Public Debt and Growth: Elements of a Controversy

Economists like controversies. An important one has emerged recently. The issue is the importance and the role of public debt and more generally of fiscal policy in the business cycle management.

The starting point is an article published in 2010 by two American economists: Carmen Reinhart and Kenneth Rogoff. The main result of this paper is the following: when public debt is above 90% of GDP it has a strong negative impact on growth. Below this level there is no clear statistical link between public debt and growth. In other words, when public debt is above the threshold then average growth on the sample used by the authors is -0.1%. The sample is 20 developed countries from 1946 to 2009.
Too much debt kills growth.

This new rule became rapidly very popular: at least for two reasons

  • In the economic literature, there was no systematic link between public debt and growth. Theoretical models didn’t give strong results on the causality between each other. With this publication, economists had the missing link. The key message was this threshold of 90%. The two authors gave an interpretation of their results saying that causality was from public debt to growth.
  • The second reason is a more theoretical issue. In the Keynesian school of thinking, government can have a role in the business cycle management. Higher public debt can be the result of this management as it was the case after 2009 when governments’ plan to revive economic activity to avoid a collapse. The rule found put a clear limit on this kind of intervention. Therefore it limits the impact and the value of the Keynesian approach. If the view is extreme this means that government has nothing to do in business cycle management.

The combination of these two points led to the necessity of a more modest role for government in regulation. This can then be a support for austerity policies. In a large number of developed countries public debt to GDP ratios are close to or above 90%. Following Reinhart and Rogoff’s rule this means that it’s mandatory to reduce public debt if the main target for economic policy is growth and employment.
This argument has been used on both side of the Atlantic.
It is not the first time that some economists want to reduce the government role in the business cycle management. Robert Barro in a very famous article in 1974 showed that fiscal policy was systematically inefficient and that the best rule for government was to stop intervening on economic issues. This point has been severely criticized (his approach is known as the Ricardian approach). In a way Reinhart and Rogoff were in the same line.

Since Reinhart and Rogoff publication and the threshold, there were controversies between economists. There were doubts on the size of the sample and there was no theoretical model behind the causality interpretation.

The recent controversy came after the publication of a working paper by three economists form the University of Massachusetts (Thomas Herndon, Michael Ash and Robert Pollin – Their paper is here). Taking Reinhart and Rogoff sample (20 developed countries from 1946 to 2009) they noticed a calculus mistake on an Excel spreadsheet (in doing an average some cells were not taken into account. This can be understandable when you do a lot of calculus of this kind). They were more fundamentally critic on the methodology used to calculate averages.
After corrections the 90% threshold became meaningless. Average growth associated with it was no more -0.1% but +2.2%. It’s then a totally different story. The threshold is no more pertinent to distinguish between good and bad practices.
At the same time the causality between public debt and growth is also withdrawn. It’s no more a drag to growth and higher public debt can be caused by the fact that growth is too low (see Japan).
This means that if there is no more general causality we all have to renew our thinking of fiscal policy. The public debt level is no more a scarecrow that can be put in front of governments to force them to rebalance rapidly their public finance in order to converge to a higher growth trajectory.

The absence of the 90% rule implies that fiscal policy will have to change. Controversies between economists are often on the adjustment mechanism. If you are Keynesian you are sensitive to aggregate demand to manage short term issues. You push up production, employment and income which can have some virtues. That’s what has been done in the USA. On the other side, if demand is not the good tool to manage, prices will do the job. In a recession this can lead to lower prices to try to rebalance the economy. In a way that’s what is currently done with internal devaluation in some countries inside the Euro Area (as competitiveness cannot be reached by currency devaluation, internal devaluation on wages is perceived as the main solution to converge to a growth trajectory. The question is on the costs of such a policy as it can bring a lower level of activity and a lower level of employment. In the Euro Area, competitiveness has to be rebalanced but it mustn’t be the only tool to be used.

 Without the 90% threshold economists have to renew their approach on fiscal policy and be more attentive to growth and employment. If the controversy has contributed to this renewal and to relax the 90% rule then it’s a success.