Repercussions Of The Reinhart, Rogoff Flawed Analysis

by: MA Capital Management

In 2010, Harvard economists, Carmen Reinhart and Kenneth Rogoff (R&R) published an influential research paper which analyzed the economic growth of countries as a function of their level of government debt. The results showed that a 90% government debt to GDP ratio was the prudent ceiling, beyond which economic growth of the country was adversely affected.

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This research paper has been instrumental in the austerity driven agendas of Central banks globally and is also the centerpiece of the European austerity program which has led Europe into a recession and high unemployment rates. With the US adopting a similar austerity program, the repercussions of the R&R flawed analysis could be felt here as well.

On April 15th 2013, Thomas Herndon, graduate student at the University of Massachusetts Amherst, aided by professors Michael Ash and Robert Pollin, highlighted some serious flaws in the Reinhart, Rogoff analysis which has started a firestorm among academic, economic and global political circles. The ramifications of these errors are far reaching as the conclusions of the paper have influenced public policy globally.

Error 1

The original analysis was supposed to include 20 countries, but a programming error meant that they only accounted for 15 countries. While this error is certainly embarrassing, it did not change the results of the outcome much.

Error 2

This is a more serious problem that takes away a lot of credibility from the paper and their authors. The analysis failed to include the early postwar data for some very indebted countries like Australia, Canada and New Zealand. These countries experienced high growth rates with high debt levels, which weakens the results of the R & R paper.

Error 3

R & R use an unconventional weighting of summary statistics to support their conclusion. This is quite serious as well, as it shows tweaking data analysis to support conclusions rather than conclusions be drawn from proper data analysis. Please refer to Herndon, Ash, Pollin response to see the full explanation of the statistical methodology used.

Bottom Line

Bottom line, is that after correcting for the errors, the GDP growth for countries with a government debt/GDP ratio of greater than 90% rises from -0.1% to +2.2%. This is highly significant, as it trashes the R&R conclusion that high debt levels lead to low GDP growth rates.

The reason why the errors in the R&R paper and the ensuing debate have far reaching repercussions is that it affects government policy, unemployment rates and the economic growth of countries around the world.

Differentiate between Currency Users and Currency Issuers

A lot of the misunderstanding at the highest levels comes from not differentiating between currency issuers and currency users, and the eurozone is the perfect example. In the eurozone, the ECB (European Central Bank) is the issuer of currency and it can issue currency without any revenue constraint. But the users of the currency, i.e. countries in the eurozone are constrained by revenues (taxes). Excessive borrowing by countries like Greece, Spain, Italy, etc. landed them in hot water.

But countries that are issuers of their own currency are not constrained by revenues to increase deficit spending, like the US and Japan. Government bonds are issued to provide an interest bearing instrument for the increased money supply and conversely bonds are removed from the system to lower interest rates and move money into assets (Quantitative Easing). Neither operation requires more than a key stroke on a computer by the Central bank.

Government Spending in the Eurozone

Europe embarked on a massive austerity program after the PIIGS debt crisis while not truly understanding the difference between currency issuers and currency users. A country's GDP is defined as:

GDP = Govt. Spending + Consumer Spending + Corporate Investment + Exports - Imports

Austerity in Europe meant that government spending fell, jobs were cut which led to a fall in consumer spending and lack of spending meant that corporate profits fell which led to a fall in corporate investment. It should be no surprise that GDP fell in tandem with the advent of the austerity programs. Economic weakness in the eurozone has now spread from the peripheral economies to the core countries as well (Germany). Unemployment is rising from one awful record to another. (In Spain, for example, the rate increased to 27.2%, with an even more stunning 57.2% rate among the young).

Continuing austerity will not make things better in the short term, but much worse which will reduce GDP further and thereby increase the Debt/GDP ratios further. A vicious cycle!

The ECB and the EU need to step in and increase government spending as they have the power to print Euros without constraint. This will help to shore up growth in the Eurozone while the private sector has time to increase investment, create jobs and take over the fall in domestic government spending. This is akin to the Federal government in the US helping ailing state governments which has been done numerous times.

The Cliff and the Sequester in the US

The start of the year hike in FICA rates and the cuts from the sequester are starting to show signs of strain on our economy as well. April economic numbers have been decidedly weak. March jobs report, Q1 GDP, consumer spending and even the housing starts have all slowed or come in below expectations.

Furthermore, QE, which is often incorrectly understood as increasing money supply, actually decreases it. By removing interest bearing securities from the market, the Fed has de facto moved investor's money from a savings account into a checking account. The interest that would have been earned by investors holding government bonds has been removed which is akin to a tax of $90 billion imposed on savers. With another $1.6 trillion in budget cuts coming our way, the prospects for economic growth in the US also do not look good.

Quite clearly, the errors in the Reinhart and Rogoff paper and the subsequent conclusions have had some very far reaching ramifications for the global economy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.