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.

Labor Shortage, Misallocation, and Abuse: Big Mac Edition

Let's start with an interesting photo from a McDonalds restaurant:

Similar to my past observations on KFC, this Shanghai McDonalds seems really eager to hire. I'm always amazed by how happy and cute the pictured workers always are. Happiness is also the theme of the banner message: Join McDonalds and take the first step towards happiness. The message is particularly clever because it capitalizes on how the character that makes the "Mc" sound has the same pronunciation as the character 迈, which means to step.

McDonalds is also a great example of Balassa-Samuelson effect. Even if aggregate productivity grows much faster in China  than in the United States, it's unlikely that a Chinese McDonalds franchise can raise its productivity any faster than an American McDonalds franchise. Just look at the registers; how do you expect the cashiers to ring people up any faster?

The low productivity growth can ultimately be traced to one factor: there's not much space for innovation within McDonalds. No doubt, running a McDonalds franchise is no easy task, but for the individual cashiers, cooks, and janitors, there's only so much you can "learn-by-doing". Compare this with other sectors such as, solar panel production or apparel, and you can see why there's a large productivity differential between fast food and manufacturing.

These two factors, aggressive hiring and low productivity growth, are connected; the second can lead to the first. This is not necessarily only because low productivity growth requires a higher amount of labor to produce the same amount of product, but rather also because low productivity enables employers to abuse an initial probationary period to hire more aggressively with minimal downside. During probation, employees can be fired without cause and are paid lower wages. Limited room for innovation means there's little need to train employees to create new techniques, thereby shortening training times. Since  training time for an average employee is relatively low, McDonalds can afford more worker turnover without significantly impacting productivity. But to fill this demand for workers, they need to aggressively hire. This is arguably a violation of Chinese labor laws, but given McDonald's other violations, it should not a surpise. Chinese labor laws such as minimum wage and worker's insurance have also been frequenly abused by Yum Brands, the parent company of KFC, Pizza Hut, and Taco bell.

This story is problematic because it contradicts the idea that there's a labor shortage. If workers are hard to find, how can McDonalds and other fast food restaurants afford such high turnover? A possible explanation is that they pay high enough of a wage to entice workers from other restaurants, and therefore exacerbate the worker shortage for other businesses. Yet because they do not advertise as aggresively, I do not notice.  

Another possibility is that the target demographic, college students, is not the same demographic of workers that coastal plants are lacking. College students often won't or can't hold low-skill manual manufacturing jobs, but they may be willing to take up a job at a McDonalds while they go to school. College workers also reside in a grey area of labor law. Guangdong marketing director of Yum Brands has been on record saying "part-time workers are neither full-time workers or non-full-time workers (既不属于全日制用工也不属于非全日制用工)" to justify the low pay of part-time college student employees. Ignoring whether this is ethical, if college students are advantageous from a labor/wage perspective, this would match both the type of advertising we see on both the KFC and McDonalds hiring notices with the concept of a skill mismatch. The firms would have an incentive to hire college students to save on wages and insurance fees, not to capitalize on their unique skills.

The story from here would be that China does not suffer from just a lack of workers, but rather that there's a severe skill mismatch. College students, who should be building human capital, are being cycled through low-skill, low productivity jobs. This pushes the unskilled to even lower productivity jobs such as street sweeping or selling road-side trinkets. Yet while all this happens, coastal firms struggle to find enough talented workers to stay open. This, of course, does describe the Chinese labor market in much depth, but it does point to a key structural problem holding back further Chinese growth.

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.