Over the past five years, economists have been waging a fierce battle over if and when fiscal stimulus is an appropriate tool to fight the deleterious effects of the ongoing crisis.
On one side are the Keynesians, taking their name from the great 19th-century British economist John Maynard Keynes who believed that the most effective way to combat high unemployment is through direct government intervention in the economy — that is, by building things like roads and bridges. On the other side are classical economists who take the position that government spending is ineffective because it crowds out, or takes the place of, private spending. To this group, an economy is a zero-sum game.
If you’ve read about the Great Depression or studied economics, you’d be excused for finding the latter hypothesis difficult to reconcile with history. I say this because most reasonable minds would agree that government spending during World War II is what fully and finally lurched the U.S. economy back into action. It’s for this reason the classical view was in desperate need of an alternative explanation for its long-held disdain for fiscal stimulus.
Enter Carmen Reinhart and Kenneth Rogoff, two widely respected Harvard economists. In 2010, Reinhart and Rogoff published a now-infamous paper titled “Growth in a Time of Debt” (link opens PDF). The gist of the paper is that a country’s debt level and economic growth rate are inversely correlated — as debt relative to GDP increases, economic growth decreases. Most controversially, the paper argued that “for levels of debt in excess of 90 percent,” GDP growth would be “roughly cut in half.”
It’s no exaggeration to say that the latter “finding” had a particularly robust impact on the course of modern history. Cited by conservatives to stop the expansion of government, and despite Reinhart and Rogoff’s protestations to the contrary, it’s widely believed that this paper almost singlehandedly convinced European policymakers to choose austerity over growth, and stymied any further attempts by the government here in the United States to pursue the same type of policies that helped put an end to the Great Depression. As Paul Krugman recently noted in The New York Review of Books,
[Growth in a time of Debt] may have had more immediate influence on public debate than any previous paper in the history of economics. The 90 percent claim was cited as the decisive argument for austerity by figures ranging from Paul Ryan, the former vice-presidential candidate who chairs the House budget committee, to Olli Rehn, the top economic official at the European Commission, to the editorial board of The Washington Post.
What happened next is shocking. After trying to replicate Reinhart and Rogoff’s results, three graduate students at the University of Massachusetts, Amherst, uncovered a litany of errors including data omissions, questionable methods of weighting, and coding mistakes which collectively obliterated the paper’s central thesis. As my colleague Morgan Housel noted at the time, “Rogoff and Reinhart showed economies with debt-to-GDP above 90% experience average GDP growth of negative 0.2%. Fix the math errors, and the real figure is positive 2.2%. Oops.”
The distinguished Harvard economists were quick to defend their work, arguing in a New York Times op-ed piece that, while they did indeed “miscalculate the growth rates of highly indebted countries since World War II,” the underlying relationship between high debt and lower growth remained unscathed. “Our 2010 paper found that, over the long term, growth is about 1 percentage point lower when debt is 90 percent or more of gross domestic product,” Reinhart and Rogoff recounted. “The University of Massachusetts researchers do not overturn this fundamental finding, which several researchers have elaborated upon.”
That is no longer the case. As Mike Konczal, author of the blog Rortybomb, noted at the end of last week, two new papers cast serious doubt on the existence of a causal relationship between sovereign debt and economic growth. This paper by a professor and student at the University of Michigan concluded that “high debt does not slow growth.” And this paper (link opens PDF), by a fourth economist at the University of Massachusetts, goes so far as to suggest that there may indeed be a relationship between debt and growth, but that it’s the other way around — i.e., that slow growth causes higher debt levels and not, as Reinhart and Rogoff conclude, that high debt slows growth.
On the surface, you’d be excused for chalking all this up to a meaningless dispute among academics with far too much time on their hands. But while that may be true, the unfortunate reality, as I noted above, is that the repercussions of Reinhart and Rogoff’s work have been real and tangible. Among other things, it’s arguably one of the principal reasons that 13.9% of Americans remain either unemployed, underemployed, or so discouraged that they’ve removed themselves from the labor force altogether. And on top of that, it’s left the responsibility to support the economy solely on the shoulders of the Federal Reserve.
While the latter has been great for stocks, as both the Dow Jones Industrial Average and S&P 500 have recently shot to new highs, the potential distortion to asset prices is something to be concerned about. No group of stocks illustrates this better than mortgage REITs, which live and die by the interest rates that the Fed has been obligated to manipulate. Since the beginning of 2013, ARMOUR Residential REIT, Inc. (NYSE:ARR) and American Capital Agency Corp. (NASDAQ:AGNC) are down by 24% and 15%, respectively. Why the dramatic decline? Investors are concerned that the Fed will prematurely abandon its support for the housing market.