For Sussing Out Whether Debt Affects Future Growth, the Key is Carefully Taking into Account Past Growth

On Miles' website we have a companion post to the previous post on an instrumental variables analysis of the RR dataset. In the companion post, we walk through more of the regressions and illustrate how controlling for past growth can erase almost any effect of debt on future growth. The core conclusion?

The two of us could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth for either growth either in the short run (the next five years) or in the long run (as indicated by growth from five to ten years later).

Even though the estimated slopes are still small, we also discuss why this difference -- between small negative and small positive numbers -- matters for policy. For more, be sure to read the full post here.

Data Release

The data and code used in the Quartz column with Professor Kimball can be found on the data page here.

Instrumental Tools for Debt and Growth

A Joint Post by Miles Kimball and Yichuan Wang

In a recent Quartz column, we found that high levels of debt do not appear to affect future rates of growth. In the Reinhart and Rogoff (henceforth RR) data set on debt and growth for a group of 20 advanced economies in the post WW-II period, high levels of debt to GDP did not predict lower levels of growth 5 to 10 years in the future. Notably, after controlling for various intervals of past growth, we found that there was a mild positive correlation between debt to GDP and future GDP growth.

In a companion post, we address some of the time window issues with some plots how adjusting for past growth can reverse any observed negative correlation between debt and future growth. In this post, we want to address the possibility that future growth can lead to high debt, and explain our use of instrumental variables to control for this possibility.

One major possibility for this relationship is that policy makers are forward looking, and base their decisions on whether to have high or low debt based on their expectations of future events. For example, if policy makers know that a recession is coming, they may increase deficit spending to mitigate the upcoming negative shock to growth. Even though debt may have increased growth, this would have been observed as lower growth following high debt.On the other hand, perhaps expectations of high future growth make policy makers believe that the government can afford to increase debt right now. Even if debt had a negative effect on growth, the data would show a rapid rise in GDP growth following the increase in debt.

Apart from government tax and spending decisions informed by forecasts of future growth, there are other mechanical relationships between debt and growth that are not what one should be looking for when asking whether debt has a negative effect on growth. For example a war can increase debt, but the ramp of the war makes growth high then and predictably lower after the ramp up is done and predictably lower still when the war winds down. So there is an increase in debt coupled with predictions for GDP growth different from non-war situations. None of this has to do with debt itself causing a different growth rate, so we would like to abstract from it. 

To do so, we need to extract the part of the debt to GDP statistic that is based on whether the country runs a long term high debt policy, and to ignore the high debt that arises because of changes in expected future outcomes or because of relatively mechanical short-run aggregate demand effects of government purchases as a component of GDP. Econometrically, this approach is called instrumental variables, and would involve using a set of variables, called instruments, that are uncorrelated with future outcomes to predict current debt.

Since we are considering future outcomes, a natural choice for instrument would be the lagged value of the debt to GDP ratio. As can be seen below, debt to GDP does not jump around very much. If debt is high today, it likely will also be high tomorrow. Thus lagged debt can predict future debt. Also, since economic growth is notoriously difficult to forecast, the lagged debt variable should no longer reflect expectations about future economic growth.   
By using lagged debt and growth as instruments, we isolate the part of current debt that reflects debt from a long term high debt policy, and not by short run forecasts or other mechanical pressures. We plot the resulting slopes on debt to GDP in the charts below, for both future growth in years 0-5 and for future years 5-10. For the raw data and computations, consult the public dropbox folder.


From these graphs, we can make some observations.

First, almost all the coefficients, across all the different lags and fixed effects, are positive. Since these results are small, we should not put too much weight on statistical significance. However, it should be noted that the plain results, OLS and IV, for both growth periods are all statistically significant at at least the 95% confidence level, and the IV estimates for the 5-10 year period in particular are significant at the 99% confidence level.

The one negative estimate, OLS estimate with country fixed effects, has a standard error with absolute size twice as large as the actual slope estimate.Moreover, country fixed effects are difficult to interpret because they pivot the analysis from looking at high debt versus low debt countries towards analyzing a country's indebtedness relative to its long run average.

These results are striking considering therobustness with which Reinhart and Rogoff present the argument thatdebt causes low growth in their 2012 JEP article.Yet instead of finding a weaker negative correlation, aftercontrolling for past growth, we find that the estimated relationship between current debt and future growth is weakly positive instead.

Second, when taking out year fixed effects, there is almost no effect of debt and future . Econometrically, year fixed effects takes out the average debt levelin every year, which leaves us analyzing whether being more heavilyindebted relative to a country's peers in that year has an additional effect on growth. Because this component isconsistently smaller than the regular IV coefficient, this suggests,for the advanced countries in the sample, it's absolute, not relative, debt that matters.

This should be no surprise. As most recently articulated in RR's open letter to Paul Krugman, much of the argument against high debt levels relies on a fear that a heavily indebted country becomes “suddenly unable to borrow from international capital markets because its public and/or private debts that are a contingent public liability are deemed unsustainable.” The credit crunch stifles growth and governments are forced to engage in self-destructive cutbacks just in order to pay the bills. At its core, this is a story about whether the government can pay back the liabilities. But whether or not liabilities are sustainable should depend on the absolute size of the liabilities, not just whether the liabilities are large relative to their peers.

Now,our conclusion is not without limitations. As Paul Andrew notes,the RR data set used focuses on “20 or so of the most healthy economies the world has ever seen,” thus potentially adding a high level of selection bias.

Additionally, we have restricted ourselves to the RR data set of advanced countries in the post WW-II period. The 2012 Reinhart and Rogoff paper considered episodes of debt overhangs from the 1800's, and thus the results are likely very different. However, it is likely that prewar government policies, such the gold standard and the lack of independent monetary authorities, contributed to the pain of debt crises. Thus our timescale does not detract from the implication that debt has a limited effect on future growth in modern advanced economies.

In their New York Times response to Herndon et. al., Reinhart and Rogoff “reiterate that the frontier question for research is the issue of causality”. And at this frontier, our Quartz column, Dube's work on varying regression time frames, and these companion posts all suggest that causality from debt to growth is much smaller than previously thought.

Friday Roundup

China is not much of a global economic leader. China doesn't see financially protecting Europe as critical for its own economy; it feels that is is segmented enough to protect itself. This also shows how China is not willing to provide global public goods (ie stable finance). It is no economic hegemon, and therefore doesn't act in a way conducive to global economic coordination.

There's been a series of good posts from FT alphaville on the issues facing European finance. Given the meteoric rise and fall of finance in Europe, one has to wonder why the markets didn't price in the risk. The most plausible answer? There was too much that they could never have known; markets were too opaque. This should be a lesson for people who think they can "calculate" the optimal level of risk. You know too little about probabilities to make a surefire judgment; you should resort to looking at fragilities instead.

Banking union? Not likely. International economic coordination is hard, and Europe isn't quite up to it. There's just too many different interests at play for a banking union to work; who would we hold responsible to pay? Banking is a market that extends beyond governance, which makes it almost impossible to solve the problems with capital flight and get the Euro on solid footing.

China is slowing down further: steel edition It's really quite staggering how many different factors are converging at the same time: China bleeding into Australia, India slowing down, and then the Eurozone is falling apart. We have no idea how bad it's going to get, which makes the fragility of all financial systems particularly worrisome.

Global equities fall on the announcements of one Federal reserve chair. Asia was counting on further easing, and the fact that Bernanke didn't come out clearly in support of it is not good news. The announcement really marks how the United States truly is a monetary superpower; a tentative decision on QEIII is enough to send markets roiling. These are the kinds of problems that make me really wish that monetary policy was done in a more rule-based fashion that took into account the gigantic output gap. Perhaps something like NGDP targeting...

More on the safe assets story and the fiscal cliff. This shadow banking dimension is something I want to investigate going forward because it seems to be a new channel for traditional fiscal and monetary policies. Shadow banking seems to make fiscal policy more powerful as it improves the stock of collateral, whereas it makes monetary policy more problematic as stocks of collateral are bought up.

An interesting look at the linkages between Europe and the United States. I think the finance data coupling indicates that the relationship really goes beyond simple export statistics. This is an interesting problem from the concepts of "opacity", because we really don't know the extent of the connection. All that we know is that there are hints of financial coupling, which might make the Eurozone contagion problematic for the United States.

Market Lessons, Fragility, and Debt

How does the market make sure businesses learn the right lesson?

(Photo credit to Seven Bedard)

What is the invisible hand?  How does it push businesses towards the right prices, the right contracts, the right decisions?  Introductory supply and demand models suggest that businesses are always profit maximizing, thus changes in the market induce changes in business behavior to maximize that profit. However, this is, at best, a theoretical abstraction. While businesses may intuitively know the law of demand, they do not have some demand curve available to them for analysis. To optimize price, they tinker until they find a satisficing option. Given enough tinkering, the firms eventually reach a price that is profit optimizing. The trial and error of individual firms eventually crafts a market equilibrium.

But how does this work on a larger scale, with more complicated decisions? How do businesses decide between the right balance of debt and equity? How do they determine what their production function to determine the "optimal" amount of investment? What's the "expected value" of long term research to power the company? These are all unknown values; how does the market then move firms to act optimally with respect to them?

According to an evolutionary approach, the market does not teach or push existing firms to the optimal levels, rather those who fail to reach the optimal levels are naturally selected out of the market. Firms don't need rational expectations about price growth, all that is necessary is that the market is deep enough that the irrational expectations are purged from the system. Along with the adaptive market hypothesis, this suggests that markets only work as our idealized models would predict if and only if the market is fast paced with strong pressures that punish "irrational" strategies. These markets need to have constant sources of volatility so the invisible hand can keep on pushing businesses in the right direction. Market don't teach, they destroy. In the end, efficient markets are only the result of survivorship bias, as every inefficient market loses firms until the remaining ones act "rationally".

If evolution is why markets equilibrate, then we need to be especially concerned about systemic crises and debt. Taleb warns about the impact of debt crises in his list of steps towards a Black Swan free world;

5.  Counter-balance complexity with simplicity. Complexity from globalisation and highly networked economic life needs to  be countered by simplicity in financial products. The complex economy is already a form of leverage: the leverage of efficiency. Such systems survive thanks to slack and redundancy; adding debt produces wild and dangerous gyrations and leaves no room for error. Capitalism cannot avoid fads and bubbles: equity bubbles (as in 2000) have proved to be mild; debt bubbles are vicious.  

From his description, one can see many channels through which debt disrupts the evolutionary process in markets. If there's no room for slack and redundancy, and if these crises go systemic, there would be no firms left untouched by the crisis. As a result, no firms are left and there's nothing left that the evolution in markets can teach them. Systemic crises destroy the history record of firms with better models for long term growth, so the evolutionary pressure evaporates.

Moreover, the buildup of debt suppresses short term volatility in exchange for long-term blowups. Debt financing can tide you over in the short run, but eventually debt catches up with businesses, resulting in a catastrophic, if not systemic, collapse later on. This suppression of volatility also crimps the ability of markets to force firm evolution, as there is no longer the short term volatility to promote tinkering. Given these diverse channels in which debt interferes with the evolutionary equilibrium of markets, the fragility imposed by debt should draw greater attention in the regulation of complex economies.

Debt and Growth: The Chicken or the Egg?

..., and what to put in the European omelet?


How does debt affect growth?  The well-known correlation found by Rheinhart and Rogoff in their analyses of financial crises found that growth tends to substantially slow down as the debt to GDP ratio approaches 90%.  Based on this correlation, policy makers began to advocate austerity as a way to reduce debt, and thereby restore growth.

Of course, correlation does not prove causation, and Paul Krugman jumped at that, pointing out that it was quite likely that causation ran the other way.  As a result of anemic growth, countries would pursue countercyclical fiscal policy.  This would create the appearance that only low growth countries pursue higher levels of debt.  However, the association between the two variables actually arises from textbook countercyclical fiscal policy.  Had the government decided to retrench, the economy would have suffered even more, compounding the growth problem.

So how to resolve these issues?  A recent VoxEU article on the relationship between debt and growth caught my eye, as it proposed a novel mechanism to estimate the effect of debt on growth.  While I don't understand the full mechanics, the working paper seems to use the stock of foreign debt as a variable to instrument the stock of debt.  At the end of the analysis, the authors conclude that, while R+R find a strong correlation, the new data instrumented for endogenity cannot reject the null hypothesis that debt has no effect on growth.  This then has a critical role in determining policy because it suggests that countries, when in dire output straits, should not ignore the role of fiscal policy.  The debt effects are unlikely to be strong enough to overwhelm any first order effects from fiscal stimulus.  Especially given the recent interest in hysteresis and reductions in potential output, it seems almost certain that fiscal retrenchment is not the answer.  Along these lines, I also found some older articles, one an old study looking at old U.S. time series data, and another on Latin American growth, that both suggest we should be worry about the output gap.  Long run growth can be seriously affected by temporary deviations, and therefore we need to fill the gap, whether by fiscal or monetary policy.

Another note in the paper that was particularly interesting was that the authors traced much of the negative correlation between debt and growth to the destructive policies governments would pursue when at high levels of debt.  In the words of the authors:

We believe that there is a subtle channel through which high levels of public debt can have a negative effect on growth. In the presence of multiple equilibria, a fully solvent government with a high level of debt may decide to put in place restrictive fiscal policies aimed at reducing the probability that a change in investors’ sentiments would push the country towards the bad equilibrium. These policies, in turn, may reduce growth (Perotti 2012), especially if implemented during a recession (such policies may even be self-defeating and increase the debt-to-GDP ratio, DeLong and Summers 2012, UNCTAD 2011).3 In this case, it would be true that debt reduces growth, but only because high debt leads to panic and contractionary policies.

This argument piqued my interest for two key reasons.  The first is that it echoes a paper by Bernanke on the effect of supply shocks on the economy.  In the paper, Bernanke argued that a lot of the damage from a supply shock wasn't actually from the shock itself, but rather from the monetary policy response.  In the case of debt, much of the harm from high levels of debt isn't from the debt, but rather from the fiscal policy response.

The second is that this advice on debt and growth seems particularly pertinent for the Eurozone.  This paper provides strong evidence that the austerity cure is anything but.  Even if growth is needed, but fiscal retrenchment is not the answer.  Netherland's recent rejection of harsh cuts, and France's electoral shift both show that democracy is having its say and is refusing this cup of self-defeating suffering.  They recognize that cutting budgets cannot be the only way forward, and that policy needs to be fundamentally changed to recognize the elaborate chicken and egg relationship between debt and fiscal policy.  I only hope that they figure out that omelet before the bond markets take away the chance.

Nominal GDP Targeting and Complexity

The Complexity View

I've recently started rereading passages of The Black Swan: The Impact of the Highly Improbable and I find it fascinating. The prose is fluid, and the arguments are powerful. Much of the book mocks economic theory, as models tend to minimize the role of large shocks that defy normal distributions.  In the book, Taleb inserts the following chart that shows how much these "outliers" influence the stock market.

Taleb places the blame for these large swings in the market on the shoulders of the Federal Reserve.  He argues that stabilization policy actually makes the economy more fragile, making it more likely to go down in a dramatic fashion once the "big one" hits.  He sums up this argument in the following quote from a section titled "Beware Manufactured Stability" in a supplementary essay.

...fear of volatility, leading to interference with nature to impose "regularity" makes us more fragile across so many domains.  Preventing small forest fires sets the grounds for more extreme ones; giving out antibiotics when it is not very necessary makes us more vulnerable to severe epidemics... 

Which brings me to another organism: economic life. Our aversion to variability and desire for order and our acting on it has helped precipitate severe crises... Another thing we saw in the 2008 debacle: the U.S. government (or, rather, the Federal Reserve) had been trying for years to iron out the business cycle, making us exposed to a severe disintegration. This is the sort of reasoning I have against "stabilization" policies and manufacturing a nonvolatile environment ...

In a sense, the reduction of volatility in the Great Moderation was only an illusion of stability.  We were, as Taleb would say, "sitting on a pile of dynamite," unaware of the risk that lay underneath.

Impact on NGDP Targeting Policy

This kind of critique seems rather damning against nominal GDP targeting.  The typical analysis of NGDP targeting hinges on the assertion that low volatility implies high stability.  But what if this isn't true?  What if these times of low volatility are just times of high fragility?  Some analysis of the arguments for NGDP targeting even suggest mechanisms by which this is the case.  Debt problems are waved away because NGDP is stable, financial opacity becomes a non-issue because monetary policy compartmentalizes it,  perceptions of "safe" assets  change because expectations of nominal growth are maintained.  Stable expectations permit these innovations because agents can plan ahead, allowing for higher growth.

However, this higher efficiency comes at the cost of redundancy.  Taleb jokes in an interview with Russ Roberts that:

An economist would never design a human being with two lungs and two kidneys. It's wasteful. Deadweight loss.  

He follows up with:

So, the opposite of spare parts would be debt. And nature doesn't like debt. Nature likes redundancies. This mechanism of overreaction is redundancy.

And this is what terrifies me about NGDP targeting.  The incredibly stable regime creates an environment in which redundancy is eschewed in favor of fragility.  Perhaps it would be better to have a more resilient economy that wouldn't be able to accumulate as much capital, but one that has lower levels of debt.  The cost of a mistake in an NGDP targeting world would be incredible.  Even if, theoretically, under a stable monetary regime, there are no demand-side recessions, would you be willing to bet the stability of the entire global financial system on it?  Even if it were true, can you guarantee the Fed will be able to maintain a "stable monetary regime" for perpetuity?

I'm not trying to say the current monetary system is ideal; the dismal employment numbers firmly reject that view.  But when we look onto NGDP targeting as the solution to the global economic malaise, we need to be careful that we don't put all of our eggs into one basket.  NGDP targeting is an incredible tool for monetary policy; but it can't be a panacea for all of these troubles.  

This critique of NGDP targeting brings up another key issue for the design of policy.  Optimal policy has to do more than maximize welfare, it must also be robust to errors.  While in the game playing, platonic world of models NGDP targeting should create incredible reductions in volatility and instability, what are the possible effects on global fragility?  Policy engineering needs to take into account Murphy's Law: "If anything can go wrong, it will."  The only question is how we prepare.

NGDP Targeting: What if it fails?

Recently in the economics blogosphere, the monetary paradigm of nominal GDP level targeting (NGDPLT) has been gaining steam.  NGDP targeting takes a departure from the classic regime of inflation targeting by the growth rate in NGDP, allowing for balance between employment and inflation.  This then leads to a wide variety of benefits, as the new regime is robust to supply shocks, can craft stable expectations of overall future growth, and can reduce fears of any specific industry going through a crisis.  It's particularly attractive for financial crises, as if NGDP growth is stable, previously sustainable levels of debt are less likely to become unsustainable.  If the economy's productive capacity is constant, there's no reason for it to be less able to service its debt.

However, this view seems almost too simplistic.  Even though the US economy was incredibly stable during the over the 20 year Great Moderation, it all came down to a screeching halt with the 2008 financial crisis.  Similarly, even though Britain managed to stay out of a major recession for 16 years, NGDP fell by about 4.7% during the crisis.  Given that there had been such a long legacy of stability, how did expectations suddenly become unanchored?  Even if the US Federal Reserve made a bad policy decision at that point to focus on oil prices and other supply shocks to the detriment of nominal stability, why did the expectations of prudent policy in the future not "solve back" the concerns?  In the end, the crisis culminated into the worst disruption since the Great Depression: hardly a desired result for a responsible regime.

The unhappy ending in 2008 seems to suggest that responsible policy can break down into chaos given a large enough of an exogenous shock.  This problem is very close to what Nicolas Nassim Taleb discusses in The Black Swan: in exchange for low volatility, the economy goes along with high fragility, such that one large shock can cause non-linear, disproportionate harm.  So in the end, the question is about credibility.  How is it established?  How is it maintained?  If decades of prudent monetary policy were not enough to anchor expectations, why should we expect the Federal Reserve to be considered "credible" when the next large financial bubble appears?  If shadow banking markets start to grow shadows and systemic risk goes through the roof, why should we expect the Federal Reserve to be considered "credible"?  Especially if non-monetary factors as posited by Bernanke play a key role in recessions, why would nominal stability be enough?  And when everything crashes down, how will we deal with the mess of debt and contracts that were only sustainable under the old regime?  NGDP targeting seems to play on circular logic.  Boost aggregate demand to hold the expectation; with the expectation there's no need to boost aggregate demand.

So when a policy maker messes up, and lets a NGDP crisis unfold, the crisis emerges.  This is where the black swan hides, cloaked by the rhetoric of stable expectations and the "perfect" monetary policy.