Carmen Reinhart

(Episode 421; 17 minutes 15) Some forecasters and politicians would like us to believe that we will rebound out of the global financial crisis with a period of high economic growth. Others say that’s unrealistic when high government debt will have to be met with higher taxes that will only inhibit growth.

So can an economy grow an economy with high government debt? The answer seems to be to a point. Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard University) have studied the relationship between growth and data for their paper Growth in a Time of Debt. Based on a mass of government data from around the world they have concluded that debt has little impact on growth so long as it stays below 90% of GDP.

Does that mean countries can keep spending to buy their way out of recession? Hear what Carmen Reinhart has to say in today’s edition of BTalk.

Read the latest draft of the paper here.

• Transcript

Phil Dobbie: Hello. I’m Phil Dobbie. Welcome to BTalk. Today we’re all steeped in debt. Governments, companies, my credit card. In these circumstances can we really expect the economy to start growing again?

Well, one thing the Western world has in common, that is as we come out of the global financial crisis, there’s a lot of government debt. The US national debt is over $12 trillion. In the UK the government is forecasting £1.1 trillion pounds by 2011. While Australia, the national debt’s a mere 61 billion Australian dollars. But many commentators, and particularly opposition leaders around the world, say this is all extremely bad news. This debt has to be paid for in higher taxes, which of course is going to reduce spending, slow the economy and lead to a loss of jobs. Are they right?

Let’s ask Carmen Reinhart from the University of Maryland. She’s co-authored a paper on Growth in a Time of Debt, Looking at Historical Debt. Now Carmen, you’ve gone far and wide for this study, haven’t you? You looked at a lot of countries and you’ve gone a long way back as well.

Carmen Reinhart: Yes. We put together massive data on government debts, which is easier said than done. Governments are not the most forthcoming when it comes to debt numbers.

Dobbie: Now out of all of this you’ve come up with a magic figure. The answer to the question is there’s not a lot of impact on growth, so long as the level of debt doesn’t hit 90 percent of GDP.

Reinhart: That’s right. That was actually quite surprising to us in that the relationship is not a linear relationship. You can have 30 percent debt or you can have 60 percent debt and it doesn’t actually make that much difference, at least historically, for growth. But when you cross that threshold of 90 percent or higher, it’s pretty much across the board. It’s a very conclusive picture. One of the things I’d like to highlight that this isn’t the question, is this result driven perhaps by Japan in which the periods of high debt are abysmally lower growth years? No, it isn’t. Because you have to bear in mind that we’re working with thousands and thousands of observations, in some cases going back 200 years.

Dobbie: So why this figure? Have you got a theory? It’s an interesting percentage. It looks as though there might be an element of psychology in here somehow.

Reinhart: I think you hit a wall in which it could be market psychology, but it could be the realisation that debt difficulties become increasingly likely.

We have done work looking at risk premium, various measures of risk premium. And again, the relationship between risk premium debt is not a linear one. You can have quite a bit of debt for quite a while with low risk premium. But then you hit a wall and risk factors become an issue. And when you have very high risk premium or very variable risk premium — those are the two things — those things would not be considered good for growth.

Dobbie: But it seems a very high percentage. Then again I guess a lot of countries are getting dangerously close to this. It’s a warning, isn’t it? So a lot of governments really do have to rein in spending now.

Reinhart: Indeed. In the new era that we’re in of even greater government guarantees, now we may cross the 90 percent threshold if we take into account a lot of the government guarantees at what are lower levels of central government debt.

Dobbie: Of course. The governments are getting up to that 90 percent point without necessarily knowing it when they’re looking at guarantees. But also, you talk about risk, is that the main element? It’s just that it becomes prohibitively expensive to manage that risk and that’s what is resulting in this 90 percent figure, or thereabouts.

Reinhart: Something we would like to investigate, but don’t have yet conclusive evidence on, is that perhaps at higher levels of debt people also start expecting a fiscal adjustment involving higher taxes, lower government services and so on. And that that in and of itself is a driver to the growth results.

Dobbie: And what about inflation — where does inflation fit with all of this? You’d expect in times of high debt it does have to be paid off at some point that is going to result in lower taxes. That’s presumably going to mean less spending and less jobs, and inflation normally does follow when you have that scenario?

Reinhart: There are results which are along the lines of what one would expect, which was our growth results. We really did expect to find lower growth at high levels of debt. We also expected higher inflation at higher levels of debt. But that second result did not pan out for the advanced economies. For the advanced economies the evidence is sort of all over the map. You get very conclusive evidence for emerging markets, and you don’t hit the 90 percent.

So in the merging markets as debt levels start rising beyond 60 percent, ie, the Maastricht criteria that Europe uses, you start seeing inflation increases. For the advanced economy this is really all over the place.

For the United States, you see higher inflation at the higher debt levels. But that’s not the case for the whole sample. In part, if I could just explain a little bit of this result. You have countries there, like notorious Greece, in which it went from a country that financed its fiscal spending importantly through inflation in the early ’80s and in the ’70s. To a country that depended more on debt to finance its expenditure as it tried to bring inflation at bay to join the Eurozone. So you have actually countries like Greece in which you see declining inflation as debt increases because they’ve changed the way they’re financing their budget deficits.

Dobbie: I noticed also another interesting occurrence, is that getting back to the issue of growth, Australia’s bucked the trend a little bit. Historically, Australia seems to get higher growth when the government debt-to-GDP ratio is over that magic 90 percent.

Reinhart: You’ve got to be careful interpreting, which is why we stress the pool of countries rather than individual countries.

Let me say something about Australia. Australia’s notoriously high levels of debt were, like so many countries, right after World War II. And so the very rapid growth that you get in some years in which Australia has high levels of debt is really very much tied to recovery from World War II.

Dobbie: Yes, a bit of nation building going on. That was the time of the Snowy Mountains scheme and all that stuff.

Reinhart: Indeed. And so that’s why we like to stress the pool results, because those are not prone to this kind of sensitivity that ‘oh, well, but this is really post-World War II that we’re picking up here’, which is the case in Australia.

Dobbie: OK, so it’s not an argument that we’ve done it before, we can do it again?

Reinhart: No. Australia isn’t scot-free in this. I mean it just so happens that historically Australia has been by and large a country that saw its highest debt levels at a predetermined point in time right after the war. And right after the war it was a good growth period, as Europe was rebuilt and Japan was rebuilt. And I wouldn’t extrapolate from that.

Dobbie: Right. Now have you been able to tell from your results whether there’s any difference in terms of how quickly this debt is incurred? Because obviously we have been through a period, everywhere, because of the bailout packages and the like debt levels have skyrocketed. Does that make a difference?

Reinhart: One of the things we start out the paper is just by showing how much debt has increased in recent years. For the countries that have had major financial crises on average you’re talking about debt-to-GDP rising by 75 percent. That’s not 75 percent of GDP but it’s nearly doubling in other words in the two years after the financial crisis.

For countries like Australia that did not have the systemic financial crisis, but were nonetheless impacted by world economic conditions as everyone else was, debt increases have been in the order of 20 percent. Not 20 percent of GDP. Just a 20 percent increase in the level of debt in the last couple of years.

The question is you can get the debt to increase very quickly, and that is not just stimulus packages we’re talking about. As the economic activity slows one of the things we’ve been really harping on is don’t focus so much on just the fiscal stimulus costs. But focus on the declining revenues that you get as a major driver of the fiscal problems.

Dobbie: Yes, for sure.

Reinhart: It is asymmetric, so the debt tends to go up quicker than it does to come down in general. So you seldom grow your way out of debt. It’s very few cases that you can say well, they just sprinted ahead in terms of growth, and debt GDP’s ratios sort of whittled down. That kind of very Pollyannaish scenario doesn’t really pan out very often. Not historically.

Dobbie: So it’s going to take a long time to fix, in other words.

Reinhart: It’s going to take a long time. It’s a long-winded answer to your question, but because it doesn’t primarily happen through rapid growth it does take a while.

Dobbie: But that 90 percent of GDP, historically that figure has still applied irrespective of the speed at which that debt’s been incurred.

Reinhart: That’s right.

Dobbie: But it is different for developing nations, isn’t it? I mean that figure is slightly lower. The threshold’s quite a bit lower actually.

Reinhart: It depends what type of debt you’re talking about. Emerging markets can still carry quite a bit of public debt, not that dissimilar from advanced economies. But you’re absolutely right that when it comes to external debt thresholds have real big teeth in emerging markets.

Dobbie: Because they have to go elsewhere to get the money because they don’t have it themselves.

Reinhart: Absolutely. What you see in emerging markets, that is, if just rather than focusing on public debt you focus on external debt which includes both the public debt and the private debt, which is often guaranteed by the government. Then you start getting growth consequences and adverse inflation consequences. And much lower levels of debt at 60 percent. And that result was not surprising to us because one of the observations that we have made from our earlier work is that if you look at the major emerging market default, sovereign defaults, they occurred at levels that would have met the Maastricht criteria in more than half the cases.

Dobbie: Right.

Reinhart: So their tolerance for debt is much more limited than for the advanced economies.

Dobbie: One of the problems over recent years has been less to do with government debt, it’s been more to do with private debt. And we have seen that blowout, and I would have thought this is going to have a bigger influence on the economy, isn’t it? I mean we’re likely to see that happen.

Reinhart: Absolutely. That’s absolutely right.

Dobbie: That heavy deleveraging that we can expect. In fact, we’re starting to see it already of course.

Reinhart: If you look at a profile over the years 2003 to 2007 when subprime erupted, it had been a period of heavy debt build-up by the private sector in most of the advanced economies. But most acutely actually in Europe, where countries like Ireland in particular, saw a big surge in private debts, bank debts. With debt-to-income ratios so high for the private sector, and in many, many cases the United States included, they are at record levels. Deleveraging lies ahead, which does not really bode well for rapid growth. Periods of deleveraging have tended to be associated with more circumspect consumption and with somewhat higher levels of unemployment.

Dobbie: In normal circumstances the government can try and react to that, can’t they? By saying well OK, we’ll increase government spending a little bit to try and cushion that blow as that deleveraging happens. But not easy for Barack Obama. He’s very close to your 90 percent threshold. He’s not really got anywhere to move, has he?

Reinhart: For the very near term one has to sort of now put the cart before the horse. The recovery here is still fragile. We are in the early stages of it. And so right now focusing on the debt issue as the primary focal point is, I think, not the right thing to do given the current conjuncture.

If we were already in a well-grounded recovery that’s a different story. That doesn’t mean, however, that you shouldn’t be thinking of exit strategies now. So it’s a question of not about thinking about an exit strategy from high debt, but rather when you implement it.

The reason I say these things has to do with my analysis of the great Depression and the Japanese banking crisis in which the tendency for the government was to declare a victory over the recession too soon and tighten in a significant manner. And really engineer a double dip that happened in the Depression and it happened in Japan after the ‘92 major financial crisis. So that’s the situation. So it’s not a pretty scenario.

Dobbie: No, absolutely. I wonder whether the Reserve Bank in Australia is doing the right thing by pushing interest rates up. They’re trying to tighten the controls already. Whereas what you’re saying is that we need a more softly-softly approach to try and get over this crisis.

Reinhart: Absolutely, which is why I try to reiterate the experience of the ’30s and the Japanese, in which you declare victory too soon in what is still fragile. And it could be self-defeating because you could wind up, as Japan did, as the US did, during the Depression with both a weaker economy. And as a result an even higher level of government debt.

Dobbie: This is all based on several centuries worth of data that you’ve collected. That has to be meaningful. Carmen, do appreciate your time. Thanks for joining us.

Reinhart: Absolutely. Thank you so much. Thank you for having me.

Dobbie: No worries.