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Ireland's political and cultural magazine
— June – July 2013
S
INCE publication of the working paper by Thomas Herndon,
Michael Ash and Robert Pollin (HAP), ostensibly subverting the
paper by Carmen Reinhart and Kenneth Rogoff (RR), the
Irish Left has, like a small boy who has been told that glucose is
good for him, been sugar-high with renewed anti-austerity zeal.
According to the Neo-Keynesianistas, the article by Reinhart and Rogoff
‘Growth in a Time of Debt’ published in the American Economic Review
in May , provided the intellectual foundation for the argument that
austerity is necessary for countries with public debt in excess of, or near,
% of GDP. And, they implore, the article has now been demolished by
the HAP critique.
In the immediate aftermath of the HAP publication, both new and tradi-
tional media were saturated with ‘austerity is dead’ missives from indignant
leftists of all shades. The HAP paper’s student co-author became an over-
night celebrity.
Alas, the HAP critique of the Reinhart and Rogoff study grossly exagger-
ated the extent of the errors perpetrated by Reinhart and Rogoff. The tidal
wave of anti-austerity rhetoric unleashed since the HAP publication has
vastly distorted the nature of the original study and ignored the large body
of academic research on the relationship between public expenditure, eco-
nomic growth and public debt.
It is alleged, first, that the authors identified a glaring and undeniable
error in the spreadsheet calculation for one of the six main RR findings.
This error, unfortunate as it might be, is insignificant to the core conclu-
sions. Correcting for this error changes the impact of debt on growth by just
three tenths of a percent – within the statistical margins of error. In other
words, economically, the error was barely significant, even to the particu-
lar conclusion. A .% swing in growth for an ‘austerity-hit’ economy like,
say Ireland or Spain, is negligible. Between and , the standard
deviation in real growth in the peripheral euro area states averaged more
than nine times the magnitude of the Excel error discovered by HAP.
Second, the authors have claimed that the methodology used in the RR
paper in computing three of the six core reported results was flawed. In fact,
the major discrepancy between the HAP and RR papers is as to which aver-
ages matter when it comes to summarising countries’ experiences across
periods of crises.
The significance of this error can be best understood in terms of a prac-
tical example, provided by James Hamilton of the University of California,
San Diego.
Between and – the period covered by both papers – the US
experienced debt-to-GDP ratio in excess of % in only four years. In con-
trast, Greece was in a similar predicament for years. To compare the
two countries’ experiences, one has to deal with the averages across time
(four years versus years) and across countries (the US is structurally
robust and much larger; Greece is weaker and smaller). The periods matter:
if the US experienced four years of high debt when the global economy was
growing slowly, some of the US slowdown would be attributable to global
conditions and not to debt overhang. In contrast, if Greece experienced
years of debt overhang amidst, say, a robust global expansion, then more
of the impact of excessive debt levels can be attributed to internal condi-
tions in Greece. And so on: variations in exchange rates, interest rates, and
inflation all matter.
HAP assume that the correct way to deal with all these differences is to
ignore them completely. Thus, under HAP, the expected growth rate for
Greece under debt overhang (in excess of % of GDP) conditions is exactly
the same as it would be in the US. More than that, HAP assumptions also
The need for austerity
in economies with debt
overhangs like Ireland’s
has not been disproved
by the recent study
G
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Austerity abú
Shouldn’t go away
Despite all the hoopla about the HAP study,
it conrms the main argument set out in the
RR paper, namely that breaching 90% debt/
GDP is associated with signicantly slower
rates of growth. Predictably, the Neo-
Keynesianistas ignore this
“
imply that growth volatility around the mean is
identical in the US and Greece, despite the fact
that smaller economies tend to be much more vol-
atile than larger ones, and that volatility in growth
changes over time and across countries. The
upshot of the HAP assumption is that the Greek
debt overhang is weighted as if it was almost five
times more significant than the US’.
In contrast, RR assume that differences across
economies and time do matter, and therefore that
we should consider separately the average growth
rates in the US from those in Greece. The table
opposite summarises the differences.
Note that unlike RR, HAP fails to report median
results, which are (a) not as different from the HAP mean-based results as
RR’s own mean-based results, and (b) were always clearly stated by RR to
be the preferred results. The omission of the median findings by HAP is a
major one. The difference between the median and average growth rates
reported by RR is indeed very sizeable in the case of the countries with debt
overhang. This statistically skews the data and suggests that in addition to
being associated with lower growth rates, high debt/GDP ratios are also
associated with greater risk or volatility in growth.
Despite all the hoopla about the HAP study, it confirms the main argu-
ment set out in the RR paper, namely that breaching % debt/GDP is
associated with significantly slower rates of growth. Predictably the Neo-
Keynesianistas ignore this. Uncomfortably for them, the analysis by RR
is broadly and even numerically close to other studies by the two authors
which were based on different data and models, as well as to papers from
BIS (Cecchetti, Mohanty and Zampolli paper from ), ECB (Checherita
and Rother, paper), the IMF (the World Economic Outlook, 2012),
and a number of other studies. All of these papers have clearly confirmed
that higher debt levels in post-war advanced economies are associated with
lower levels of economic growth.
The debate re-ignited by the HAP criticism of the RR paper is emblematic
of the problem of politicised thinking on the ‘austerity or Keynes’ debate.
While we do not know much about the causality between debt and growth
overall, what we do know is that:
) Higher debt is associated with lower growth,
) Higher debt is associated with higher present and future interest rates,
and
) Higher interest rates are associated with higher borrowing costs for gov-
ernments, households and companies alike.
The latter points were established for a number of advanced economies
across the post-war period in a recent paper from the Bank of Japan (Ichiue
and Shimizu, ), and by the likes of Laubach; Greenlaw, Hamilton,
Hooper and Mishkin; Ardagna; and Baldcacci and Kumar.
The US Congressional Budget Office – hardly a hot house for austerity
zealots – clearly shows that for the US the net interest cost of debt financ-
ing relative to GDP can be expected to double over the next decade. This will
take net interest cost of funding the US government debt from .% of GDP
in the- period to .% of GDP by . By -, US
Defense and non-Defense discretionary expenditures will be less than the
cost of net interest funding.
In the case of another heavily-indebted economy, Ireland, the latest IMF
projections show that the interest cost of our debt will rise from 1.bn in
(.% of GDP) to 1.bn by (.% of GDP). A full % of
all income-tax increases since , including those to be achieved from
the forecast increases in economic activity in Ireland up to will be
consumed by the hikes in interest costs on Irish government debt. The IMF
does not publish underlying interest rates and government bond yields. But,
given the dynamic of debt accumulation, it is relatively safe to assume that
the IMF is expecting Irish government bond yields to average around %
for -year bonds between and . This is optimistic. As I have
repeatedly pointed out, we can expect ECB rates to rise to above the .%
historical average in the medium-term future. With risk premium broadly
consistent with higher Irish debt levels, this may lead to sovereign yields
averaging closer to % over the - period. In this case, govern-
ment interest costs could be €bn or closer to .% of GDP. If this were
to occur, the growth in the economy projected by the IMF can fall short of
the levels required to deflate our government debt to GDP ratios.
If neo-Keynesianists think this to be sustainable, we can add the poten-
tial impact of higher government yields on cost of funding Irish mortgages
and corporate loans.
Another major issue missing in the HAP v RR debate is the question as
to whether the aggregate comparatives, based on datasets pooling together
vastly distinct countries over differ-
ent periods of time and underlying
economic conditions, is a mean-
ingful way for looking at the debt
overhang problems. In the case of
Ireland, consider two sub-periods
of high government indebtedness:
the s and the present period.
In both, debt/GDP ratios for the
Irish government were running at
similar levels. However, the s
were associated with Ireland fac-
ing an exceptionally robust global
demand for its exports. Ireland’s
comparative advantage vis-à-vis
our main trading partners – our
high corporate tax rate incentives
and low cost basis – drove rapid
expansion of our exports. The
low-interest-rate environment
that followed devaluations of the
currency has resulted in a series
of asset bubbles helping to reduce
debt/GDP burden inherited from
the s. None of these condi-
tions are present in Ireland today. Lastly, while in the s Irish debt levels
were flashing red only for government debt, today we have one of the most-
indebted private- and public- sector economies in the world.
Which means – in terms of the table above – that we are not starting from
a %-plus growth benchmark of pre-crisis long term growth trend, and
we are not heading for a .% median or .% average growth rate in the
aftermath of the debt overhang crisis. More likely than not, we are going
from a structural growth rate of -.% pre-crisis to a post-crisis long-term
average growth rate of %. Whatever Reinhart and Rogoff or HAP aggre-
gates might tell us about the future, it is hardly going to be rosy unless we
get our debt and deficits under control and, more crucially, unless we shift
our economy from the slower-structural-growth path associated with cur-
rent economic environment onto a higher growth path.
How this can be achieved, however, is an entirely different debate from
the superficial austerians v neo-Keynesianists ‘to cut or not to cut’ ideo-
logical warfare.
Debt to GDP Ratios
Reinhart & Rogoff, 2010 HAP, 2013
Debt/GDP Mean Median Mean
0-30 4.1 4.2 4.2
30-60 2.8 3.9 3.1
60-90 2.8 2.9 3.2
Above 90 -0.1 1.6 2.2
“
Fully 65% of all
income-tax increases
since 2009,
including those to be
achieved from the
forecast increases in
economic activity in
Ireland up to 2018
will be consumed by
the hikes in interest
costs on Irish
government debt
