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There are errors and errors. Does the Reinhardt and Rogoff miscalculation mean that Osborne should change tack?

The distinguished American academic economists, Carmen Reinhardt and Ken Rogoff, have been very much in the news. Their 2009 book, This Time is Different, was a comprehensive examination of financial crises over the past 800 years. The work received many plaudits and awards. They suggested that when the ratio of public debt to GDP in a country rose above the 90-100 per cent range, the chances of a financial crisis increased sharply. And the consequence was that economic growth in the country would be adversely affected.

The finding has been queried by a trio of fellow Americans. Reinhardt and Rogoff do seem to have conceded that their own calculations contain a glitch. The new analysis has been seized on by opponents of austerity policies. But how much does it matter that an error was made? At the moment, the debt to GDP ratio in the UK is just below the crucial level of 90 per cent. Does this miscalculation mean that George Osborne should change tack and spend to try and stimulate the economy?

In defence of Reinhardt and Rogoff, they never elevated their suggestion into a ‘theorem’ or a ‘law’. They simply suggested that high levels of public debt tend to be a Bad Thing. Even the most devoted Brownite would surely accept that there is some limit to how much public debt can be incurred relative to the size of the economy. The real question is: what is this limit?

A great deal depends upon the extent to which an increase in debt leads to higher interest rates. More public expenditure financed by issuing long-dated gilts at around the current yield of 2 per cent is one thing. But if it causes gilt yields to rise to, say, 4 per cent, it is pretty disastrous.

Higher interest rates would have an adverse effect on business confidence. If rates doubled, the capital value of the outstanding stock of gilts held by the private sector would fall by 50 per cent – a severe negative shock to the wealth of the sector. And higher taxes will at some point be needed to meet the higher interest payments.

There is a lot of evidence to suggest that high public debt levels relative to GDP are indeed associated with higher interest rates. The Mediterranean economies are just the latest example of this. But there is no automatic connection between debt and rates. The relationships which are coaxed out of the data are not like the laws of physics.

So much depends upon psychology. Osborne pushing up debt by cutting taxes might be one thing. Balls doing the same by hiring more bureaucrats might be perceived quite differently. But at some point, regardless of who the Chancellor might be, an increase in public debt would have an adverse impact on the economy. The theoretical channels by which this happens are well understood.  And an ounce of good theory is worth a ton of applied econometrics.

As published in City AM on Wednesday 24th April

Watch Paul present this argument on Newsnight in debate with Nobel prize winner Joseph Stiglitz (feature from 23:30)

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Sovereign debt and Euro zone reality

The recent debacle in Cyprus has essentially been shrugged off by the markets. The European Central Bank vigorously asserts the crisis in the Euro zone is over. So why is there continued unease about the financial viability of countries such as Spain and Portugal, a morass into which even the French are now being dragged?

Economic theory helps us understand a bit more about why this is the case. One thing which the last few years in Europe have shown very starkly is the massive difference between debt which is denominated in nominal terms and that which is in real terms. Nobel Laureate Chris Sims makes the point clearly in his recently published Presidential Address to the American Economic Association.

As Sims puts it, real sovereign debt promises future payments of something the government may not have available—gold, under the gold standard, Euros for individual country members of the EMU, and dollars for developing countries that borrow mainly in foreign currency. Nominal sovereign debt promises only future payments of government paper, which is always available. In other words, money can always be printed. Sims notes almost in passing that ‘obviously, outright default on nominal debt is much less likely than on real debt’.

In order to be able to repay any given level of debt, a country must be capable of generating in the future what are called in the jargon ‘primary surpluses’. These are simply a surplus of government revenue over expenditures, taking interest payments out of the picture. For a country with its own currency, as long as it is capable of generating any primary surpluses at all, it need not default. In accounting terms, the present value of its debt is simply the discounted value of future surpluses. It might not be worth much, but its debt has some value. In contrast, if the debt is in real terms – in Euros for the Italians and Spanish – the country needs to be able to generate primary surpluses which cover its debt commitments in real terms, an altogether more challenging task.

There is a definite risk of the Southern European countries becoming trapped in a real debt spiral, from which the only escape is either – or possibly both – default on debt or exit from the Euro in order to be able to denominate their debt in nominal rather than real terms. France is now looking uncomfortably close to this group.

The experience of the 1930s suggests that exiting the Euro may be far from being a disaster. Once the taboo on leaving the gold standard was lifted, those countries which exited early revived earlier than those which chose to prolong the agony.  One reason was that the financial position of the state was once again judged to be viable. The UK quit in 1931, and the very next year our GDP had exceeded the pre-crash peak in 1929. France waited until 1936, and even by 1938 its output was lower than in 1929.

As published in City Am on Wednesday 10th April 2013

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George Osborne’s economic policy seeks to blind markets from the truth

Andrew Mitchell, the government’s chief whip, remains in some difficulty after his exchange with the police at the gates of Downing Street. At the heart of the incident there is an objective reality. Either he used the word pleb, or he didn’t. Either the police were officious jobsworths, or they were the epitome of politeness.

But, in many instances, perception matters much more than reality. It is perhaps unfortunate for Mitchell that he went to Rugby School, the home of the arrogant bully Flashman in the novel Tom Brown’s Schooldays. This fictional setting, and this fictional character, have played an important role in shaping how many regard the incident.

Perception often matters more than reality in economic policy, also. After allowing for one-offs, UK public borrowing was 22 per cent higher in the April-August period than in the same months last year. So the deficit-reducing Osborne is actually presiding over a sharp increase in government borrowing. Yet the markets continue to believe in him, to have faith that he is committed to deficit reduction.

Further, the objective difference between the policies of Osborne and Labour’s Ed Balls is minute. Osborne wants to achieve his target for deficit reduction in six years. Balls has the radical alternative of getting to the same number in seven years.

The margins of error involved in forecasting public spending and receipts, even one year ahead, are also huge. And the potential error in predicting the projected deficit, the difference between these two numbers, is even larger.

Given the size of this margin of error, to all intents and purposes there is no effective difference between the strategies of Balls and Osborne. Yet Balls struggles to gain credibility in financial markets, while Osborne currently has their confidence. Narrative and perception outweigh reality.

This Time is Different, the monumental study of government debt by Carmen Reinhart and Ken Rogoff, former chief economist at the International Monetary Fund, showed that, when public sector debt to GDP ratios rise above the 90 to 100 per cent mark, there is a sharply increased risk of lower growth and default. The data shows clearly that Germany is hovering very close to this critical value. Yet it is perceived as the epitome of financial stability.

A great deal of economic policy in Europe, at the moment, can be seen as an attempt by various players to get their narrative of events to “go viral.” They want to reassure financial markets, almost regardless of objective reality.

This is the future of macroeconomics. With a real basket case, like Greece, the facts are so glaring they will be hard to ignore. But, in general, as with the Mitchell incident, the truth is usually capable of more than one interpretation. Perception trumps reality.


As published in City AM on Wednesday 26th September 2012

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