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The debt-growth nexus

Back in May, 2010 when I had just finished the course work of my graduate degree programme at Columbia University, an academic paper by professors Carmen Reinhart and Kenneth Rogoff, both at Harvard, created a stir in the academic and public policy circles. In a nutshell their paper, ‘Growth in a time of debt’, said that public debt-to-GDP ratio of 90 percent was the tipping point and crossing this point meant a huge decline in economic growth and that too for a long period.

This was not the first paper that had explored the relationship between public debt and growth. The relationship between economic growth and public debt has remained an important relationship worth studying for macroeconomists who have attempted to answer the following two questions while exploring it. First, what is the level of public debt when economic growth suffers a deep dip? Second, what causes what? Does public debt slows down economic growth or is it growth that causes public debt?

Based on data from 44 countries – spanning over two hundred years – on public debt, inflation and growth, Reinhart and Rogoff found that when public debt reaches 60 percent of GDP, annual growth declines by more than two percent and for levels of public debt in excess of 90 percent of GDP, growth rates are roughly cut to half. Both the timing and the findings of the paper were shocking since recession had taken over the globe and a fierce intellectual debate had ensued between the proponents of austerity and fiscal stimulators.

In common parlance, advocates of austerity prescribed that public spending should be reduced to slash fiscal deficit while fiscal stimulators suggested that the governments should adopt expansionary policies through public spending to bring the economy out from the recession as had been done during the Great Depression of the 1930s.

The Reinhart-Rogoff paper became a new weapon in the hands of the proponents of austerity. The findings of the paper were immediately used by them to tilt public policy in their favour, though we are not certain that the authors of the paper had such intentions in mind while empirically analysing the data. The validity of the findings of the Reinhart-Rogoff paper was not seriously questioned for three years. The austerity measures adopted in the US and in western Europe at least derived their intellectual support from these findings.

But economists are not in the habit of striking a consensus amongst themselves on economic issues and their prescriptions. We have both ‘left-handed’ and ‘right-handed’ economists. George Bernard Shaw was perhaps right when he said about the economists: “if all economists were laid end to end, they would not reach a conclusion”. This applies to the Reinhart-Rogoff findings as well. After a period of about three years, Thomas Herndon, Robert Pollin and Michael Ash at the University of Massachusetts have come up with a paper, ‘Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff’, in April 2013 wherein they concluded that the results given by Reinhart and Rogoff were not correct mainly on three accounts.

First, Reinhart and Rogoff made an error in their excel spreadsheet formula which resulted in wrong calculations. Second, some episodes of high-debt, high-growth were excluded from the analysis. Third, the assumptions for assigning weights to different historical episodes are also contestable. For example, they weighed each country equally – regardless of the number of the data years available for that country.

Despite the corrections made by these researchers, the finding to the extent that high-debt countries grow less compared to high-growth countries remains intact, just the estimations about the slowdown of growth have changed. Their findings are that decline in economic growth for debt-ridden countries is bit low compared to that estimated by Reinhart-Rogoff but the negative relationship between public debt and economic growth does not change. However, a key question – is the high debt responsible for low growth or does low growth cause high debt or is it something else that causes both simultaneously? – remains unanswered even after this critique of the Reinhart-Rogoff paper.

A specific answer to this question is not possible and opinion is, as usual, divided among the economists. For example, Paul Krugman in his article, ‘The excel depression’ in The New York Times on April 18, 2013 wrote: “…truth is that Reinhart-Rogoff faced substantial criticism from the start, and the controversy grew over time. As soon as the paper was released, many economists pointed out that negative correlation between debt and economic performance need not mean that that high debt causes low growth. It could just easily be the other way around, with poor economic performance leading to high debt. Indeed, that is obviously the case for Japan, which went deep into debt only after its growth collapsed in the early 1990s”.

Even Professor Reinhart and Professor Rogoff in their article, ‘Debt, growth and the austerity debate’ (New York Times, April 25, 2013) have admitted that public debt is not necessarily the single variable that causes low growth. They write: “The economic literature on debt and growth has for some times been focused on identifying causality.

Does high debt merely reflect weaker tax revenues and slower growth? Or does high debt undermine growth? Our view has always been that causality runs in both directions and that there is no rule that applies across all times and places”. This means that both public debt and low economic growth need to be taken care of since you cannot correct the one imbalance without taking care of the other.

What insight does this growth-debt debate provide for us? Simply: Pakistan should address the causes of high public debt to bring it within tolerable limits as it may be one of the most binding constraints to economic growth. Our public debt has persistently increased in the last five years and is now reported to be at 62 percent of the GDP. Primarily this unprecedented surge is due to two main factors ie fiscal and current account imbalances and the erosion of the rupee-dollar parity. For fiscal adjustment, there is need to work on both expenditure rationalisation and domestic revenue generation.

However, while rationalising expenditures, it should be kept in view that the hammer of austerity should not fall on social spending like health, education or income support programmes meant for the poor and the unprivileged. Rather, we need to reduce the frivolous expenditures by rationalising the ministries, divisions and public sector departments. Improving governance of the state owned enterprises (SOEs) should be another area that can be worked on for reducing deficit. Reforming the SOEs will not only save public money but also make their operations more efficient.

According to Simon Johnson, a professor of economics at MIT Sloan, austerity is about the distribution of income in the society. So the real question is: who will bear the brunt of fiscal adjustment? Will it be the children of the poor, the unprivileged and the downtrodden or the rich elite involved in tax evasion? While adopting measures for public debt reduction and fiscal adjustment, policymakers should not lose sight of such considerations and their long-term implications.

The writer is a graduate of Columbia University.Email: jamilnasir1969@gmail.com

Jamil Nasir, "The debt-growth nexus," The News. 2013-05-31.
Keywords: Economics , Economic issues , Policy making , Public policy , Public debt , Foreign debt , Macroeconomic policy , Economic policy , Economic growth , Fiscal policy , GDP growth , Macroeconomics , Thomas Herndon , Robert Pollin , Michael Ash , George Bernard Shaw , Simon Johnson , Carmen Reinhart , Kenneth Rogoff , New York , Pakistan , GDP , MIT