By Jeremy Smith (with a hint of irony in his soul)
Over the last few years, we have been told time and again that a public debt-to-GDP ratio that goes beyond 90% is dangerous, and leads to slower economic activity. The main source for this thesis, which has been accorded the status of fact, is a paper by Carmen Reinhart and Kenneth Rogoff entitled “Growth in a time of debt”, published in early 2010.
By extraordinary coincidence, on the very day that blogger Rortybomb uncovered curious discrepancies in the data used by Reinhart and Rogoff, casting much doubt on the correctness of the thesis, PRIME are proud to announce the results of our own in-depth research (fieldwork took place this evening), covering the experience of the UK from 1949 to 2011. Our findings? A bit radical, really.. A period of public debt-to-GDP ratio of over 90% is associated, on average, with a higher level of annual increase of GDP than is the case for periods with a debt-to-GDP ratio under 90%.
What’s the evidence and methodology for this somewhat surprising set of findings?
Our researchers (well, me actually), took the IMF data for annual UK public debt-to-GDP ratios available here. Then we took data on annual increases in GDP from the ONS database, available from here (see column BU) starting in 1949, and ending with 2011. Using our complex model (i.e. adding up) we found that for 18 years, from 1949 to 1966, debt to GDP ratios were above 90%. If one adds up the ONS annual increases and divides by the number of years, the average annual GDP increase over these 18 years when the ratio was over 90% is 3.19%.
We then looked at the periods when the debt-to-GDP ratio was between 60 and 90%. There are two periods totalling 9 years, from 1967 to 1972, and recently from 2009 to 2011. The average rate of GDP increase for these 9 years of 60 – 90% is 1.93%.
Finally, we looked at the rest of the period in question, when the debt-to-GDP ratio was between 30 and 60%. This was from 1973 to 2008, covering 36 years. For this period of 30 – 60%, the average annual GDP increase is 2.60%.
So our conclusion is that the UK economy grew more rapidly, in real terms, at a time when – for 18 years covered by this study – it had a high debt-to-GDP ratio, and still managed to reduce that ratio almost year by year. The 36 years when the debt-to-GDP ratio was between 30 and 60% achieved the next best rate of annual GDP growth, but also saw the crises and recessions of 1991 and 2008/9. The worst rate of growth was during the 2 periods when debt-to-GDP was between 60 and 90%.
Ah yes, time for some charts. First, a nice simple one showing the evolution of the UK debt to GDP ratio.
Source: IMF. Vertical axis = debt-to-GDP ratio
Second, a chart that shows the annual increase (with a few nasty decreases in the era of liberalisation) in GDP, colour-coded for the relevant debt to GDP ratio band.
Source: ONS, IMF
Let’s return to Reinhart and Rogoff. Here is what they profess to conclude:
“Our main result is that whereas the link between growth and debt seems relatively weak at “normal” debt levels, median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower. Surprisingly, the relationship between public debt and growth is remarkably similar across emerging markets and advanced economies.”
“Why are there thresholds in debt, and why 90 percent? ….A general result of our “debt intolerance” analysis.. highlights that as debt levels rise towards historical limits, risk premia begin to rise sharply, facing highly indebted governments with difficult tradeoffs. Even countries that are committed to fully repaying their debts are forced to dramatically tighten fiscal policy in order to appear credible to investors and thereby reduce risk premia. The link between indebtedness and the level and volatility of sovereign risk premia is an obvious topic ripe for revisiting in light of the more comprehensive cross-country data on government debt.”
It appears that the data and/or selection of data used by Reinhart and Rogoff are open to major question – and this set of conclusions are also now evidently wrong, for countries that have their own currencies and central banks.
We do not of course believe that having a high debt-to-GDP ratio causes growth in GDP to be higher or faster. We looked at the data set out above in a spirit of tongue-in-cheek, since we have always considered the “90%” thesis to be absurd, and are not seeking to replace it with a similar ‘model.’ It just so happens that in the UK after WW2, the economic policies adopted by Britain and internationally through the Bretton Woods system on average worked out better than has been the case since the liberalisation of finance (which commenced under the Heath government) and the adoption of neoliberal policies generally, in particular from 1979 on.
The truth is that there is no level of debt which is in particular more risky or leads of itself to worse results. It is always a matter of context, and of getting the right mix of policies. But the (probably wrong) “findings” on public debt of Reinhart and Rogoff have been used as cover for contractionary policies of austerity which have ruined the lives of millions. For this they bear a heavy burden of responsibility.
Great stuff Jeremy. I think, though, there’s a case to be made for the liberalisation of finance being started earlier, than 1979, in 1971 with Anthony Barber’s “Competition & Credit Control” system (dubbed ‘all competition & no control’) which lifted controls over:creation of credit and the rate of interest for short & long-term loans, safe & risky loans and which led to an explosion in credit creation & rising borrowing costs. In the same year Nixon unilaterally dismantled Bretton Woods.
Thanks David.. point taken on liberalisation, though I did say “in particular” from 1979!