3 Lessons From The Reinhart-Rogoff Affair

by: Dan Morillo

Economists' academic work and late-night comedy rarely go together, but a few nights ago Stephen Colbert capped off a string of very lively media articles and blogs with a lengthy, comical segment on the Reinhart-Rogoff affair.

How did an academic economic research paper become the subject of late-night comedy? Back in 2010 Harvard economists Kenneth Rogoff and Carmen Reinhart ("RR") published a paper on the relationship between public debt and economic growth. The paper quickly became very influential in policy-making circles, concluding that there seemed to be a correlation between countries with public debt levels above 90% of GDP and significant decreases in GDP growth. But last month economists Herndon, Ash, and Pollin ("HAP") uncovered an Excel spreadsheet error in RR's original analysis that unleashed a firestorm of criticism of the paper's original conclusions.

Given that RR's work has been one of the most quoted pieces of economic analysis in recent memory, the controversy is attracting unusual media and political attention. The paper has played a central role in the ongoing debate around austerity and the best way to conduct fiscal policy in a persistently low-growth environment.

Instead of dissecting RR's original work, I'd like to highlight three lessons for investors watching the debate and asking how it may influence their investment decisions.

1. Beware of simple rules of thumb.

One of the key attractions of RR's original analysis was the apparent simplicity of the results, including the 90% "threshold" of debt-to-GDP as a way of evaluating a country's economic health and future prospects. It is of note that the 90% threshold was an estimate subject to both statistical error as well a wide range of possible interpretations. (See, for example, "Debt and Delusion" by Robert Shiller at the Project Syndicate, July 21, 2011.) But it has not been uncommon over the last three years to see this "rule of thumb" applied by many investors as a simple way of accounting for public debt in their investment decision-making process. A cursory look at the data shows that whatever the general relationship may be between public debt and economic growth, the specifics in each case can be quite different from the average.

To illustrate, consider the case of Germany, the United States and Spain shown in the charts below. (The debt-to-GDP data is from the IMF public debt database. Returns data are from Bloomberg and are based on MSCI local currency indices for each country.) Spain entered the financial crisis period with the lowest public debt burden of the three countries, but it has also suffered the worst growth decline and equity market performance of this small group. In contrast, the United States has showed the best performance in terms of equity-market returns and has experienced economic growth close to that of Germany. This is notwithstanding of the fact that it has the highest public debt burden of the three countries.

Many investors find it surprising that Spain's public debt levels are lower than those of Germany and the United States. The association between poor economic performance and public debt levels has become a strong part of how investors think about markets -- a testament to the popularity of the work that RR and others have published in the last few years.

2. Correlation is not the same as causation.

For all the hoopla surrounding the Excel error, the most interesting part of the debate is not whether high public debt is associated with low economic growth (the preponderance of the evidence suggests that it is), but which causes which. Indeed, recent work by a number of academics suggests that the observed relationship may well be partly explained by low-growth countries accumulating public debt as opposed high public debt causing low growth.

In particular, if some of the relationship documented by RR arises from low-growth causing public debt, then the timing of debt-reduction programs may have significant impact on a country's economic performance. This is because the benefits from public debt reduction may well be made up by the short-term impact of reduced government expenditure. Investors looking at the nature of debt-reduction programs when assessing their allocation to international markets should take care to note both the timing as well as the size of debt-reduction policy. We have cautioned in our own work that while long-term debt reduction should be on the menu for most developed countries, too much austerity too quickly can be counterproductive.

3. Don't judge a book by its cover.

Whatever the final outcome might be of this controversy, investors would be remiss in writing off RR's larger body of work. Their 2009 book on the history of economic crises made a significant contribution to economists' understanding of the nature of economic cycles -- especially the differences in the shape and speed of economic recovery after downturns that are linked to a banking crisis. RR provided unprecedented depth and empirical support for the idea that banking crises are followed by very slow recoveries, a prediction that has proven all too accurate since the financial crisis.

A key finding of that body of work is that the nature of a banking crisis induces slow recovery for a wide range of reasons, including the need to repair balance sheets across private markets and individuals as well as regulatory, institutional and political changes that tend to follow banking crises. The upshot is that investors should still be prepared for what is likely to be a continuation of the slow growth environment that we have seen over the the last five years. High public debt levels may or may not make the problem worse at the 90% GDP threshold. But either way a range of other post-banking-crisis issues remain, including only a very gradual working out of private debt overhangs, regulatory changes and higher-than-normal unemployment.

Original Post