Prime Minister Julia Gillard informed us yesterday that the budget deficit will be much worse than predicted. Her speech has been greeted with the usual debate about whether it even matters if we go into deficit.
But this time is different. Thanks to a recent academic controversy, it seems like the anti-austerity, pro-deficit spending crowd has won a major victory.
Here’s the story. In January 2010, two prominent American economists, Carmen Reinhart and Kenneth Rogoff, released a working paper, ‘Growth in a Time of Debt’.
The paper took data spanning 200 years from 44 countries and analysed the relationship between public debt and economic growth.
The findings were striking. Once debt hits 90 per cent of GDP – that is, when a government owes almost as much money as the entire economy produces each year – then the rate of economic growth dramatically slows. (Obviously Australian debt is nowhere near this high.)
But fast forward to April 2013 and three economists at the University of Massachusetts Amherst published a critique after looking at the original data sources. They found that Reinhart and Rogoff a) made a coding error in Excel, b) excluded some data, and c) made some methodological choices which they describe as “unconventional”.
Then came the wall of commentary. It was hard to avoid. Here’s one interesting take on the controversy. Here’s another. And another here. Here’s one, another here, here, here, and here. My Institute of Public Affairs colleague Julie Novak weighs in here. Reinhart and Rogoff respond here, and here, and here.
And here, the Nobel-winning New York Times columnist Paul Krugman asks: “Did an Excel coding error destroy the economies of the Western world?”
Well, obviously not.
This whole spat has nothing to do with the economics of public debt. It has everything to do with the politics of austerity.
Strip away the rhetoric and the actual argument about the paper is actually pretty modest. Is the 90 per cent ratio a tipping point – a line countries must not cross? Or does economic growth just decline slowly while public debt rises? The tipping point argument was interesting, but not particularly compelling. It’s all well and good to crunch some numbers that throw up an interesting result. But you have to explain why it has done so. What’s so special about 90 per cent?
Yet after all this fire and brimstone, nobody seriously disputes that high debt and low growth are correlated.
More important is figuring out whether debt hurts growth. Or is it that low growth leads to increased debt? In other words, is debt to blame for economic problems or is it merely a symptom of those problems? Have a flick through the links above. The answer is probably a bit of both.
The problem with public debt is today as it always has been – politicians have few incentives to balance their budgets, and every incentive to grow debt unsustainably. Just look at the United States to see how this plays out in practice. But eventually bills have to be paid.
Reinhart and Rogoff did not invent the problems of unsustainable deficits. Ever since Adam Smith, economists have been talking about the need to balance budgets. And Smith didn’t rely on Excel to make his case. Two and half centuries later, there is a huge literature on public finance.
Nor did Reinhart and Rogoff invent the current austerity movement. The timeline doesn’t work. In the UK, David Cameron was talking about an austerity budget early in 2009. Spain had an “austerity plan” that December, a month before the Reinhart-Rogoff paper was released. As did Greece, Ireland, Romania, and Latvia.
Anyway, for all their rhetoric, it isn’t clear many countries have really pursued “austerity”, as I argued in the Drum last year.
So let’s not overestimate the political power of academic research.
In his most famous book, the General Theory of Employment, Interest and Money, John Maynard Keynes wrote, “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” Obviously economists love this little quote.
The irony was governments were following Keynesian-esque policies well before the General Theory was released in 1936. They were already trying to spend their way out of the Great Depression. Keynes’ theoretical arguments suited the times.
It’s the same story with austerity. No surprise that some politicians who had already committed to cutting spending embraced Reinhart and Rogoff’s paper. Paul Ryan cited their 90 per cent tipping in his Path to Prosperity budget plan. Surely nobody thinks these two academic economists gave Ryan the idea to cut government spending? Politicians will take any evidence they can find to support their existing views.
And those who are certain austerity is the wrong path – that it has led the world into a deeper crisis than Keynesian spending might have – have embraced the Reinhart-Rogoff saga as a sort of intellectual triumph. But they’re being even more opportunistic.
One of the Massachusetts economists believes their critique demonstrates that “under particular circumstances, public debt can play a key role in overcoming a recession”. This is a huge overreach. As Greg Mankiw has written, “just because someone in Team A makes an inadvertent excel error does not mean that everything Team B believes is true.”
If nothing else, this saga should remind us that excessive government spending is first and foremost a political problem, not an economic one.