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.


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:


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:


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.


This Time It’s Different 2013 Edition

A small note on the frankly hilarious news that the Dow Jones Industrial Average smashed through to all-time-highs.

First of all, while stock prices are soaring, household income and household confidence are slumping to all-time lows. Employment remains depressed, energy remains expensive, housing remains depressed, wages and salaries as a percentage of GDP keep falling, and the economy remains in a deleveraging cycle. Essentially, these are not the conditions for strong organic business growth, for a sustainable boom. We’re going through a structural economic adjustment, and suffering the consequences of a huge 40-year debt-fuelled boom. While the fundamentals remain weak, it can only be expected that equity markets should remain weak. But that is patently not what has happened.

In fact, it has been engineered that way. Bernanke has been explicitly targeting equities, hoping to trigger a beneficent spiral that he calls “the wealth effect” — stock prices go up, people feel richer and spend, and the economy recovers. But with fundamentals still depressed, this boom cannot be sustained.

There are several popular memes doing the rounds to suggest, of course, that this time is different and that the boom times are here to stay, including the utterly hilarious notion that the Dow Jones is now a “safe haven”. They are all variations on one theme — that Bernanke is supporting the recovery, and will do whatever it takes to continue to support it. Markets seem to be taking this as a sign that the recovery is real and here to stay. But this is obviously false, and it is this delusion that — as Hyman Minsky clearly explained last century — is so dangerous.

There are many events and eventualities under which throwing more money at the market will make no difference. Central banks cannot reverse a war, or a negative trade shock, or a negative production shock, or a negative energy shock simply by throwing money at it. And there are severe limits to their power to counteract financial contractions outside their jurisdiction (although in all fairness the Federal Reserve has expanded these limits in extending liquidity lines to foreign banks). Sooner or later the engineered recovery will be broken by an event outside the control of central bankers and politicians. In creating a false stability, the Federal Reserve has actually destabilised the economy, by distorting investors’ perceptions.

But, of course, some analysts think that this time really is different. Here’s a chart from Goldman showing the S&P500 by sectoral composition:

screen shot 2013-03-06 at 4.50.16 am

The implication here is clear — with no obvious sectoral bulge like that of the late 1970s, the tech bubble, and the financial bubble — there is no bubble. But what if the bubble is spread evenly over multiple sectors? After all, the Federal Reserve has been reinflating Wall Street in general rather than any one sector in particular.

Wall Street leverage is, unsurprisingly, approaching 2007 levels:


Is this the final blowout top? I’m not sure. But I would be shocked to see this bubble live beyond 2013, or 2014 at the latest. I don’t know which straw will break the illusion. Middle eastern war? Hostility between China and Japan? North Korea? Chinese real estate and subprime meltdown? Student debt? Eurozone? Natural disasters? Who knows…

The wider implications may not be as bad as 2008. The debt bubble has already burst, and the deleveraging cycle has already begun. Total debt is slowly shrinking. It is plausible that we will only see a steep correction in stocks, rather than some kind of wider economic calamity. On the other hand, it is also plausible that this bursting bubble may herald a deeper, darker new phase of the depression.

With every day that the DJIA climbs to new all-time highs, more suckers will be drawn into the market. But it won’t last. Insiders have already gone aggressively bearish. This time isn’t different.