Thursday, 18 April 2013

Trusting your political career to economic theory is a dangerous game


In 2010, two Harvard economists, Carmen Reinhart and Kenneth Rogoff,  published an academic paper entitled  “Growth in a Time of Debt”  which used research on around 20 of economies over the last 250 years to show that annual GDP growth ranges between about 3 per cent and 4 per cent when the ratio of public debt to GDP is below 90 per cent. But average growth collapses to -0.1 per cent when the ratio rises above a 90 per cent threshold.  Much political capital has been expended by Osborne and other on the dangers of exceeding the 90% debt / GDP ratio.  Why 90% should be such a perfect tipping point should seem strange to anyone with an ounce of common sense, but more important men than me have pinned their careers to this ‘fact’.


This earth shattering insight has been used by various politicians including our own George Osborne, the UK chancellor.  However, a new paper, by Thomas Herndon, Michael Ash and Robert Pollin of the University of Massachusetts, checked the Reinhart-Rogoff results for the post-war period.  When they performed recalculations using their own data, they found that countries with debt-to-GDP ratio exceeds 90 per cent, average growth is 2.2 per cent, not -0.1 per cent.   

So what can politicians and other observers learn from this academic spat?   

Firstly, we should be wary of economic theories that grossly over simplify the impossibly complex;  virtually all modern economies are way beyond any current economic modelling methodology.  The level of government debt is only one factor that impacts growth:   interest rates, inflation, competitiveness, productivity and trade balances are also vital not to forget private debt and bank solvency.

Secondly, we might remember that all economist have a personal agenda and all ‘evidence’ will be used to further this agenda.  The Harvard pair produced research that suited their own political and social motivations and it’s likely that the pair from Massachusetts have done the same.  As an economic conservative I make damn sure that any research I use supports the general view that economies perform better without the burden of huge interest payments, but am I certain this is always true?  Probably not!

Thirdly, as we remember the life of Margaret Thatcher we should also recognise the need to be wary of politicians who stake their career to economic theory.  Thatcher’s fixation with the control of M3 in 1979 - 1982 as the only means of dealing with inflation was a costly error.  She repeated the trick in 1989 when her blind belief in the economists Sir Alan Walters  led to the resignation of her best assets, the chancellor Nigel Lawson.  Let’s hope Osborne’s fixation with keeping our level of debt below 90% of GDP is not a similar blind spot.

Marx mixed politics and economic theory with disastrous consequences 

Updated on the 19th April The economist followed my post with this more detailed and insightful piece

http://www.economist.com/news/finance-and-economics/21576362-seminal-analysis-relationship-between-debt-and-growth-comes-under

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