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Perils of placing faith in a thin theory

Monday 3 June 2013

By Wolfgang Münchau

Reinhart and Rogoff told policy makers what they wanted to hear

John Kenneth Galbraith memorably put down his fellow economist Milton Friedman by saying: “Milton’s misfortune was that his policies had been tried.”

The same observation might be made of Carmen Reinhart and Kenneth Rogoff. Especially in Europe, pro-austerity policy makers have tried policies based on their research with catastrophic economic and human consequences. The Harvard economists’ tragedy is not the misuse of a Microsoft Excel spreadsheet but the misuse of Microsoft PowerPoint. They hyped their results. In doing so, they followed the golden rule of tabloid journalism: simplify then exaggerate.

After the publication in 2009 of their bestselling book, This Time Is Different, the professors published research on the relationship between debt and growth which suggested there is a 90 per cent threshold of debt to gross domestic product beyond which economic growth declines rapidly. Many policy makers have interpreted this rule as a call to reduce debt to below that level for the sake of growth. Profs Reinhart and Rogoff have thus become the intellectual godmother and godfather of austerity.

To see their enormous influence on the European debate, it is worth quoting an extract from a speech by Olli Rehn, the European Commission’s economic chief, to the Council on Foreign Relations in June 2011. “Carmen Reinhart and Kenneth Rogoff have coined the ‘90 per cent rule’,” he said. “That is, countries with public debt exceeding 90 per cent of annual economic output grow more slowly. High debt levels can crowd out economic activity and entrepreneurial dynamism, and thus hamper growth. This conclusion is particularly relevant at a time when debt levels in Europe are now approaching the 90 per cent threshold, which the US has already passed.”

Mr Rehn presumably did not read the original papers, which were more ambivalent in their conclusions, as academic papers tend to be. Policy makers, such as Mr Rehn, are always on the lookout for economic theories that seem plausible and accord with their deep beliefs. In Europe, most of them have little exposure to macroeconomists who think out of the box.

Clearly, most policy makers find it counter-intuitive that governments should spend money in a recession. It is against their own experience, especially if they come from northern European countries. They may have read the history of the Great Depression, and yet they find that a Keynesian response is less plausible than pro-cyclical austerity. If two of the world’s most respected economists then come along and tell them that their gut instincts have been right all along, this is the conservative policy maker’s equivalent of birthday and Christmas coinciding. At last, the message they always wanted to hear.

The Reinhart and Rogoff thesis, as it is understood by policy makers, incorporates two separate myths. The first is the existence of the 90 per cent threshold. The second is about causality.

The first was debunked last week by Thomas Herndon, Michael Ash and Robert Pollin, researchers from the University of Massachusetts Amherst. Their corrected figures show a rather smooth negative relationship between growth and debt. Economists will always squabble about statistical issues – whether to use the median or the mean, and the like. But no matter how you twist and turn this, there is no structural break at a 90 per cent threshold. There is no structural break anywhere.

For the policy discussion, this point is hugely important. It pulls apart the notion of 90 per cent as some magic number – which European policy makers now obsess about, just as they used to about annual budget deficits not exceeding 3 per cent of GDP, for which there was no theoretical basis.

The reduction of everything to a single number was followed by an exaggeration of the impact. Causation could go from high debt to low growth, as the authors suggest; or the other way round; or in both directions. Or the relation might be spurious. Or something altogether different might cause both. If causality is the other way round, the story is much less exciting for someone who peddles economic policies. You might as well say: people are poor because they have no money. If your growth is negative, your debt ratio rises for the simple reason that it is expressed in terms of nominal GDP.

Statistics cannot tell you which causes what. For that you need a theory. But macroeconomists have no theory about optimal debt levels. The only known answer is that it depends – on real interest rates, on growth, on the type of economy, the exchange rate regime, and many other factors.

Unlike Profs Reinhart and Rogoff, Friedman did have a theory when he pushed monetarism in the late 1960s and the 1970s. There were no fat-finger errors in the 1960s equivalent of an Excel spreadsheet. He had solid empirical evidence. The theory subsequently failed, but one can understand why central bankers bought into it at the time. The 90 per cent rule, by comparison, is unbelievably flimsy. And even though it has been refuted, it will continue to shape the policy debate for a while.

As for Profs Reinhart and Rogoff, I suspect that they, too, will be mostly remembered for the fact that their policies have been tried.

This article has been updated to correct the publication date of ‘This Time is Different’

Copyright The Financial Times Limited 2013.

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