Write Off Rogoff and Reinhart?
By David A. Levy and Srinivas Thiruvadanthai
So which is it? Is rapidly growing U.S. government debt leading the economy toward disaster or not? The past week brought a new wrinkle to the ongoing debate with the revelation that a research paper by Harvard University economists Carmen Reinhart and Kenneth Rogoff—which had been often cited by austerity advocates—contained several errors. The academic debate rages on, with much of the discussion focusing on the question: “If government debt rises over 90% of GDP, just how much slower will the economy grow?”
That’s the wrong question to ask, especially if one has in mind the present situation in the United States. In truth, the relationship between government debt and economic growth can vary greatly from country to country and from period to period.
Several combatants in the debate have acknowledged this reality, but a few critical facts remain missing from the popular discussion.
There are practical limits to how much debt a government can safely carry, but a few countries, including the United States, have a much higher capacity for government debt than others. Comparisons of the United States to Greece and Ireland break down on many levels, as we explain in our paper “Uncle Sam Won’t Go Broke.” A government’s capacity to carry debt depends on a number of factors, including (1) whether the debt is denominated in a currency that the government controls, (2) the stability of the government and its ability to collect taxes effectively, (3) the size and liquidity of the market for the debt, and (4) the government’s history of honoring debt payments.
In the past, the United States and the United Kingdom have both had public debt-to-GDP ratios over 100%, and in Britain’s case over 250%, without calamitous consequences. In fact, those times of high public debt were followed by periods of robust growth.
U.S. government debt has been soaring in the past few years primarily because the U.S. economy is in the midst of a depression, and the budget deficits have been essential in keeping the depression contained, avoiding a disaster worse than the 1930s. Since 2008, aggregate U.S. private sector balance sheets have been in a period of secular contraction, the first such contraction since the 1930s. This change in balance sheets is hugely important because a private economy cannot generate profits—at all—without private balance sheet expansion. Large government deficits provide a direct injection of wealth into the private sector, boosting profits and preventing a vicious cycle. (To read more on these dynamics, see our report “The Contained Depression.”)
During a depression, an economy cannot absorb much deficit reduction. Deficit-slashing actions during depressions tend to be self-defeating because they so damage the economy that revenue plunges. Japan’s efforts to cut deficits several times during the 1990s are one prime example; deficit-cutting efforts in several eurozone countries today are another. In the United States at present, one of the principal risks to the expansion is the prospect of deficits being cut too sharply.
The conditions presently causing high public debt growth in the United States and other advanced economies are not permanent and will eventually reverse, improving government fiscal situations dramatically. Eventually, all the deleveraging will have created circumstances for a vibrant revival of investment, credit expansion, and wealth creation, which will bring booming growth and surging government revenues.
This is not to say that the U.S. government is presently maintaining the optimal fiscal policy. People can disagree on how deficits ought to be run. Some may prefer slashing both taxes and government spending, while others may support increasing both. And indeed, some policies will do a better job of promoting economic prosperity. Regardless of how we run deficits, during this unusual chapter of economic history large deficits are needed, virtually inevitable, and more sustainable than most people realize.
David A. Levy is Chairman of the Jerome Levy Forecasting Center LLC, where Srinivas Thiruvadanthai is Director of Research.
