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It has been a while since a debate among academiceconomists attracted so much interest from the mainstream press as has the rowbetween Carmen Reinhart and KennethRogoff, on one side, and Paul Krugman, on the other. In fact, it has evenbecome fodder for television comedy shows.
At issue is an influential 2010paper by Rogoff and Reinhart that purports to show that high levels of public debtare associated with lower long-term economic growth. A new paper by Thomas Herndon, a graduate student at theUniversity of Massachusetts at Amherst, and two of his professors, Michael Ashand Robert Pollin, questioned this finding, and Krugman made their work famous.
Herndon, Ash, andPollin argue that the results obtained by Reinhart and Rogoff are based on coding errors andquestionable methodological choices. But, after all their quibbles, their paperweakens but does not refute the Reinhart/Rogoff paper’s main result. So why allthe fuss?
The debate isconsidered important because it is supposed to have implications for the choicebetween cutting the deficit and stimulating the economy now. But this is justnot so. Instead, the paper needs to be understood in the context of the debatebetween Keynesians and (as Krugman calls them) “Austerians” – those who proposefiscal austerity to stem spiraling government debt.
The Keynesianprescription is simple: If the economy is weak, fiscal policy should be used tostimulate it; if it is overheating, spending cuts or tax hikes should be usedto cool it down. Public-debt levels will rise and fall, but policymakers shouldnot pay too much attention. After all, look at the United States and the UnitedKingdom: despite high deficits and rising debt, inflation remains subdued andlong-term interest rates are at historic lows. Why not use this opportunity tostimulate the economy and invest in its future?
Interestingly, Reinhartand Rogoff broadly agree with this recommendation (at least for the US), andthey even support heterodoxpolicies such as writingdown mortgages and targeting a higher inflation rate. But their paper isreally about a different subject. It is about the long-term effects of highlevels of public debt, which they argue are deleterious to growth.
That conclusionimplies that Krugman is wrong to claim that one can be blasé about the debtlevel. Krugman would argue that, if the economy remains weak, interest rateswill remain low, despite high and rising public debt. Fear of a speculativeattack by so-called “bond vigilantes”is unwarranted, hewould claim, as the US and the UK show.
The Reinhart/Rogoffpaper provides worldwide evidence in favor of the view that high public debt can become aproblem, and that countries should beware of putting themselves in a vulnerableposition. But the ensuing debate sheds no light on the question of whetherpolicymakers should disregard debt levels when their economies are depressed,as Krugman recommends. There really is a big bad debt wolf, and the world isfull of examples in which it has emerged from its lair to create havoc.
Consider Spain. Whenthe 2008 crisis erupted, the G-20 convened that November to coordinate aKeynesian response. All member countries were supposed to fight the comingrecession by stimulating their economies through simultaneous fiscal expansion.Pedro Solbes, Spain’s finance minister at the time, quickly ordered an acceleration of publicinvestment and spending.
By the spring of2009, however, Solbes was forced to reverse course. With tax revenue collapsingand expenditure ballooning, the government found itself running such largedeficits that the markets were spooked – government-bond prices collapsed, interest ratessoared, and the country found itself unable to finance its deficit. Where werethe rock-bottominterest rates that are supposed to characterize periods of weak growth andhigh unemployment?
Financial history isfull of similar examples: Mexico in 1994, Russia in 1998, Ecuador in 1999,Argentina in 2001, Uruguay in 2002, the Dominican Republic in 2003, and eventhe UK in 1976. All were battling recession and high unemployment, only to findthemselves unable to finance their deficits. In fact, when a country is in thispredicament, fiscalcontraction may end up being expansionary to theextent that it reestablishesfinancial confidence and lowers sky-high interest rates.
As much as Krugmanhas made of the Reinhart/Rogoff paper, the debate between “Austerians” andKeynesians has limited relevance outside of the US. Krugman does not mentionissues that he knows are central to fiscal choices.
The level of debtdoes matter, and its currency composition matters even more. The US is in the enviable position ofissuing debt in its own currency. The Federal Reserve can create as manydollars as it sees fit in order to buy government debt. Moreover, as theworld’s reserve currency, the dollar plays a very particular role in the globaleconomy.
Japan, too, canfinance its deficits, despite astronomical public debt, because it borrows in yen – andoverwhelmingly from Japanese institutional investors.
By contrast, Spain’sdebt is in euros, a currency that it cannot print, and is held mostly byforeigners. And many emerging-market countries are in a similar position. In a recent paper with Ugo Panizza of the Graduate Institute ofDevelopment Studies in Geneva, we show that in the aftermath of the 2008crisis, emerging-market countries that could run the kind of counter-cyclicalKeynesian policies espousedby Krugman had low levels of foreign-currency debt. It is only because theywere “Austerians” before the crisis that they could afford to be Keynesiansafterwards.
Whatever weaknessesone finds in the Reinhart/Rogoff paper, it does not follow that countries inrecession should always disregard deficits and debt levels and focus onstimulus. That might be the right recommendation for the US today, but as auniversal rule of thumb,it is just plain wrong.
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