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So, has the US been handed a Get Out of Debt Trap Free card? Some proponents of more fiscal stimulus, mostly on the left, seem to be drawing that conclusion from the so-called debunking of the famous Reinhart-Rogoff study on the linkage between government debt and GDP growth. (The above chart shows the original R&R figures versus the modified data from Herndon, Ash, and Pollin.)
Reinhart and Rogoff have offered a response, and the gist of it is this:
So where does this leave matters on debt and growth? Do Herndon et al. get dramatically different results on the relatively short post war sample they focus on? Not really. They, too, find lower growth associated with periods when debt is over 90 per cent. Put differently, growth at high debt levels is a little more than half of the growth rate at the lowest levels of debt. They ignore the fact that these results … are not very different from what we report in our 2012 Journal of Economic Perspectives paper with Vincent Reinhart—where the average is 2.4 per cent for high debt versus 3.5 per cent for below 90 per cent. … There is also the question of whether these growth effects can be economically large. Here it is very misleading to think of 1 per cent growth differences without recognizing that the typical high debt episode lasts well over a decade (23 years on average in the full sample.)
It is utterly misleading to speak of a 1 per cent growth differential that lasts 10-25 years as small. If a country grows at 1 per cent below trend for 23 years, output will be roughly 25 per cent below trend at the end of the period, with massive cumulative effects.
1. There are other studies, including from the IMF, OECD, and BIS, more or less arriving at the same conclusion as R&R. Dishonest critics will ignore that research as they continue to tout the debunking angle as a way of arguing for more government spending. Honest critics will continue to make the case that a) R&R have only proved correlation not causation, b) these results may be less relevant for countries that control their currency like the US.
2. The tipping-point argument is a distraction from more important macro fiscal issues: a) Higher debt can hurt growth by crowding out private investment, b) nations with larger public sectors tend to grow more slowly, and c) the coming wave of entitlement spending risks driving US debt to unsustainable levels. All these argue for a long-term debt plan instituted ASAP. I have argued that reducing debt/GDP by half over the next two decades might be a reasonable goal.
3. Arguments for a more accelerated debt reduction schedule or a balanced budget within five or ten years (or ever) are not strong. And expectations for near-term, austerity-driven expansion are likely to lead to disappointment without corresponding monetary easing. Thankfully, spending austerity + easier money seems to be exactly the economic formula the US is following at the moment.
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