A Significant Miscalculation
April 23, 2013 Leave a comment
In 2010 two Harvard professors, Carmen Reinhart and Kenneth Rogoff, published an academic paper in which they showed that once the national debt rises beyond 90 percent of GDP, average growth rates fall precipitously to near zero.
Their analysis drew on data from 44 different countries over a 200-year period. These findings were later republished in the book This Time is Different, which won numerous awards and became a best seller.
The study was quoted by many Republicans and even a few Democrats as conclusive proof that the U.S. economy (which had reached this 90% mark early in 2010) was at a critical ‘tipping point.’ Comparisons were made to Greece (its debt to GDP ration topped 113% in 2009), and alarm bells were raised about the danger of American insolvency and a looming economic collapse.
The Reinhart-Rogoff report became a chief pillar in the argument against any additional stimulus spending that might expand the national debt. Instead, deep budget cuts and austerity were the order of the day if America was to be rescued from looming catastrophe.
It turns out that Reinhart and Rogoff’s findings were dead wrong.
It took a 28-year old graduate student named Michael Herndon to discover the errors. This spring he was completing an assignment for an econometrics course that required him to replicate the data analysis of a well-known study. He chose Reinhart and Rogoff’s 2010 paper because of its significance, but then found that he was not able to replicate their results.
He repeatedly emailed Reinhart and Rogoff to get an explanation. Reinhart finally sent him the raw data and told him to sort the answer out for himself. He did. In going over the data spreadsheet, he discovered some errors in their calculations.
I clicked on cell L51, and saw that they had only averaged rows 30 through 44, instead of rows 30 through 49.
The missing rows contained data from Canada, New Zealand, and Australia – countries with highly developed economies like the United States – that have sustained solid growth even while maintaining high debt-to-GDP ratios. The inclusion of this additional data seriously undercut the report’s main thesis that high debt prevents economic growth.
Rather than showing average economic growth plunging precipitously from 2.8% to -.1% when the 90% threshold is reached, the revised calculations show a decline in the growth rate to 2.2%. Significantly, this matches the average economic growth rate in the U.S. over the last three years. Right on target with what one would expect. It is slow – less than what one would like. But the economy is by no means dead in the water.
Yes, large indebtedness does weigh upon an economy. No one disputes that. But the revised data clearly shows that there is no sudden plunge after a certain level. There is no looming cliff. There is no cause for panic. In fact, the cost of paying off the debt as a percentage of GDP is actually less now than it was in in Ronald Reagan’s final year as President. No one was shouting fiscal crisis at that time.
The solution to the high GDP-to-debt ratio is to grow the economy. Austerity will not do this. Austerity slashes government spending, which eliminates jobs, which reduces production, which lowers overall GDP. The goal is to decrease the value of the debt-to-GDP ratio. The smaller the GDP, the higher the ratio. (To use a simple example: a Debt/GDP ratio of 8/10=80% but a ratio of 8/9.5=84%.) Reducing the GDP through austerity does not bring down the overall debt-to-GDP ratio; it has the opposite effect. Growing the economy, on the other hand, does bring down this ratio. (E.g. a Debt/GDP ratio of 8/10.5=76%).
It’s simple math. Unfortunately the economists neglected to do the math properly and our politicians blindly followed their lead. One should always check the facts behind the arguments. Fortunately, someone finally did.