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The Misreading of Reinhart and Rogoff

January 10, 2012

by Robert Huebscher

Moreover, in my conversation with Rogoff, he explained that their research was about “correlation, not causation” and that there is a two-way relationship between debt and growth.  Investment professionals know the dangers of relying on data relationships without a supporting theory; this is why we reject investment ideas built with back-tested data.  Without an underlying theory, there is no reason to expect that the relationship will continue in the future.

Debt and growth are unquestionably linked on a theoretical basis.  But a complete theory would incorporate more than just two variables (GDP growth and the debt-to-GDP ratio); it would consider other factors, such as interest rates and the nature of the deficit.  When governments can borrow at near-zero long-term real interest rates, as the US can today, higher debt can be tolerated.  In the case of the US, its status as reserve currency affords it even greater borrowing capacity.

Robert Lucas, who won the Nobel Prize in economics in 1995, called attention to the dangers of formulating economic policy based on observed historical data, especially the sort of highly aggregated data that Reinhart and Rogoff employed.   This finding, known as the Lucas critique, led to the development of more sophisticated models that consider a broad range of underlying parameters.

I will come back to the important issue of how the nature of the deficit affects a country’s borrowing capacity, but the key point is that bond markets charge higher interest rates to governments that spend wastefully.  Rogoff concurred, and said “It is common sense that, if the government invests in productive infrastructure projects, then debt is more likely to be sustainable than if it dissipates the funds on consumption, although – as in the case of Japan – it's not always easy to distinguish the two.”

One final caveat bears mentioning with respect to Reinhart and Rogoff’s findings.  Because most of the incidences of high debt followed World War II, these were sustainable debts, they say, because “postwar growth tends to be high as wartime allocation of manpower and resources funnels to the civilian economy.”

But, as Columbia Professor Bruce Greenwald has said, it was not the war efforts per se that allowed global economies to grow their way out of the Great Depression.  Instead, it was the agrarian to industrial transformation of economies, and the migration of populations from farms to cities.  Similarly, Great Britain faced debt-to-GDP in excess of 200% in the early 1800s (when the pound was the reserve currency), but grew its way out thanks to the Industrial Revolution.  War is neither a necessary nor a key factor to facilitate growth in an era of high debt.