Why this time is not different - revisiting debt and growth for the infinite time

Well, if I don't get this out now, I'm not likely to do it later because I would have read the whole paper and a lot more people would have too. It turns out there is something amiss this morning! - namely this. It's a paper by 3 UMass researchers that sought to duplicate the famous (infamous to me!) Reinhart-Rogoff narrative on what high debt levels do to growth, and among other things- median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower.

I don't think I've been quite critical enough of these debt-growth studies - but most of the time, there are enough people doing the taking down. This time is not different.

Tim Fernholz at Quartz lays less into the study and more into the blatant disdain political figures showed while repeatedly misusing it. He quotes a passage from Republican senator Tom Coburn's book of debt that describes a scene where, in April 2011, 40 senators met R&R for a briefing - here's what transpired (all emphasis is mine):

“Absolutely,” Rogoff said. “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point,” he warned us.

Senator Kent Conrad...explained to his colleagues that when our high debt burden causes our economy to slow by 1 point of GDP, as Reinhart and Rogoff estimate, that doesn’t slow our economy by 1 percent by 25 to 33 percent when we are growing at only 3 to 4 GDP points a year.

Reinhart echoed Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent threshold, we would expect a higher incidence.”

I present to you -  the "scratch-your-head-till-it-hurts-and-you-find-the-least-smart-comment-game"...STARRING...:

 -  “[I]t is widely acknowledged, based on serious research, that when public debt levels rise about 90% they tend to have a negative economic dynamism, which translates into low growth for many years.” — European Commissioner Olli Rehn.

 -  “Economists who have studied sovereign debt tell us that letting total debt rise above 90 percent of GDP creates a drag on economic growth and intensifies the risk of a debt-fueled economic crisis.” — House Budget Committee Chairman and former Republican vice-presidential candidate Paul Ryan.

 -  “It’s an excellent study, although in some ways what you’ve summarized understates the risks.”— Former US Treasury Secretary Tim Geithner. 

 -  “[W]e would soon get to a situation in which a debt-to-GDP ratio would be 100%. As economists such as Reinhart and Rogoff have argued, that is the level at which the overall stock of debt becomes dangerous for the long-term growth of an economy. They would argue that that is why Japan has had such a bad time for such a long period. If deficits really solved long-term economic growth, Japan would not have been stranded in the situation in which it has been for such a long time.” Lord Lamont of Lerwick, former UK chancellor and sometime adviser to current chancellor George Osborne.

 -  “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.”— Doug Holtz-Eakin, Chairman of the American Action Forum.

This is a close one but I've just got to give it to L-cube for those really fancy initials and of course the Japan parallel. Your winner emeritus - Lord Lamont of Ler...

...Anyway, on to more serious critiques, Mike Konczal (Rortybomb/NextNewDeal) summarizes the three issues of the HAP do-over (I would think that this was the post on the econoblogosphere that set off things):

"First, Reinhart and Rogoff selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias in favor of their result, and without them you don't get their controversial result."

There's more detail on these three here if it interests you. But there's something else too!

That would be the average excluding Belgium, which had a robust 2.6% growth in a "time of high debt". Yes, that's the cell not being dragged all the way down - it leads to the average being 2.2 instead of -0.1%. 

But Krugman has some more insight on this. He points to two studies that have acted as a sort of foundation for this harmful austerity drive. The first is the Alesina-Ardagna paper on the expansionary macro-benefits of austerity. The second of course, is the R-R study, and the point he makes (perhaps justifiably!), is that while some could obviously observe the effects of observed correlation and reverse causation, the "crime" so to speak, lies with all the policymakers that actually used it as a public defense of their agenda. Think of this in a David-Li-and-the-Gaussian-Copula way. Should he blamed because rating agencies and investment firms adopted his interpretation?  

Anyway, Krugman uses his own scatterplot but differentiates between countries so as to test the effects of the weighting system. His sample is only 1950-2009 and works for the G-7 only (which in retrospect might not be a bad thing at all). While he concedes that there does seem to be some sort of an association, "most of the apparent relationship is coming from Italy and Japan; Britain didn’t seem to suffer much from its high debt in the 1950s. And it’s quite clear from the history that both Italy and (especially) Japan ran up high debts as a consequence of their growth slowdowns, not the other way around."

But I saved the defence for the last! Here's what Reinhart-Rogoff state in a WSJ piece (in response to the HAP research):

"...On a cursory look, it seems that that Herndon Ash and Pollen also find lower growth when debt is over 90% (they find 0-30 debt/GDP , 4.2% growth; 30-60, 3.1 %; 60-90, 3.2%,; 90-120, 2.4% and over 120, 1.6%). These results are, in fact, of a similar order of magnitude to the detailed country by country results we present in table 1 of the AER paper, and to the median results in Figure 2. And they are similar to estimates in much of the large and growing literature, including our own attached August 2012 Journal of Economic Perspectives paper (joint with Vincent Reinhart) . However, these strong similarities are not what these authors choose to emphasize.

The 2012 JEP paper largely anticipates and addresses any concerns about aggregation (the main bone of contention here), The JEP paper not only provides individual country averages (as we already featured in Table 1 of the 2010 AER paper) but it goes further and provide episode by episode averages. Not surprisingly, the results are broadly similar to our original 2010 AER table 1 averages and to the median results that also figure prominently.. It is hard to see how one can interpret these tables and individual country results as showing that public debt overhang over 90% is clearly benign...

...By the way, we are very careful in all our papers to speak of “association” and not “causality” since of course our 2009 book THIS TIME IS DIFFERENT showed that debt explodes in the immediate aftermath of financial crises. This is why we restrict attention to longer debt overhang periods in the JEP paper, though as noted there are only a very limited number of short ones...

...Lastly, our 2012 JEP paper cites papers from the BIS, IMF and OECD (among others) which virtually all find very similar conclusions to original findings, albeit with slight differences in threshold, and many nuances of alternative interpretation.. These later papers, by the way, use a variety of methodologies for dealing with non-linearity and also for trying to determine causation. Of course much further research is needed as the data we developed and is being used in these studies is new. Nevertheless, the weight of the evidence to date –including this latest comment — seems entirely consistent with our original interpretation of the data in our 2010 AER paper."

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In a way, it's kind of what you expect, perhaps a bit more defensive, a little less calm - I wouldn't know, I'm not too good at gauging reactions. 

What I do know is that any kind of study that seeks to establish an association, tries to imply causation and uses historical data that might be of little use in the world we live in today must be taken with a pinch of salt. 

It can be used to provide perspective and complement or contradict other lines of thought. What it shouldn't do however, is be misused as a tool, and treated as "evidence" just so that politicians and policy makers can advance an agenda. 

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P.S: Some further further reading (because it just never stops):

 - Ryan McCarthy has a good encapsulating summary at Counterparties

 - Matt Yglesias at Slate asks what exactly this will really change

 - The folks at Alphaville (Garcia/Cotterill) have a far more specific critique of the study in general and the lack of vetting that went along with it

 - Tyler Cowen, at Marginal Revolution, on a lighter note, has an interesting and fair point-by-point take on future consequences. He asks whether this should change the ratios (quant/narratives) of what he reads.

 - Dean Baker at CEPR emphasizes the implications that this paper led to (it's provocatively  titled "how much unemployment was caused...") along with a follow-up of his own post post-response

 - Noah Smith has his own noahpinion where he chooses to focus instead on the book that sheds light on historical financial crises. He also excuses the "gotcha" excel moment (which I do think is fair, hey it could happen to me!)

 - Owen Zidar has his own take presenting us with two graphs from a collaborative effort on an IMF presentation with Tyson and DeLong.

 - Dylan Matthews at Wonkblog had a detailed "debt/deficits/spending etc" piece just over a week ago. One of the sections is "Countries with debt over 90 percent of GDP enter a danger zone". Worth the read

 - Ryan Avent plays the twitter role

 - The last word should go to Robert Shiller for his Project Syndicate piece almost two years ago with this gem, 

"A paper written last year by Carmen Reinhart and Kenneth Rogoff,...found that when government debt exceeds 90% of GDP....

...One might be misled into thinking that, because 90% sounds awfully close to 100%, awful things start happening to countries that get into such a mess. 

But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90% figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30%, 30-60%, 60-90%, and over 90%. And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category".

More on the dog that did not bark...

Picking up where I left off last time, the next step of course, is attention to detail - namely, what role does 'economic slack' or the output gap play along with the anchoring of expectations?

Ryan Avent over at free exchange asks that if you factor in the change in central bank credibility over time, and assume that it was effective, then what happened to unemployment?

Anyway, the key here to take away is to zero in on the notion that slack in demand affects quantity shifts rather than price shifts. Essentially, "Workers expecting prices to stay flat amid falling demand will resist wage cuts, and firms expecting workers to resist wage cuts will be reluctant to cut prices. Instead firms will produce and sell less and lay off workers, turning a given shock into much more of a real output loss". 

But that's not something new. To that extent, Avent draws back to an '88 paper by Mankiw, Ball and Romer on  the inflation-output trade-off titled, "The New Keynesian economics and the Output-Inflation trade off". Essentially, they empirically observe the same - during high inflationary periods, firms and workers are likely to adjust prices and wages more thus increasing responsiveness to shifts in demand. In contrast, during low inflationary periods, nominal rigidity sets in.

What the authors conclude is this: 
High inflation -> relatively flatter Phillips Curve (changes in nominal AD have significant effects on output). Low inflation -> steeper curve (shift in demand is reflected faster in the price level).

But back to Chapter 3.

I won't dwell much on output gaps but this is what the estimates suggest - Capacity Utilization decreased by about 5-6% since the beginning of the GFC while Unemployment gaps averaged roughly 2%. The study clearly states that what this suggests is a considerable share of the GFC unemployment increase being cyclical (the gap between current unemployment and NAIRU).

More importantly, on the anchoring of expectations angle, it turns out that although current and expected inflation are positively correlated (as you might expect), the slope is low, implying that expectations are anchored to targets rather than the current level. 

The basic approach involved here is again, eerily simple. Two differences are used, the regressor is the difference in the actual inflation rate (at the time expectations are collected) and the central bank's target level. The dependent is the difference between the long-term expectation at a given time and once again, the central bank's target level rate. If you visualize this, you can see why:
1) If the regression coefficient estimate is zero, then the relationship between expectations and the actual inflation would not be significant
2) If the estimate of the intercept is zero, then expectations would be centered at the central bank's target rate.

The results are best explained in a graph of the coefficient estimates:

For the record, these are rolling (five year window) regression on a 12 advanced economy sample since 1990. 
Further, evidence on the relationship between the inflation level and its responsiveness to economic slack shows that slack persists and that "the recent stability of inflation is indicative of greater anchoring of expectations and a more muted relationship between economic slack and inflation".

But these are naturally tentative observations (what about headline CPI, import-relative price inflation, lags, shocks etc?) - whether this approach holds consistently can be explored further in a more formal framework and model. 

More on that soon.

The WEO's inflation primer - the dog that never barked

From the chapter with a witty opening quote from Silver Blaze, here's a small excerpt from the forthcoming WEO which has a whole chapter (about time too!) devoted to inflation or in their own words - the dog that didn't bark, forget bite! 

I just wanted to get in a quick reasoning on the whole inflationary quiescence in an era of unprecedented and unconventional monetary accommodation. But before that, here's a nice graph from the chapter that shows the staggered short-medium run behavior over the long-term between inflation and unemployment. As expected, it differentiates between the GFC and the rest - the '70-'79 decade is characterized by that vertical spike while the GFC has a horizontal extension closer to the principal axis:

The fund begins by looking at a New-Keynesian framework of a Phillips curve variant. It assumes that inflation (p(t)) is impacted by inflation expectations (pe(t)) and the level of cyclical unemployment (u(t)) (you can leave the cyclical/structural debate for later!). 

So, p(t) = (pe(t)) - k.u(t)
 where k is the parameter that is the slope of the curve. Using this basic framework, the following explanations can then be discussed retrospectively.

First - if the increase in unemployment had a dominant structural component instead of a cyclical one, then the change in u(t) will have little impact on p(t).

Second - (Bernanke might have a lot more to say on this), inflationary expectations may well be a lot more anchored than people presume they are. This could be a direct or indirect result of the difference in perspective of central bank credibility. 

Third - prior to the GFC, inflation was still the dog that didn't bark and this initial level or "other changes" could well have impacted the response mechanism of inflation to cyclical developments. That is, you would expect a somewhat flatter curve and hence, a smaller coefficient for the slope (k). 

I'll get more wonkish on this (as they do), tomorrow.

How Growth + Austerity go hand in hand

Here's Wolfgang Schaeuble in Berlin :

“Nobody in Europe sees this contradiction between fiscal policy consolidation and growth...We have a growth-friendly process of consolidation, and we have sustainable growth, however you want to word it.”     

Here's what he's referring to (courtesy DeGrauwe/Ji) - fiscal consolidation versus growth (2011-2012):

Clearly some "growth-friendly" consolidation.

Now I'm aware of the sample, the time-frame and the other nuances. But what I'm not that aware of is:
a) What is meant exactly by "growth-friendly"
b) Growth friendly for whom? Everyone?

SMH.

Might the BoJ overshoot?

Desmond Lachman writes in responding to the FT editorial on the BoJ's unprecedented moves. But naturally, if you're writing in from the right, then you just have to play the debt card which he does immediately, but not before accusing the editorial of understating the downside risks to the BoJ's moves:

"With a gross public debt to gross domestic product ratio in excess of 240 per cent, and with a primary budget deficit of 7 per cent of GDP, Japan’s public finances are clearly on an unsustainable path"

But unsustainable path to where? Till the vigilantes strike? What's the alternative? Slash spending and spiral downwards into contraction upon contraction? Impose a dose of severe euro-style austerity till the debt level drops? What about some more deflation? What does that do to the real debt burden?

Lachman goes on to write:
"Equally troubling is the rapid rate at which Japan’s population is ageing and the correspondingly rapid rate at which its domestic savings rate is declining. This has to raise serious questions about how the Japanese government will finance itself over the longer haul without permanent resort to the BoJ’s printing press."

Fair enough, no one's claiming that Japan's demographics are in its favor but from a savings-investment dynamic, shouldn't this sort of unconventional and aggressive monetary expansion help out a little? 

He then goes on to talk about the yen's depreciation and how, coupled with inflation (towards the 2% target), it would lead to exit-problems for the BoJ. Also, with a depreciating currency and rising inflation, investors will begin to find JGBs highly unattractive and the love-affair will soon end (cue the vigilantes!)

Anyway, what does Lachman advocate?
"...a medium-term strategy to place the country’s public finances on a very much sounder footing, there is the all-too-real risk that the BoJ is leading the country down the well-trodden path of very much higher inflation"

What kind of consolidation does a "medium-term" strategy involve? I wouldn't be one to deny that Japan needs some sort of fiscal initiative. Short-term? No! Medium-term? Long-term? That's the grey area. Does medium-term imply action now? Or after some effects of the monetary expansion have been seen? Moreover, with low growth (but also low interest rates!), would there really be a significant impact on the debt-GDP ratio? 

I'm not sure. No one's saying this is a perfect and optimal solution but you can be sure the BoJ's probably warned themselves more times than others have warned them before setting off on this untrod path. And each time they warned themselves, they probably asked, "What's the other alternative?"

Exactly.

More on the Bee-Oh-Jay

What's left to say of Abe, Kuroda and the rest of them that have pulled off such a stunner?
Not much, I would think - just a hell of a lot left to do.

The BoJ has pulled out surprisingly powerful weapons and the experiment has officially begun. Heck, Abe even managed to surprise Noah Smith! But how does this compare to the QEs that we've already witnessed courtesy the Fed? Well, for one, this is quite unprecedented. 

If you were to listen to Soros or a few of the research teams, you'd hear (fairly aptly methinks) that it's about thrice the size and in a way, a fair bit more diverse. For one, in addition to buying longer dated JGBs, the BoJ will also dabble in stock and real estate. 

Anyway, I tried to pinpoint a time when this movement basically took off and I'm guessing it's late 2012. So what's been happening since then and what's been happening in the past couple of years? 

Basically this:

The Effective rates are based on the BIS Indices for countries. The Bilateral USDJPY rising implies a depreciation of the yen and for the sake of visual convenience, I indexed them to January 2011. As you'd expect, the NEER and REER don't really diverge but they start their downward plunge around mid-2012.

Much in the same manner, here's the Nikkei 225 from the beginning of 2012 along with the bilateral USD-Yen Bilateral Rate - both have been indexed to 100 from the start (to compare the pace of bilateral depreciation to the rapid equity spurt). Again, from here, the race starts in November 2012 (on the 8th to be a bit precise).

This is the BoJ's Monetary Base over the past couple of years. Significant expansion (about 100 to 130 trillion yen). What happens if you zoom out of this a bit and project what the BoJ projects for its MB (the grey shaded area)? You get this:

Yup, that's just one of the reasons why this is huge, figuratively speaking too! 

There's clearly not enough detail on structural reform and the third prong on a whole but the excitement being generated just by the monetary policy announcements is more than palpable. 

The mandate is strong and its been given a chance. This is more than worth watching.

BoJ Minutes

From the action-packed BoJ, here's the simplest chart in the world that shows two year projections for the Monetary Base and the Government Bonds. It also shows the projected expansion in the central bank balance sheet which is roughly 40% and 30% for '13 and '14!!:

(TRILLIONS OF YEN)

Some more quick highlights (or what you already know!):

-  In line with the projection of the expansion in the monetary base (what you see above in blue), the BoJ will achieve the price stability target of 2% in a yoy % change in the CPI as quickly as possible but realistically within two years (note: there was a motion to remove this '2 year horizon' claim but it was shot down 8-1 in a vote).To do this, the monetary base will be doubled (visible above). This will also apply to the JGBs and the ETFs (while also pushing further on the average remaining maturity of its JGB purchases). 

- Conceivably, its target for money market operations would be through the monetary base (from the uncollateralized overnight call rate).

-  A unanimous vote to increase JGB purchases as well as their maturity extensions to spur a further reduction in rates across the curve. Additionally, even maturities including 40 year bonds would come under this purchase-net while the average remaining maturity of its purchases gets extended from slightly less than 3 years to about 7 years.

- To reduce the risk premium in asset prices, REITs and ETFs would be purchased at the proposed pace, while the Asset Purchase Program naturally bids farewell.

- Here's what the statement has to say about the 'banknote principle' - that all these government bond purchases are for the purpose of monetary policy implementation and not to finance its fiscal deficits. Then there's the usual brouhaha on "establishing a sustainable fiscal structure...ensuring the credibility of fiscal management.."

- An extension of funds-supplying operations to support financial institutions in disaster areas. This is why the Loan Support Program has an expected annual percentage expansion of almost 300% followed by 40% over the next two years. 

- On the economy, you see your conventional terms of "signs of picking up" and "a moderate recovery path".  While the change in CPI still hovers in negative territory, there might be indicators suggesting a change in inflationary expectations which I believe still remain relatively anchored. 

The last statement on this, which reads "conditions in financial markets have turned favorable due to the abatement of global investors' risk aversion and expectations for domestic policies" could be another way of saying, "The Nikkei has been booming with all this talk" but we'll leave that for another time...

Laughter and More - The Dead-State Path to Despairity

I don't quite understand how this happens but the more you try and ignore something, the more it finds ways to show up. Case in point, what the what the WSJ ed-page spews. As a political portal that blatantly attempts to act as a mouthpiece for ridiculously stupid policy, I'm not surprised by this latest piece from Arthur Laffer and Stephen Moore titled "Laffer and Moore: The Red-State Path to Prosperity".

I could take, as Ritholtz pointed out, a variable such as weather and spin a brilliant tale with it - namely that colder climates are losing jobs faster. To sound even more ridiculous, I could proceed to say that we need a bit more global warming to buck this trend. 

I may be on to something but the point is that I have zero evidence to back it up! Not one bit conclusive, not one bit truthful and not one bit sensible. And while this doesn't make me wrong, it does make me evil in a way - for pushing through with my global warming agenda based on...wait for it...a correlation that I turned into causation for my own convenience. 

Here are some highlights of the inconsistencies:

"Among the 10 fastest-growing metro areas last year were Raleigh, Austin, Las Vegas, Orlando, Charlotte, Phoenix, Houston, San Antonio and Dallas. All of these are in low-tax, business-friendly red states. Blue-state areas such as Cleveland, Detroit, Buffalo, Providence and Rochester were among the biggest population losers.

This migration isn't accidental. Workers and business owners are responding to clear economic incentives. Red states in the Southeast and Sunbelt are following the Reagan model by reducing tax rates and easing regulations. They also offer right-to-work laws as an enticement for businesses to come and set up shop. Meanwhile, the blue states of the Northeast, joined by California, Minnesota and Illinois, are implementing the Obama model of raising taxes on businesses and the wealthy to fund government "investments" and union power.

But it isn't just higher taxes that make these so-called progressive states less attractive to business. Red states Texas, Oklahoma, Wyoming, West Virginia, Montana and North Dakota (and a few blue states like Ohio and Pennsylvania) are getting rich from oil and gas drilling. Meanwhile, bluer-than-blue New York has extended its moratorium on the technological advance behind the boom, hydraulic fracturing, citing overblown environmental hazards, and Vermont has outlawed it altogether. California's regulations prohibit nearly all new drilling of any kind.

All the empirical evidence shows that raising a state's tax burden weakens its tax base. Still, too many blue-state lawmakers believe that a primary purpose of government is to redistribute income from rich to poor, even if those policies make everyone, including the poor, less well off. The obsession with "fairness" puts growth secondary.

In short, red states of the South and other areas of the country are moving forward with pro-growth tax reform, while California and the blue states of the Northeast are doubling down on Obamanomics and European progressivism. Who will come out on top? Our money is on the red states and those wisely following their lead."


Yes, it's true. Laffer and Moore have claimed the right of empirical evidence! Scratch your head some more, it's the only thing that'll help.