The Misreading of Reinhart and Rogoff
If the rallying cry for deficit reduction rests on an intellectual framework, it would be the work of Carmen Reinhart and Ken Rogoff, whose book, This Time is Different, has been hailed for its exhaustive historical study of financial crises. A key finding of those scholars – that economic growth slows once the ratio of debt-to-GDP exceeds 90% – has been widely cited by those calling for decreased government spending.
But those calling for deficit reduction have largely ignored a number of caveats that Reinhart and Rogoff gave with respect to their 90% threshold, and as a result many warn that the US faces the imminent danger of a Greek-like sovereign-debt crisis.
Take, for example, PIMCO’s Bill Gross, who wrote the following on October 31 of last year:
The situation, of course, is compounded now by high debt levels and government spending that always used to restart capitalism’s private engine. However, as economists Rogoff & Reinhart have shown in their historic text, This Time Is Different, sovereign debt at 80-90% of GDP acts as a barrier to growth.
First of all, Reinhart and Rogoff did not write about the 90% threshold in This Time is Different; they published research about that threshold only after the book was written, in two separate articles (found here and here).
The more important problem with the claims that Gross and others have made about the 90% threshold is that they ignored Reinhart’s and Rogoff’s own words of caution with respect to the special situation of the US, and they failed to consider the limits inherent in Reinhart and Rogoff’s dataset of countries with high debt levels.
I spoke with Rogoff last week, and he explained that one of those limitations is the rarity of such high-debt events and the extreme rarity of examples of countries exceeding 120% of debt-to-GDP.
Rogoff did not comment on how others have interpreted his research, but I will. I will explain its limitations and caveats, and then turn to the decisions policymakers should make in the context of our growing fiscal deficit.
What Reinhart and Rogoff did and did not say
Let’s look at what Reinhart and Rogoff said in the two papers cited above. Using the same data that they used in This Time is Different, which consisted of observations from 44 countries over the last two centuries, they found that there was very little relationship between economic growth (as measured by GDP) and public (government) debt, for debt levels below 90% of GDP.
For advanced economies, however, Reinhardt and Rogoff found that once debt exceeds 90% of GDP, median growth slows by roughly 1% annually. The data for advanced economies consisted of 1,186 annual observations, of which 96 were from countries with debt-to-GDP greater than 90%; most of those observations came in the immediate wake of World War II.