The Exchange

In Defense of Rogoff and Reinhart

The Exchange

By Michael Pento

Mistakes found in Rogoff and Reinhart’s paper called, “Growth in a time of debt,” published in the American Economic Review in 2010, have impugned their basic conclusion that a nation’s growth rate falters once the debt to GDP ratio eclipses 90%. The mea culpa from the authors stems from their omission of 5 of the 20 countries used in determining the threshold in which economic growth stalls.

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Keynesians worldwide seized the opportunity to castigate Rogoff and Reinhart and the study’s conclusion that growth rates suffer once a country’s debt to GDP ratio reaches an onerous level. But the debate shouldn’t be about whether or not a high debt level actually suppresses growth; the argument instead should be about determining the true level at which growth begins to stall.

A sound principle

Regardless of the ambiguity surrounding what that exact level is, the economic principle espoused by their paper is still sound. Having an elevated debt to GDP ratio always means that a nation will suffer at least one of the following three conditions: growth-killing tax rates, onerous interest rate levels and rapidly rising inflation. In fact, if the debt to GDP level growth remains unchecked, the nation in question will eventually suffer all three devastating consequences.

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Any country with outstanding debt that is equal to or greater than its GDP is forced into sucking an exorbitant amount of capital out of the private sector due to burdensome rollovers and interest payments on that debt. In addition, rising tax rates act as a disincentive to increase productivity. And whatever money that is taken from the private sector is always redeployed in an inefficient, GDP-destroying manner. Rising interest costs also discourage borrowing and lead to capital shortages. And finally, inflation destroys the purchasing power of the middle class by eroding the value of the currency and leaving consumers with an inability to make discretionary purchases.

No country is immune from the economic principle that high debt levels inhibit GDP growth. There is no better example of this than Japan. This island nation has a debt to GDP ratio that is now approaching 240% and the latest reading on growth showed a decline of 0.4% at an annual pace. However, while it has so far avoided the scourge of rising interest rates and inflation, the same cannot be said for its tax rates. Japan already has the second highest corporate tax rate in the world (38.1%); the U.S. has the highest (39.2%).

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And now, its surging debt levels are engendering higher tax rates just as the immutable principles of real economics have predicted. Prime Minister Shinzo Abe's ruling Liberal Democratic Party will implement tax increases starting in 2015. The income tax rate for the top income bracket will be raised to 45% from 40%. The Japanese government will also scale back the amount of tax exemption for estates to ¥30 million (US $304,000) from the current ¥50 million. By further increasing taxes on consumers the government will guarantee the economic malaise that has plagued Japan since 1989 will remain intact. In addition, once the Bank of Japan is successful in achieving its inflation target of 2%, you can be sure that interest rates will also soar, leaving the country suffering under all three of the most destructive economic conditions.

The U.S. case

It is no different here in the United States, as we have just undergone a recent increase in payroll taxes. Also, President Obama’s 2014 budget is proposing to raise an additional $800 billion in revenue during the next decade. Our Fed is seeking a similar inflation target as the BOJ. You can bet higher interest rates won’t be too far behind either.

When inflation, interest rates and taxes are rising, you can be sure that GDP growth will be elusive at best. This means the revenue to the government will also become stagnant, if not in actual decline. Nevertheless, deficits will continue to pile up and the debt to GDP ratio, and most importantly, the debt as a percentage of revenue will skyrocket. Eventually, it becomes clear to everyone that the debt far outstrips the tax base of the nation and its creditors lose faith that they will be paid back in a currency that isn’t going to be massively depreciated. Interest rates then start to rise inexorably and the nation is rendered insolvent while suffering a complete bond and currency meltdown.

That is the terrible price the U.S. and Japan will pay for ignoring the basic tenets espoused by Rogoff, Reinhart and me.

Michael Pento is the President and founder of Pento Portfolio Strategies.

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