1945 the U.S. public debt to GDP ratio was 113%, a lot higher than even today. But in the years after, public debt was reduced dramatically (to a post WWII low of 24.6% in 1974) without negative effects on growth, which remained at a solid 3% in that period. In the private sector, the debt was only 43% of GDP in 1945, however. That figure lies at a stunning 250% today. Thus, a decrease in public spending will be much harder to absorb for the private sector. To the contrary, the private sector will want to reduce rather than increase its debt. Moreover, in the period 1945-1974 the U.S. population became younger on average whereas it is ageing today. (See here for these points.)
Without telling a country and historically specific story of the financial health of a nation, arguments to the effect that austerity is ‘good’ or ‘bad’ should be unconvincing, quite independently of whether or not Reinhart and Rogoff’s figures were fudged or not.