Reinhart & Rogoff’s Scary Red Line

One frustrating fact regarding Reinhart & Rogoff’s controversial paper Growth in a Time of Debt — which incidentally was never peer reviewed, even in spite of its publication in the American Economic Review — is that the arbitrary threshold for diminished growth of “above 90%” seems to have no relation whatever with recent events in the United States.

When the financial crisis happened in 2008, and the United States was plunged into deep recession the public debt was actually moderate — higher than the level that Bush inherited in 2000, but less than the level Bill Clinton inherited in 1992. After the crisis, the deficit soared, but as soon as the deficit rose above Reinhart and Rogoff’s red line real growth actually picked up again.

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This very much suggests that in this case the soaring debt was a reaction to recession. Lowered growth preceded soaring public debt, not vice verse.

This is a result supported by econometric analysis. Arindrajit Dube finds a much stronger association in Reinhart and Rogoff’s data between a high debt-to-GDP ratio and weak growth in the past three years than between a high debt-to-GDP ratio and weak growth in the following three years, strongly implying that America’s experience of weak growth preceding soaring public debt is the norm not the exception:

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Reinhart and Rogoff claim that their empirical study never made any claims about causality, although their 2011 editorial for Bloomberg reads as an exposition for the virtues of austerity:

As public debt in advanced countries reaches levels not seen since the end of World War II, there is considerable debate about the urgency of taming deficits with the aim of stabilizing and ultimately reducing debt as a percentage of gross domestic product.

Our empirical research on the history of financial crises and the relationship between growth and public liabilities supports the view that current debt trajectories are a risk to long-term growth and stability, with many advanced economies already reaching or exceeding the important marker of 90 percent of GDP. Nevertheless, many prominent public intellectuals continue to argue that debt phobia is wildly overblown. Countries such as the U.S., Japan and the U.K. aren’t like Greece, nor does the market treat them as such.

Reinhart and Rogoff’s interpretation, then, is clearly that the debt trajectory itself – as opposed to underlying factors driving the debt trajectory — that is the risk, which is a claim unsupported by their own and other research. But the problem is larger than this.

Other empirical work on debt has focused on a broader range of debt while still following Reinhart and Rogoff in attempting to draw arbitrary danger lines on graphs. Cechetti (2011) attempts to factor in household debt (drawing a danger line at 85% of GDP) and corporate debt (90% of GDP) as well as government debt (85%), implying a cumulative danger line of 260% in total credit market debt:

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Total debt seems to have been a more appropriate metric than public debt, because it was in the danger zone when the crisis hit, and after the crisis hit total debt began gradually deleveraging after forty years of steady rises as a percentage of GDP, implying a deep and mechanistic connection. But there is still a lot of room between the crossing of the red line, and the beginning of the deleveraging phase. The red line itself doesn’t tell us anything about the phenomenon of 2008, or the period preceding 1929, where a similar phenomenon occurred, other than implying in a nonspecific way that the rising debt load was becoming unsustainable.

Drawing an arbitrary line on a graph implies that negative effects associated with excessive debt are a linear phenomenon; cross the line, and bad things are more likely to occur. This is an unsophisticated approach. The bursting of debt bubbles is a nonlinear and dynamic process that occurs when credit dries up, and leverage collapses. This specific effect is not tied to any specific nominal debt level, but instead to an unpredictable mixture of market participants’ expectations about the economy, profit taking, default rates, the actions of the central bank, input costs (e.g. energy), geopolitics, etc.

Steve Keen’s modification of Goodwin’s models may be an important step toward a clearer and more mechanistic understanding of the credit cycle and how an economy can be driven into a Minsky Moment.  One of the keys to modelling Minsky’s notion of a credit-driven euphoria giving way to credit contraction, asset price falls and despair is the notion of credit acceleration, the speed at which growth in credit grows. While total credit growth acceleration is clearly a signal of an impending Minsky Moment and debt deflation, drawing scary red thresholds is a fundamentally fruitless exercise, especially in sole regard to government debt levels which do not appear to drive an economy into a Minsky Moment followed by deleveraging and weakened growth and employment.

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