Paste your Google Webmaster Tools verification code here

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

Posted by on April 25, 2013 in Debt, Economic Policy, Economic Theory, Financial Crisis, Government Borrowing, Government Spending, Politics, Public Policy, Recession | 2 comments

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)


  1. “And an ounce of good theory is worth a ton of applied econometrics”, the problem being that sometimes it is not easy to tell good and bad theory apart.

  2. There is no evidence that high public debt levels relative to gdp lead to higher interest rates. And the Mediteranean economics are in a very exotic situation, since they are part of the eurozone and so they suffer of the faulty design of the euro and eurozone. And if we look at Japan, we see, that their figures prove you wrong: low interest rates, low inflation rate (it is actually a deflation) and a debt-to-gdp-ratio far over 200%, which is much more than even in Greece.

    What is more interesting to me, is that many economists seem to believe, that one can examine 800 years of economic history and find a single cause for financial crisis, and that the last 800 years of history deliver enough data, to express this cause as a single number.

    To me it looks as if Rogoff knew before, what he was searching for and was very willing to find it. This would explain his missing doubt about his findings that could have led him to find his error himself. And what surprise: 2009, 3 years after the start of the financial crisis, which started as a very private debt crisis, a well known economists wiped away what cannot be by blaming the state, the old enemy of many economists. And in 2013 you Paul, see the Mediterranean countries, which had low to lowest debt-to-gdp-ratios before the start of the private debt crisis, as a strong hint for Rogoffs thesis.

    To me, this sounds like ideology, not like science.

Leave a Comment

Your email address will not be published. Required fields are marked *