Ken Rogoff and Carmen Reinhart try and put the recent debate over their statistical results behind them. Their latest defense appears in the Financial Times and is titled "Austerity is not the only answer to a debt problem."
As people who have read my posts over the past few years know, I am not a big fan of debt…especially government debt. I am especially critical of a government following a policy of credit inflation, like the United States government has done for the past fifty years or so, that creates more risk-taking, higher amounts of financial leverage, and a greater mis-matching of maturities on the balance sheets of financial institutions, non-financial businesses, and households.
Such a house of cards is bound to tumble sooner or later, and, given such a tumble, will require a substantial amount of time to rebuild.
Furthermore, I am critical of governments that try to stimulate an economy…create a credit inflation…in order to achieve high levels of employment, and achieve these high levels of employment by trying to push unemployed persons back into the jobs that they previously held. Forcing people back into jobs they previously held can produce structural problems in the economy that may take an economy longer to recover from a recession than would be the case if the problem were just one of too much debt.
This seems, to me, to be the current situation. There is too much debt in the United States economy, and there are major structural problems in the economy that must be overcome before the United States can get back on the path to more rapid economic growth and higher levels of employment. I have written about this situation in recent posts: see, for example, "Mediocre Economic Growth Continues: Going Nowhere Fast" and "Auto Sales Up, Stk Market Down."
During this time, I have argued against further large federal deficits that will result in more and more government debt piling up. I have projected that the gross federal debt will approach $25.0 trillion in the early 2020s. In November 2012 the gross debt outstanding stood at $16.1 trillion.
One of the conditions I put on these negative feelings about the increasing debt was that the programs that the government was underwriting basically attempted to put people back into the jobs that they had lost…regardless of whether or not these jobs existed any more. In other words, the government seemed to be trying to keep people in dead-end jobs that were "legacy" positions unneeded in the current or future economy.
The reason for the government acting in this way was to try and insure that the politicians in office would get re-elected in the next campaign…and the next campaign…and the next campaign…
The funny thing…or, in other words, the unintended consequences of such an effort…is that all this effort created structural problems. The capacity utilization in manufacturing in the United States declined in a secular fashion over the past fifty years and now rests at a level below 80 percent. Labor force participation in the United States has currently dropped to a level not seen since the early 1980s, just when more and more women began to participate in the labor force outside their homes. Less than 64 percent of the people eligible to be in the labor force are in the labor force. These are structural problems.
Rogoff and Reinhart argue in their Financial Times piece that not all government deficits are bad. That is, there are times when austerity is not totally appropriate…if the right government programs are introduced. However, these programs, aimed at reducing the structural problems in the economy, do not produce major results in the short-run and hence are not that popular with politicians that are only concerned about getting re-elected in their next election.
These programs are designed specifically toward the end of reducing the dislocations that now exist within the economic system. And, they are not necessarily programs that have a specific end in mind…that is, they are not outcome orientated. This is another reason why politicians don't like these types of programs because they cannot point to a specific result and claim "ownership" of the result.
In addition, Rogoff and Reinhart argue that there are other "unpopular" programs that can be followed to reduce the debt that has been accumulated during the upswing of the credit inflation that resulted in the heavy debt burdens. They write, "First and foremost, governments must be prepared to write down debts rather than continuing to absorb them. This principle applies to the senior debt of insolvent financial institutions, to peripheral eurozone debt and to mortgage debt in the US."
Continuing, "There are other tools. So-called 'financial repression', a non-transparent form of tax (primarily on savers), may be coming to an institutions near you. In its simplest form, governments cram debt into domestic pension funds, insurance companies and banks. Europe is there already…"
The reason for these drastic actions? Sooner or later interest rates are going to climb. There are several arguments given for why interest rates have stayed so low for so long. "But," they argue, "can these same factors be relied on to keep yields low indefinitely?"
If, over the next decade, a rise in interest rates is possible, then one must still be careful about piling up more and more and more debt.
Thus, the problem relating to the restructuring of the economy must be given a high priority. But, two things must be considered. First, much of the restructuring that will take place cannot be government driven. There is only so much the government can do. Education and training is one area that the government can contribute. Choosing specific "winners", like solar energy start-ups, may not be something the government can be very successful at.
So the government needs to be very selective in creating these programs that might contribute to deficits. But, this is not to say that deficits may not be appropriate. Politicians should realize, however, that the restructuring of the economy, regardless of whether the stimulus comes from within the economy itself or from governmental programs, will require adjustments that will take time.
This is where Rogoff and Reinhart contest the arguments of what they call the "ultra-Keynesians." The ultra-Keynesian approach is to create very large deficits because with the interest rates so low, it is almost costless to finance the new debt created. But, Rogoff and Reinhart argue that these people are "too dismissive of the risk of a rise in real interest rates." Since we don't know how long the factors that are keeping interest rates so low will continue to keep the rates low, "no one can be sure for how long their current level can be sustained."
That is why Rogoff and Reinhart argue for the more dramatic measures of the government mentioned above need to be taken. This is the second effort they believe needs to be considered. The debt overhang must be dealt with and write-offs and "financial repression" must be considered in order to help relieve the economy for the time when the interest rates do rise.
Hello, moral hazard. But, credit inflation and the creation of too much debt lead to situations like the one we are now living through. This is the reason why debt should only be used prudently. However, we got ourselves into this position…and, now we need to get ourselves out of it…without creating an even greater disaster.