Recently, Henry Blodget wrote that “The Economic Argument Is Over – And Paul Krugman Won.” The premise of the article is that the ongoing debate between economic schools of thought, since the financial crisis began, over what policies were necessary to get the domestic and international economies growing again has been resolved.
“On one side were economists and politicians who wanted to increase government spending to offset weakness in the private sector. This ‘stimulus’ spending, economists like Paul Krugman argued, would help reduce unemployment and prop up economic growth until the private sector healed itself and began to spend again.
On the other side were economists and politicians who wanted to cut spending to reduce deficits and ‘restore confidence.’ Government stimulus, these folks argued, would only increase debt loads, which were already alarmingly high. If governments did not cut spending, countries would soon cross a deadly debt-to-GDP threshold, after which growth would be permanently impaired. The countries would also be beset by hyper-inflation, as bond investors suddenly freaked out and demanded higher interest rates. Once government spending was cut, this theory went, deficits would shrink and ‘confidence’ would return.
This debate has not just been academic.”
He further states that:
“Those in favor of economic stimulus won a brief victory in the depths of the financial crisis, with countries like the U.S. implementing stimulus packages. But the so-called “Austerians” fought back. And in the past several years, government policies in Europe and the U.S. have been shaped by the belief that governments had to cut spending or risk collapsing under the weight of staggering debts.
Over the course of this debate, evidence has gradually piled up that the “Austerians” were wrong. Japan, for example, has continued to increase its debt-to-GDP ratio well beyond the supposed collapse threshold, and its interest rates have remained stubbornly low. More notably, in Europe, countries that embraced (or were forced to adopt) austerity, like the U.K. and Greece, have endured multiple recessions (and, in the case of Greece, a depression). Moreover, because smaller economies produced less tax revenue, the countries’ deficits also remained strikingly high.
So the empirical evidence increasingly favored the Nobel-prize winning Paul Krugman and the other economists and politicians arguing that governments could continue to spend aggressively until economic health was restored.”
The article really revolves around the “calculation error” in the Reinhart/Rogoff study which showed that when debt-to-GDP ratios rose above 90% economic growth slowed. Blodget believes that since the study contained an error this is clear evidence that the premise is false and that governments can continue to spend with reckless abandon until, by some miracle, economic growth is restored.
The problem, however, is that it is still way to soon to declare a winner in this debate for several reasons:
1) Reinhart/Rogoff May Not Necessarily Be Wrong. While there was a calculation error in their study which changes the dynamic of the 90% threshold of debt to GDP – there is clear and ample evidence that rising debt-to-GDP ratios slow economic growth. The chart below is the debt-to-GDP ratio of the United States on an annualized basis as compared to the annual growth rate of GDP. You don’t have to hold a doctorate in economics to clearly see the problem.
Rising debt to GDP ratios, even from low levels, retards economic growth. Conversely, falling debt–to-GDP ratios have been a boost to economic growth. This really isn’t a hard concept to understand. Rising debt levels deter savings from productive investments into debt service. The larger the debt – the larger the amount of debt service that must be paid. This leaves less to reinvest back into the economy. This is the same for both the government and the private sector.
The chart below shows the annual growth rate in GDP as compared to the personal savings rate and consumer debt levels.
The problem with Henry’s argument is that “more stimulus” has yet to translate into higher economic growth rates as expanding debt service is impeding the ability, and confidence, of the private sector from participating in the very activities needed to create growth.
The reality is that it really doesn’t matter whether it is specifically 90%, 120%, or more, of debt-to-GDP before an economy “implodes” but the inability to create economic growth that should be of real concern.
2) Deficits Do Impede Growth. A second problem with Henry’s declaration of a winner in the economic debate is the belief that “deficits don’t matter.” Keynesian economics believes that during periods of economic weakness that government spending should be increased until private spending returns. In theory this correct. However, over the past 30 years Keynesian economics has been bastardized into “the more deficit spending the better.”
Since Reagan entered office and vowed, with Paul Volker, to break the back of inflation – the rise of the debt/credit driven economy was able to mask over the effects of rising deficits. Falling interest rates and inflation combined with easy access to credit allowed consumers tospan the gap between incomes and living standards as economic growth was retarded. However, the “end game” of rising debt and deficit levels have now arrived where additional increases spending have a diminished rate of return on the economy.
While deficit spending in the short term may stabilize an economy – running deficits over an extended period of time diverts money from productive investments into debt service. Deficit spending is HIGHLY destructive to economic growth as it directly impacts gross receipts and saved capital equally. Like a cancer – running deficits, along with continued deficit spending, continues to destroy saved capital and damages capital formation. The chart below shows the annualized rate of economic growth versus the deficit balance. See the problem here?
3) Unprecedented Monetary Experiment. The current combinations of stimulative programs from bailouts, financial supports and direct liquidity injections, both domestic and globally, are of a magnitude never before witnessed in economic history. The problem with declaring a victor in the “economic debate” is the same as claiming that “Professor Plum did it in the library with the lead pipe” halfway through the game. The evidence of success is not yet available to leap to such a conclusion.
The current supporters of Keynesian economics cannot point to the tepid recovery in housing, employment or even economic growth as signs of success. The support from the massive monetary programs implemented to date have, like a life support system for a near comatose patient, kept growth from slipping into a recession or worse.
For success, and ultimately a victor, to be proclaimed will only be possilbe once the global liquidity programs have ceased, central bank balance sheets have successfully delevered and the economy begins to grow organically. There has yet to be any sign that we are anywhere near that point.
The Argument Isn’t Over
While Henry declared the argument is over between the Keynesian and Austrian economic theories – we are a long way from really knowing that answer. The discovery of the calculation error in the Reinhart/Rogoff study does little to change the overall premise the excessive debt levels impede economic growth and have, historically, led to the fall of economic empires. All one really has to do is pick up a history book and read of the Greeks, Romans, British, French, Russians and many others.
Does fiscal responsibility lead to short term economic pain? Absolutely. Why would anyone ever imagine that cutting spending and reducing budgets would be pain free? However, what we do know is that the path of fiscal irresponsibility has long term negative consequences for the economy.
It is absolutely true that the current dysfunction in government is economically harmful as it weighs on both consumer and business confidence. However, businesses are not sitting around just waiting for more stimulus to increase employment, expand production and increase wages. What they need is demand from consumers, clarity on taxation and reduction in government regulation. How do we know this? It is because these are the top three concerns as reported by businesses owners in the montly surveys.
The reality is that it will likely be many years before we are able to conclusively settle this argument. As far I am concerned the argument is irrelevant. What we need is an Austri-Keynesian policy mix that combines short-term deficit spending to help offset the drag of budgetary reform. There is little argument that entitlement programs must be reformed along with a balancing of the federal budget and reduction of the deficit. The problem, to date, has been how to do it with no one willing to make the sacrifices necessary to achieve the end result.
An Austri-Keynesian policy mix would still result in short term economic pain as there is no“pain-free” solution to the global economic environment that we face today. It is the unwillingness, and shortsightedness, of those in power that keep hoping that Cental Banks can find the “magic bullet” that will solve all economic ills and keep them in office. Alas, even the Fed has admitted that monetary policy alone is not a panacea and that evenutally fiscal policy must eventually take the lead. Ultimately, there will be a conclusion. However, without real long term budgetary reforms, that conclusion is likely not to be a pleasant one – history alone tells us this will be the case.
In the meantime we can continue to ignore to long term conseqences in exchange for short term bliss. However, as long as we do, we will continue to be plagued by lower levels of economic growth as continued monetary interventions strive to offset the inevitable drag of expanding debt.
This piece is cross-posted from Street Talk Live with permission.
8 Responses to “It’s A Bit Early To Declare A Winner In The Economic Debate”
Am anti-RR but don't worry too much about Blodget – he knows the game of baiting to click to get traffic by such headlines. You should probably quote some economist.
What an absurd piece. All one has to ask is.. what is the causation? How does higher debt during this crisis cause lower growth or lower economic activity? The debt is not pushing up interest rates right now, or foreseeably. It does nothing but sit quietly in bond-buyer's accounts, patiently paying low interest as they await better times.
Now, the other way around… is quite easy to see. A depression decreases taxes and increased welfare payments. Not rocket science.
And the supposed long-term consequences are what? Lower economic growth a decade or two out? But we have lower economic growth *right now*. What about that problem? The people who are being screwed over right now by austerity will never get those earnings back, and we will never get their services back.. it is a dead, forever loss, leading inexorably to yet more future losses as well.
I agree, but my response to Krugman et al is different. Their greatest failure is to imagine that current American conditions are the norm for all places and times. They tend to know very little about other countries or other periods of history. R&R's book has always been an irritant for them because the takeaway for the US is that it's in an exceptional situation, and historically, assuming that exceptional situations will last has turned out badly.
What makes R&R debatable is that most advanced countries are currently able to suppress their interest rates below the rate of inflation. That is not the norm, not globally, not historically. Most countries that attempt to suppress their interest rates get a bigger inflation response. This is an absolutely crucial reason why developed countries are able to get away with high deficits and why we're having this debate about austerity. In emerging markets, they don't have this luxury. If their central banks suppressed domestic interest rates anywhere nearly as aggressively as we do, their inflation would be explosive.
When interest rates are below the rate of inflation, real borrowing costs are negative. When the central bank is buying most or all of the debt issuance, there is little or no need to worry about the ability to roll it over. The worry becomes instead inflation. And if you're doing it and not seeing inflation, then you're in an exceptional situation where, for now, you can get away with boosting debt without suffering rising interest costs. You may suffer other ways, but that's a topic for another day.
The debate over austerity thus boils down to: do we trust that this unresponsiveness of inflation to interest-rate-suppression will last, and continue with high fiscal and monetary stimulus? Is this time finally, really different? Or should we be cautious, lest inflation appear and force us to choose between inflation or austerity at the worst possible time?
Another way Krugman et al go wrong is in believing that peripheral European countries are in the situations they are in because they can't devalue. That's not really their main problem. They can't hold interest rates below the rate of inflation, so their interest costs are piling up, and it's very difficult to stop that. If they quit the euro and suppressed domestic rates, they would get high inflation and devaluation. Would that be better? Possibly in the short run, but in the long run, I think not.
The most egregious example was Krugman's attempt to chide the Balts for their austerity policies. He really understood nothing about the situation and was merely cherry picking data to fit a pre-cooked position. For the Balts his advice was ignorant and stupid, as he was telling them to give up trying to join the Euro, an almost sacred project for the Balts as they are desperate to reinforce their exit from Russia's sphere by all means possible. They had ridiculously huge bubbles and no alternative to austerity – there was only a choice between austerity through fiscal consolidation, or austerity through steep devaluation. The latter was not obviously the better route. Krugman's attempt to portray the Balts as failures was stupid and ignorant. They won that debate, hands down.
I think you actually have to hold a doctorate if the conclusions are as such. Putting a chat out there and implying that debt causes GDP slows down may be effective but is just wrong and not particularly honest. I may put the same chat and tell you that economic recession causes high debt and therefore more stimulus and spending would be actually needed to reduce debt – simply by increasing one of the component of GDP, public spending. And I'd have much more theoretical literature supporting those conclusions. This is not hard to understand, either.
If we want to use numbers to justify our ideas, it's a 2 side game…
How can anyone claim that deficits impede growth when the opposite is true by definition.
GDP = Money Supply x Velocity of Money
To calculate Growth, differentiate this equation with respect to time.
Growth = Change in Money Supply x Velocity of Money + Money Supply x Change in Velocity of Money
Since the Money Supply is equal to the Debt, (All money is created as debt), the change in the Money Supply is equal to the Deficit.
Growth = Deficit x Velocity of Money + Money Supply x Change in Velocity of Money
Therefore, by definition, deficits add to growth.
Firstly, balance sheet accounting of the domestic private sector as a whole reveals it cannot run at a surplus without money injections from either of the two other sectors. Without such injections it cannot create economic growth. Secondly, monetarily sovereign governments don't have to borrow first in under to create money. It's only Austerians with minds befuddled by irrational anti-government dogma who don't understand these realities.
This post is a joke. It completely ignores the distinction between correlation and causation. As Martin Wolf pointed out in the FT the other day, it is equally plausible to argue that low GDP/slow growth causes rise in debt ratios, or that the causation is two way.
Also, I had to chuckle at the chart about GDP growth and the deficit. First, the deficit is stated in nominal dollars to make it look like it is massive now and tiny in the past, rather than as a ratio the GDP, the only thing that would count. Then, the RH axis is mislabeled as change in GDP growth rather than GDP growth itself. I would give any undergrad a D- for this chart.
Surely we will continue to suffer and see the levels of economic growth as continued monetary interventions strive to offset the inevitable drag of expanding debt.