Beyond Reinhart and Rogoff

My article two weeks ago, The Misreading of Reinhart and Rogoff, elicited a number of challenges, both from those who argued that excessive debt imperils the growth of the US economy and from those who claimed that my proposed solution was unworkable.   Among those challengers was Lacy Hunt, a highly respected economist with Texas-based Hoisington Investment Management, who raised several valid concerns.  I will explain why I disagree with Hunt and others, and I will show why a broader view of global trade imbalances, rooted in the dollar’s position as the reserve currency, increases the United States’ borrowing capacity.

But our ability to borrow cannot be a license to spend unwisely, and I will conclude by expanding on the policy choices the US must pursue.

Hunt is among those who have cited Reinhart and Rogoff’s work as evidence that the growth of the US economy will slow, now that its debt exceeds 90% of GDP.  When I spoke with him a week ago, he pointed to another study, The Real Effects of Debt, by Stephen Cecchetti, who is an economic adviser and the head of the monetary and economic department at the Bank for International Settlements (BIS), and two co-authors.  That study expands on Reinhart and Rogoff’s work, but I will explain why its message has little relevance for the US today.

In my article, I argued that the US should pursue a policy similar to that recommended by Woody Brock, consisting primarily of a large-scale investment in infrastructure.  I will address Hunt’s concerns with those policies, as well as the concerns cited in letters to the Editor last week and this week.

Cecchetti and the Real Effects of Debt

Cecchetti and his co-authors performed an econometric analysis of the debt levels and GDP growth of 18 OECD countries, using data from 1980 to 2010.  Their study expanded on Reinhart’s and Rogoff’s work by considering government, corporate and household debt, whereas Reinhardt and Rogoff considered only government debt.   It also used a panel of countries using a method that ensured they were isolating the impact of debt from other known influences on trend growth.  Their sample data were also different: The data covered two countries fewer and it started from a later date than did Reinhart’s and Rogoff’s. Finally, Cecchetti et al used GDP per capita growth rather than GDP growth.

They looked first at the direct relationship between growth and debt, finding that they were uncorrelated.  But they expanded their model, at which point they included a number of other variables (gross savings, population, education, demographics, trade barriers, inflation, financial market development and banking crises) to help explain the sources of growth.  Using this model, they found that government debt improves growth until it reaches 85% of GDP, and beyond that point it is a drag on growth.

In an email exchange, I asked Cecchetti whether the US should benefit from its ability to borrow at real interest rates of less than 1%.  He explained that while there should be a two-way relationship between growth and interest rates (i.e., the capital markets will reward a rapidly growing country with lower interest rates and vice versa), his studies didn’t find one. But the fact that the studies didn’t find one doesn’t mean there isn’t such a relationship. Hence, it doesn’t say the US can’t and shouldn’t take advantage of the opportunity that appears to be presented by its low borrowing cost.