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February 18, 2014
Sovereign Valley Farm, Chile
Probably every kid in the world has at some point dreamed of having a time machine and being able to travel back to the past… usually to see dinosaurs or something like that.
Time travel is an almost universal fantasy. And if I could snap my fingers and turn the pages of time, I’d be seriously curious to check out the thousand-year period between the decline of the Western Roman Empire and the rise of the Renaissance.
They used to refer to this period as ‘the Dark Ages’ (though historians have since given up that moniker), a time when the entire European continent was practically at an intellectual standstill.
The Church became THE authority on everything– Science. Technology. Medicine. Education. And they kept the most vital information out of the hands of the people… instead simply telling everyone what to believe.
People living in that time had to trust that the high priests were smart guys and knew what they were talking about.
Interpreting facts and observations for yourself was heresy, and anyone who formed original thought and challenged the authority of church and state was burned at the stake.
Granted, human civilization has come a long way since then. But the basic building blocks are not terribly different than before.
Anyone who challenges the state is still burned at the stake. And our entire monetary system requires that we all trust the high priests of central banking and economics. Those that stray from the state’s message and spread economic heresy are cast down and vilified.
You may recall the case of Harvard professors Ken Rogoff and Carmen Reinhart who wrote the seminal work: “This Time is Different: Eight Centuries of Financial Folly”.
The book highlighted dozens of shocking historical patterns where once powerful nations accumulated too much debt and entered into terminal decline.
Spain, for example, defaulted on its debt six times between 1500 and 1800, then another seven times in the 19th century alone.
France defaulted on its debt EIGHT times between 1500 and 1800, including on the eve of the French Revolution in 1788. And Greece has defaulted five times since 1800.
The premise of their book was very simple: debt is bad. And when nations rack up too much of it, they get into serious trouble.
This message was not terribly convenient for governments that have racked up unprecedented levels of debt. So critics found some calculation errors in their Excel formulas, and the two professors were very publicly discredited.
Afterwards, it was as if the entire idea of debt being bad simply vanished.
Not to worry, though, the IMF has now stepped up with a work of its own to fill the void.
And surprise, surprise, their new paper “[does] not identify any clear debt threshold above which medium-term growth prospects are dramatically compromised.”
Translation: Keep racking up that debt, boys and girls, it’s nothing but smooth sailing ahead.
But that’s not all. They go much further, suggesting that once a nation reaches VERY HIGH levels of debt, there is even LESS of a correlation between debt and growth.
Clearly this is the problem for Europe and the US: $17 trillion? Pish posh. The economy will really be on fire once the debt hits $20 trillion.
There’s just one minor caveat. The IMF admits that they had to invent a completely different method to arrive to their conclusions, and that “caution should be used in the interpretation of our empirical results.”
But such details are not important.
What is important is that the economic high priests have proven once and for all that there are absolutely no consequences for countries who are deeply in debt.
And rather than pontificate what these people are smoking, we should all fall in line with unquestionable belief and devotion to their supreme wisdom.
Tax burdens are so high that it might not be possible to pay off the high levels of indebtedness in most of the Western world. At least, that is the conclusion of a new IMF paper from Carmen Reinhart and Kenneth Rogoff.
Reinhart and Rogoff gained recent fame for their book “This Time It’s Different”, in whichthey argued that high levels of public debt have historically been associated with reduced growth opportunities.
As they now note, “The size of the problem suggests that restructurings will be needed, for example, in the periphery of Europe, far beyond anything discussed in public to this point.” Up to this point in the Eurocrisis the primary tools used to rescue profligate countries have included increased taxes, EU and IMF bailouts, and haircuts on government debt.
These bailouts have largely exacerbated the debt problems that existed five short years ago. Indeed, as Reinhart and Rogoff well note, the once fiscally sound North of Europe is now increasingly unable to continue shouldering the debts of its Southern neighbours.
General government debt (% GDP)
Source: Eurostat (2012)
Six European countries currently have a government debt to GDP ratio – a metric popularlised by Reinhart and Rogoff to signal reduced growth prospects – of over 90%. Countries that were relatively debt-free just five short years ago are now encumbered by the debt repayments necessitated by bailouts. Ireland is a case in point – as recently as 2007 its government debt to GDP ratio was below 25%. Six years later that figure stands north of 120%! “Fiscally secure” Scandinavia should keep in mind that fortunes can change quickly, as happened to the luck of the Irish.
The debt crisis to date has been mitigated in large part by tax increases and transfers from the wealthy “core” of Europe to the periphery. The problem with tax increases is that they cannot continue unabated.
Total government tax revenue (% GDP)
Source: Eurostat (2012)
Already in Europe there are seven countries where tax revenues are greater than 48% of GDP. There once was a time when only Scandinavia was chided for its high tax regimes and large public sectors. Today both Austria and France have more than half of their economies involved in the public sector and financed through taxes. (Note also that as they both run government budget deficits the actual size of their governments is greater yet.)
With high unemployment in Europe (and especially in its periphery), governments cannot raise much revenue by raising taxes – who would pay it? With already high levels of debt it is questionable how much revenue can be raised by further debt issuances, at least without increasing interest rates and imperiling already fragile government finances with higher interest charges.
Instead, Reinhart and Rogoff see two facts of life for Europe’s future: financial repression through higher inflation rates and taxes levied on savings and wealth. This time is no different than other cases of highly indebted countries in Europe’s history – just look to the post-War examples as similar cases in point. Don’t say you haven’t been warned.
David Howden is Chair of the Department of Business and Economics, and professor of economics at St. Louis University, at its Madrid Campus, Academic Vice President of the Ludwig von Mises Institute of Canada, and winner of the Mises Institute’s Douglas E. French Prize. Send him mail.
Finland has little room to deviate from a proposal to fill a 9 billion-euro ($12.3 billion) gap in Europe’s fastest-aging economy if it’s to avoid debt levels doubling in the next decade and a half, according to the central bank.
The northernmost euro member risks joining the bloc’s most indebted nations if the government fails to reform spending, according to calculations by the Helsinki-based Bank of Finland. Without the measures, debt could exceed 110 percent of gross domestic product by 2030, according to the bank. The ratio was 53.6 percent in 2012. Success with the plan would help restrain debt levels to about 70 percent by 2030, the bank said.
The central bank’s assessment shows that the government’s plan would have a “real impact,” Finance Minister Jutta Urpilainen said in an e-mailed response to questions via her aide. Structural reforms are needed if “the Finnish welfare state has a chance to survive,” she said.
The only euro member with a stable AAA grade at the three main rating companies, Finland’s economy is struggling to emerge from the decline of its paper makers and its flagging Nokia Oyj-led technology industry. Export demand has failed to offset weak consumer demand, as companies fire workers and the government responds to deficits with cuts. Lost revenue is hampering government efforts to set aside funds needed to care for the fastest-aging population in the European Union.
In the period August to November, Finland’s six-party coalition put together a package to streamline and reduce public spending to eliminate a gap of more than 9 billion euros in public finances by 2017. The package consists of several different measures, each to be sent to parliament independently. Some of the measures, including changes to pensions and health-care providers, are still being drafted.
Finland’s “costs related to aging will grow faster than elsewhere within the next two decades,” Petri Maeki-Fraenti, an economist at the Bank of Finland, said in an interview. Aging costs will be “decisive” in accelerating debt growth after 2020, he said.
The government reduced its economic forecasts on Dec. 19 for the 10th time since coming to power in June 2011. Even as exports look set to recover and rise 3.6 percent in 2014, GDP will grow only 0.8 percent after declining 1.2 percent in 2013, the Finance Ministry said.
The Bank of Finland’s calculations assume an average economic expansion of about 1.5 percent in the long term, compared with an average of 3.7 percent during 2003 to 2007, according to a February 2013 report by economists Helvi Kinnunen, Maeki-Fraenti and Hannu Viertola.
“We must get used to slower economic growth for an extended period of time,” Maeki-Fraenti said.
The average debt level in the euro area shot up more than 25 percentage points in five years after hovering around 70 percent for the majority of the last decade. Finland has followed suit, with the Finance Ministry estimating its debt-to-GDP ratio rising to 60 percent this year from 33.9 percent in 2008.
Euro-area debt reached 93.4 percent of GDP at the end of the second quarter, according to theEuropean Central Bank. Italy reduced its government debt to 103 percent of GDP in 2007. Since the debt crisis, its debt has begun mounting again, rising to 134 percent of GDP this year, the European Commission forecast Nov. 5.
Debt levels exceeding 90 percent hurt economic growth, Harvard University economists Carmen Reinhart and Kenneth Rogoff argued in a 2010 paper. Three years later, their claims were refuted by University of Massachusetts researchers, citing “serious errors” that overstate the significance of the boundary.
The World Bank set a similar “tipping point” at 77 percent in a 2010 paper, while a 2011 studyby the Bank for International Settlements identified a sovereign debt threshold of 85 percent. An IMF report from 2012 found “no particular threshold” that would consistently precede low growth.
Finding an absolute threshold for debt after which economic growth starts slowing is “quite impossible,” Bank of Finland’s Maeki-Fraenti said. Addressing sluggish growth and public debt is necessary for Finland due to the pressure from aging and the decline of its cornerstone industries, he said.
“As the debt level is still relatively tolerable and our unemployment hasn’t shot up in the same way, it has perhaps led some to believe that the problems shall be fixed on their own as export demand revives,” he said. “Our view is slightly more pessimistic.”
To contact the reporter on this story: Kasper Viita in Helsinki at email@example.com
To contact the editor responsible for this story: Christian Wienberg firstname.lastname@example.org
Rogoff, Reinhart and Ricardian Equivalence
St. Louis University – Madrid Campus
Volume 1, Issue 1, pages 5 – 8
Get article (pdf)
The largest economics controversy of the year belonged to Ken Rogoff and Carmen Reinhart for their research describing the relationship between economic growth and government debt. Their research, based on their popular book looking at the striking similarities between recurring booms and busts, argued that there is a critical level of debt above which economic growth is compromised (Rogoff and Reinhart 2009, 2010). Loosely stated, they argued that government debt above 90 percent of a country´s GDP is harmful to economic growth.
Earlier this year this conclusion was brought into disrepute when a review article argued that Rogoff and Reinhart’s study was plagued by “coding errors, selective exclusion of available data, and unconventional weighting of summary statistics lead to serious errors that inaccurately represent the relationship between public debt and GDP growth among 20 advanced economies in the post-war period” (Herndon, Ash and Pollin 2013).
In the melee that ensued there was a critical point all but lost. There is a relationship between debt and growth, and whether Reinhart and Rogoff massaged their numbers to get the result in question is of only secondary importance. Like all great laws in economics, the quantitative relationship is never fixed though the qualitative relationship is definitively identifiable (Mises 1962: 62-63). Just as the basic logic of a binding price floor implies that, for example, a minimum wage will cause some marginal workers to be unemployed, the same logic yields no definitive result.
No self-respecting economist would argue that a 5 percent increase in the minimum wage will decrease employment by 2 percent. By the same reasoning, it befuddles belief that otherwise respectable economists Reinhart and Rogoff would invoke the same reasoning with their 90 percent debt-to-GDP cutoff. (In their defense, this figure was less important in their work than the popular press later made it out to be.)
If Reinhart and Rogoff are guilty of anything, it is of an overly narrow analysis that ignores some important variables. In particular, the exclusive focus on the role of debt on growth, while useful within the restricted confines of their study, lacks practical importance when viewed in isolation.
1. What´s Debt Good For?
Consider the four uses an individual has for his money: consumption, investment, taxes and debt repayment. Consumption improves a person’s well-being in the present, and investment does so in the future. Taxes fund either government consumption or investment, with the usual problem in identifying how valued either of those activities are. One fact is clear: to the extent that taxes reduce private income they hamper the ability for private individuals to use their earnings to improve their well-being. Debt repayment does the same. (My own article “The Quantity Theory of Money” in this issue further explores the implications of debt repayment on consumption and investment activity.)
An individual’s well-being will be unambiguously highest when he has the largest portion of his income available to spend on consumption or investment activities. This implies that tax and debt minimization are both key factors. Note also that well-being is not just the social property of having a satisfied and content population; it also translates into higher levels of economic growth. More consumption expenditure today means that businesses must hire more employees and increase production to satisfy these demands. Increasing consumption expenditure might lead to more jobs in the present, but at the expense of the investment needed to increase the rate of economic growth in the future. Investment expenditure has a similar result, though it is aimed at satisfying consumption demands expected to prevail at some future time. The more investment expenditure we made in the present, the greater the rate of economic growth in the future (assuming all goes well, of course).
Taxes and debt repayment, to the extent that they reduce the amount of funding available for consumption and production activities, reduce economic growth and the well-being of society’s members in the present.
Rogoff and Reinhart look at debt levels and the relationship to growth, and from this they get a crude measure of the effect of debt repayment on economic growth. I say it is a crude measure because the total level of debt is not the key factor. The amount of debt being repaid each period is vital, and this results from the total amount of debt scheduled for repayment and the prevailing interest rate.
However, taxes are also important and Rogoff and Reinhart largely sidestep this issue. This is not to criticize the Harvard economists, as their goal was narrowly focused on looking at the historical role of debt in times of crisis. In drawing policy conclusions, something the press was eager to tease out of their research, one needs to have a comprehensive look at the greater facts at hand.
Very few countries run high public deficits and levy high tax rates. The reason is, as we shall see, that it is difficult to do so and the result is often detrimental to growth. Instead, most countries treat the choice as binary: either high taxes and low deficits, or high deficits with low taxes.
One end of the spectrum might be Norway. Well known for its high tax regime, total Norwegian tax receipts totaled 42.2 percent of its economy last year. This small Scandinavian country has chosen to finance its public spending exclusively through taxes. Indeed, last year the Norwegian government ran a budget surplus of 13.9 percent of GDP thus reducing the amount of government debt outstanding. High taxes have removed the necessity for the government to finance itself through borrowing.
Take the opposite end of the spectrum. The United States is widely viewed as a low tax regime, and at 24 percent of its GDP the total tax collections from all levels of government are low relative to many of its developed counterparts. This low level of tax receipts has left the U.S. government dependent on borrowing to make up the remainder. Perhaps unsurprisingly, the United States runs one of the largest government deficits in the developed world, at 11 percent of GDP in 2012. Americans pay low taxes today for their services, but at some point in the future the bill will come due.
2. Quibbling about Ricardian Equivalence
In one sense, taxes and deficits are two sides of the same coin. Indeed, the British political economist David Ricardo first hypothesized such a relationship, only to downplay its practical relevance. In a nutshell, the hypothesis that now bears his name as “Ricardian equivalence” states that since governments can either raise money through taxes or bond issuances, and that these bonds must be eventually repaid (through taxes), the choice is not binary but unique – taxes now or taxes later.
Under one strict formulation, if a government incurs a large debt today individuals will bolster their savings in the expectation of future higher taxes to pay off the debt. This increase in savings decreases consumption by a similar amount, thus having the same effect as increased taxes would.
I´m not so sure it´s as simple as that (and neither did Ricardo). The people who benefit from the deficit spending today may not live to see their taxes pay off that same debt in the future (Buchanan 1976). Perhaps most importantly, the strict interpretation of Ricardian equivalence views savings and investment as lost economic activity. Similar to how Keynes´ paradox of thrift argued that only consumption expenditure can stimulate an economy, savings are viewed as a “leakage” from the system, and a form of lost income. Yet as Hayek (1931) so succinctly put it, investment in production must come prior to consumption, and thus savings is a necessary step in enabling demand to be fulfilled.
Despite some arguments as to what degree Ricardian equivalence holds quantitatively true, there is a basic truism in its qualitative message. Spending in the present that is not directed towards consumption and investment activity – including taxes and debt repayment – are net negatives that reduce our well-being. In this light we can agree with Mises´ prescient analysis almost one hundred years ago: “it is fundamentally a matter of indifference whether [the government] … imposes a one-time tax on him of half his wealth or takes from him every year as a tax the amount that corresponds to interest payments on half his wealth” (Mises 1919: 168, as quoted in Garrison 2001: 89).
Consumption improves our well-being today, and investment is aimed at improving it in the future. At times government expenditure can take on the appearance of consumption or investment activity, though it can never be valued as highly as voluntarily activities can be. People act to relieve their most pressing needs, and only by voluntarily directing their own income can we be certain that the most dire of these needs has been fulfilled.
Income spent repaying debt, especially public debt, removes the possibility of improving our well-being by expenditure on consumption that would directly provide satisfaction. Kenneth Rogoff and Carmen Reinhart have done a great service in making this apparent, and showing that too much debt (and more importantly, debt repayment) compromises growth. A look at the pernicious effects of taxes in reducing our well-being would tell a much more complete story.
Buchanan, James M. 1976. Perceived Wealth in Bonds and Social Security: A Comment. Journal of Political Economy 84(2): 337–342.
Garrison, Roger W. 2001. Time and Money: The Macroeconomics of Capital Structure. New York: Routledge.
Hayek, Freidrich A. 1931. The “Paradox” of Saving. Economica 32: 125-69.
Herndon, Thomas, Michael Ash and Robert Pollin. 2013. Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff. PERI working paper 322.
Howden, David. 2013. The Quantity Theory of Money. The Journal of Prices & Markets 1(1): 17-30.
Mises, Ludwig von.  1983. Nation, State, and Economy: Contributions to the Politics and History of Our Time, trans. L. Yeager, New York: New York University Press.
Mises, Ludwig von. 1962. The Ultimate Foundation of Economic Science: An Essay on Method. Princeton: D. van Nostrand.
Reinhart, Carmen and Kenneth Rogoff. 2010 .Growth in a Time of Debt. American Economic Review 100(2): 573–78.
Reinhart, Carmen and Kenneth Rogoff. 2009. This Time is Different: Eight centuries of financial folly. Princeton University Press.
Rothbard, Murray N.  2004. Man, Economy, and State, Scholar’s Edition. Auburn, AL: Ludwig von Mises Institute.
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