A War of Words and 'Models'

Readers are probably aware of the ongoing controversy between the new Keynesian Paul Krugman and the monetarists/Chicagoites Carmen Reinhart and Kenneth Rogoff. We have in fact discussed the debate in some detail previously in “The Reinhart-Rogoff Study Controversy”. There is therefore no need to go through our argument point for point again.

Similar to another prominent academic, economic historian Niall Ferguson, Reinhart and Rogoff were rather taken aback by the vitriol and unfriendly tone Krugman reserves for his critics. Niall Ferguson meanwhile has also challenged Mr. Krugman by fact-checking his predictive record and noting that it is far worse than Krugman wants everyone to believe. Mr. Krugman sees himself as the only economist on the planet getting every forecast right, while everybody else is essentially an idiot (this is basically a condensed version of his view and his tone of voice). 


Yesterday a friend pointed us to a recent article by Carmen Reinhart posted at Bloomberg, in which she attempts to bring the debate back to a less personal and more factual level. In the article she tries to address the still unresolved question of whose ideas are actually correct. As a reminder, critics of the Reinhart- Rogoff study have discovered a spread-sheet error in it. Allegedly this error invalidates all its conclusions.

At the heart of the debate is the question whether the size of fiscal deficits and public debts matter to economic growth or not. Reinhart and Rogoff argue that yes, they do, as the empirical evidence they have studied supposedly proves that economic growth slows once a certain threshold in the public debt to GDP ratio is exceeded. They recommend monetary inflation as the proper 'cure' for recession.

Paul Krugman on the other hand essentially argues that public debt matters not at all. The government should spend 'as much as is needed' to restore employment to a level deemed acceptable. Similar to Reinhart and Rogoff, Krugman also marshals various economic statistics to buttress his argument. Ms. Reinhart's article is in essence a critique of Krugman's interpretation of such statistics. She writes:


“The blog of New York Times columnist Paul Krugman  recently featured a chart plotting the U.K.’s ratio of government debt to gross domestic product against the nominal yield on long-term government bonds from about 1700 to the present. See Figure 1.

The chart appeared with this comment :

“You might think that these data, and the relationship they show — or, actually, don’t show — should have some impact on our current debate, especially given the tendency of many players to reject modeling and appeal to what they claim are the lessons of history. Or are they claiming that this time is different?”

It’s hard to be sure, but Krugman appears to be saying — again — that there’s no reason to fear that high levels of public debt might inhibit growth. The chart shows that the U.K., in the 19th century, had both high levels of debt and low-and-stable nominal interest rates. So, the message seems to be, why worry about debt? Why bother to dig any deeper?

Because the chart, interesting though it is, doesn’t get you far in understanding this issue. To begin with, in judging the connection between debt and growth, it’s real interest rates (nominal interest rates minus inflation) that matter. If low nominal interest rates were the ticket to economic prosperity, then the Great Depression of the 1930s was a boom. Nominal interest rates in the U.S. hovered around zero during much of that decade — while severe deflation yielded some of the highest real interest rates in U.S. history.

Indisputably, high real interest rates place an added burden on debtors, whether they are households, companies or governments. So it’s important to know whether very high levels of debt are associated with high real interest rates. This is one of the questions that Vincent Reinhart , Kenneth Rogoff and I addressed in a study we published in 2012.

We examined 26 high-debt episodes between 1800 and 2011, looking both at growth rates and at levels of real interest rates. We found that in 23 of the 26 high-debt cases, growth was low as compared with the relevant country’s performance in periods when debt was less. Table 1 from that paper sets out this result. You’ll notice it makes clear that the U.K.’s high-debt episode of 1830-1868 is one of the three exceptions.


(emphasis added)

The chart discussed by Ms. Reinhart is this one:



Reinhart chartUK nominal bond yields vs. the debt-to-GDP ratio – by Bloomberg – click to enlarge.



It should be noted from the outset that it is quite well-known that Mr. Krugman likes to cherry pick his statistics. For an illustration see e.g. Robert Murphy's article 'Charting Fun with Paul Krugman'. In his conclusion Murphy points out that “this is not the first time that Krugman has erroneously used data to cast aspersions on the Austrian position”. He then provides links to previous examples of Krugman abusing empirical data.

It is also well known that it is often difficult to tell what Krugman actually means to convey. His language tends to be slippery, we think on purpose. Hence Ms. Reinhart too runs into the problem of having to guess what he is actually trying to say (as she writes above, “It’s hard to be sure, but Krugman appears to be saying…” etc.).

However, all of this actually misses the point. The entire debate is really moot.


One Bloomberg Reader Gets It

There are a great many 'partisan' comments by readers posted below Ms. Reinhart's article, by both socialist ('liberal' in US terminology) supporters of Mr. Krugman and his politically conservative opponents. They regard this debate mainly as a political rather than a scientific one. They are all missing the essential point however: in reality, any isolated economic statistic can be used to support whatever conclusions one wants it to support. It is vain to try to prove points about economic theory with the help of statistics. One can employ a sound and logically deduced economic theory to properly interpret the statistical record of economic history, but one cannot use economic history to prove a point about economic theory.  Among the many more or less worthless reader comments we however found this lone gem posted by one 'dnjake', which nicely summarizes our view on the topic:


“How can anyone take any side of these arguments seriously? Who believes the history of a complex economic system of hundreds of millions of human beings can be understood from a few very simple abstractions. All these arguments prove is the general incompetence of the economics profession.

Otherwise there is no possibility of proving anything one way or another from this kind of trivial data. Anybody with half a wit should understand some basic realities. One is that change is the dominant factor of human history.

Like all other times, this time surely is different. Another is that any economic theory is doing well if it manages to capture a little of the truth. Yet another is that data may help provide some insight into a theory and some reason to take the theory seriously. But, there is no possibility of economic data on a scale that would be required to prove how a system on the level of complexity of America's economy actually works. Paul Krugman surely is misguided in his belief of what monetary policy can accomplish. But Ken Rogoff's idea that a strong economy can be created through inflation is no better. Economies are mainly created by the collective decisions that are needed to run its businesses. Academic economists don't seem to have much of a clue about how those decisions are really made.


(emphasis added)

We have a little more confidence in sound economic theory than 'dnjake' apparently has, but other than that, he seems to be the only reader of the Bloomberg article who actually penetrates to the core of the issue. The economy is an incredibly complex, ever changing concatenation of processes driven by human action. One cannot take one or two data series, look at their history and then come to firm conclusions about what they mean for the economy and what economic policy prescriptions should therefore be implemented. Every historical situation is unique, and the result of the interplay of myriad factors. Looking at a handful of data in isolation is really not telling us anything of value.

In fact, the only 'policy prescription' that is really needed is 'leave the economy alone'. Interventions in this complex system will always have unintended consequences and lead to outcomes that are less optimal than those that would have been achieved in an unhampered market economy. This can inter alia be seen from the fact that every intervention invariably leads to a whole megillah of additional interventions, which are designed to 'fix' what the initial intervention botched (it is rarely considered that it might be better to simply desist from the initial intervention).



So what about the public debt debate then? Who is right? Regardless of the empirical data, it should be clear that amassing a large public debt cannot be a good thing. Government possesses no resources of its own – every cent it spends must be taken from the productive private sector in some shape or form (either by taxation, borrowing, or worst of all, inflation). It follows from this that supporting an increase in fiscal spending is tantamount to saying that government bureaucrats will be better at employing capital than the private sector.

However, this is literally impossible, as there is no way for government bureaucracies to gauge the opportunity costs of their spending. They simply have no means of calculating whether their spending results in a net economic gain or net economic loss. It is therefore a good bet that much of it will end up wasted. Incidentally this is indeed an empirically verifiable fact. If government spending were to result in economic gains, government would produce surpluses instead of deficits. In reality, the treasury is saddled with an ever greater mountain of debt that is the result of past spending and no longer produces any economic benefit whatsoever. The bigger this debt mountain becomes, the less able the treasury will become to offer citizens any tangible benefits in return for the taxes they pay.

Lastly, people are not stupid: they know that an increase in spending today means higher taxes tomorrow. Their reaction to increased spending by the government as a rule is therefore to decrease their own spending, as they have to prepare for the bill that will be presented at some point in the future. This has just been confirmed again by what has happened in the wake of the 2009 Obama 'stimulus': it has ultimately led to the tax increases of 2012, designed to bring the burgeoning deficit 'under control'.

This does however not mean that we would support the Rogoff 'solution', which consists of the proposal that the central bank should vastly increase monetary inflation. In many ways this would be even worse than increasing the public debt. We have recently discussed this idea in “A Collective Pining for More Inflation”. As noted above, we believe the only idea worth implementing is 'laissez faire' – leave the economy alone.



reinhart, rogoff, krugman

Rogoff, Reinhart and Krugman – neither spending nor inflation are going to 'work'.

(Photo via businessweek.com/ Bloomberg screenshot)





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One Response to “Reinhart-Rogoff versus Krugman”

  • Isn’t this an argument in reverse? There are only 3 ways to increase inflation, print money, bank credit and restrict production. Being the third is counter to the supposed aims of the 2 economists, then we are stuck with more debt or more government spending. Interest rates merely increase the price of financial assets or move forward the eventually reckoning day of disaster.

    As much as I hate to say it, the money printing makes more sense than merely running up more debts. Most of us, including the writers here, know there is a pitfall to that process. In QE, what we have is a financing of government by creating central bank credit and thus adding nothing to the current debt service of the government. The only benefit to this procedure is to create more deposit cash in some form, which could be used to liquidate existing bank credit. Thus, we would simply be adding in one place and subtracting in another. Krugman’s solution is merely another shot of dope to make up for the shot that just wore off. There is always a larger and larger shot of dope necessary as time goes on. I believe this thinking goes along the lines of that of Richard Koo, in Japan.

    The hazard of one process is to risk default. The other is an eventual saturation of the demand of money and a collapse of the value of such money to accommodate extra demand. This can, of course, cause an eventual hyperinflation as people move away from holding the surplus money. Then, there is the financial function of needing to account for inflation in determining investments. The current reality can’t last forever, as either the Fed will have to defend the currency, thus removing the short to long carry trade or the larger market will over run the Fed’s efforts, as we have seen in part over the last year.

    Neither of these solutions answers the question of “What then”? If anyone wants the answer to this question, they need only look to Japan, where the domestic situation is almost hopeless. The only things that has kept Japan afloat have been the large reserves built up over decades of trade surpluses and the massive short position on the yen through the carry trade. I suspect something, either their monetary policy or their aging population will eventually end this experiment badly.

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