Fiscal Revisionism

How does the attack on the two academic’s work change the landscape for macro policy, if at all?

The recent challenge to a key finding of Carmen Reinhart and Ken Rogoff’s This Time Is Different (R&R) has roiled the academic world.  But it’s far less clear that it meaningfully changes the politics and economics of deficit reduction.  My takeaways:

1.  One less cliff.  One of R&R’s results, which they and supporters promoted aggressively, was of a “cliff” at around 90 percent of GDP above which growth drops precipitously across countries.  We now know that a coding error and missing data contaminated that result.  They have also been criticized, I think unfairly, for how they weighted countries with long episodes of high debt (see recent sympathetic analyisis by Jim Hamilton).  Fix the errors and change the weights, and their cliff goes away, weakening the urgency of fiscal consolidation as debt nears 90 percent.

2.  But debt still matters.  Cliff or no cliff, higher debt is associated with lower growth in theory and in the data. R&R’s work contains a number of critical and still-valid findings, including the sluggish nature of the recovery that often follows financial and debt crises (going into the recent crisis, most economists expected a v-shaped recovery).  The critical level of debt above which growth suffers, perhaps even falls sharply, will vary across countries, being higher in the major economies than in the developing world or the periphery of Europe.  The causality can run the other way: low growth, especially when not expected, leads to higher sovereign debt as revenue falls below expectation, safety net spending increases, and governments adopt expansionary policies to spur growth.

3.  It doesn’t solve U.S. debt worries.  My belief that the United States is consolidating too quickly doesn’t subtract from the critical longer-term fiscal challenge we face, which will eventually cause a crisis if unaddressed.  But the existence of high debt remains an overwhelming political impediment to a more balanced approach today, even as the costs of funding today’s deficits remain low. Further, the dispute over the cliff, if anything, looks to deepen the divide between parties.  While the leadership on both sides say they don’t want a crisis over the debt limit, for example, the exit strategy from a showdown this fall remains unclear.

4.  The reduction in austerity in Europe is less than the talk suggests.  We are seeing in Europe a move to push back dates when deficit targets are reached.  Mostly, that reflects the reality of weak fiscal performance in a no-growth environment.  It’s reflected in an IMF forecast that has the pace of fiscal consolidation slowing as output falls.  It may be that the attack on the “Austerians” has increased the pressure on Germany in particular to acknowledge these adjustments, but it’s hard to argue that the end result is much different.

5.  Less austerity is a great idea for the European periphery…but who pays?  The periphery is where increased aggregate demand is most needed, but they have limited ability to finance an easing of fiscal policy without a counterproductive loss of confidence.  Sustainable levels of debt, including a realistic assessment of contingent banking sector liabilities, remain low there.  The IMF rightly argues that those countries that do have fiscal space (read Germany) should loosen policy to offset the contractionary forces at work in the periphery, but that argument found little traction at the recent IMF meetings. And we are years away from a meaningful fiscal union.  So, even if we discard the R&R cliff, there is little room for periphery policies to change.

In sum, the recent controversy over R&R’s results forces us to look again at what we know about debt sustainability, but it’s unlikely to lead to any immediate change in policy.  Perhaps if growth continues to disappoint we will need to reassess.  But for now, our fiscal debates remain as dysfunctional as before.