The Economy’s Trajectory in 2013

The agreement arrived at on New Year’s day implies that output at the end of 2013 will be between 0.6 to 1.0 percentage points higher than it otherwise would be under what was until New Year’s, current law, according to CBO’s preferred multipliers. The uncertainty arises in part from the unresolved nature of the sequester deal.

economy20131.gif

Figure 1: GDP (blue), forecast GDP under current law, from August 2012 (red), GDP under HR8 (assumed equivalent to low income tax cuts and no sequester) (green square) and GDP if low income tax cuts extended plus AMT fix (purple circle). NBER defined recession dates shaded dark gray; implied informal recession dates shaded light gray. Source: BEA, 2012Q3 3rd release; 2012Q4 assumes 1.5% growth SAAR (from MacroAdvisers (12/21/2012); CBO, Budget and Economic Outlook: An Update (August 2012), CBO, Economic Effects of Policies Contributing to Fiscal Tightening in 2013 (November 2012), NBER, and author’s calculations.

4 quarter growth by 2013Q4 would be 1% (conditional on the CBO’s August 2012 forecast) assuming the sequester is held in abeyance. If the sequester is fully put into effect, growth would be under 0.6%. These are calculations based on the CBO’s preferred multipliers; it’s likely that the multipliers are higher, given the accommodative nature of monetary policy.

see CBO update here

Using the high multiplier estimates, and assuming that no sequestration eventually occurs, then growth would be 2.3% 4q/4q. Working in the opposite direction is uncertainty. Given that the sequester issue and debt ceiling increase will come up in two months, one could reasonably expect that policy uncertainty will persist (exactly the concern many conservatives have highlighted over the past years).
economy20132.gif

Figure 2: Economic Policy Uncertainty index (new version). NBER defined recession dates shaded gray. Source: Baker, Bloom and Davis, at Policy Uncertainty.

Baker, Bloom and Davis (2013) argue that a 112 point innovation in the index leads to a 2.3% reduction in GDP after 4 quarters (peak response). The jump in uncertainty associated with the previous debt ceiling impasse was about 120 points (which is not quite the same as an “innovation”, but I’m pretty certain the difference is inessential in this calculation), so a back of the envelope calculation, assuming a similar elevation of uncertainty, suggests that a noticeable impact on GDP (taken literally, it implies a rule-of-thumb recession).

 

In other words, a prolonged debt ceiling debate could negate the stimulative effects of retaining the tax cuts for lower incomes, and eliminating the sequester (even if that occurs). This point should be remembered when some argue for using the raising of the debt ceiling as leverage to achieve specific goals (e.g., [1]).

 

More analysis from Economists View, Tim Duy, Izzo/WSJ RTE and Krugman; forecasts are summarized by Reddy/WSJ, Izzo/WSJ RTE, and Lange/Reuters.

 

Update, 1:40PM Pacific: Macroeconomic Advisers have bumped up their (conditional) forecast of 12/28 of 2.6% 4q/4q growth in 2013Q4 to 2.7% as of today.

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16 thoughts on “The Economy’s Trajectory in 2013

  1. 2slugbaits

    A quibble: a prolonged debt ceiling debate could negate the stimulative effects of retaining the tax cuts for lower incomes
    While allowing the tax rates to revert to the Clinton levels would be contractionary, I don’t think I would refer to the mere continuance of the Bush tax cuts as “stimulative” because there is no change or differential. It’s just maintaining the status quo. Of course, the return of the full FICA tax will be contractionary.

  2. Bruce Carman

    Regressing real GDP per capita, population, wages, and labor force for the post-’00 and post-’07 secular 3- and 5-yr. trends, and the tendency looks like no faster than 1-1.2% real GDP for Q4’13 and 0.3-0.5% per capita.
    However, the fiscal cliff deal results in recession.
    The reported 0.7% yoy (negative in real terms) holiday spending was attributed to the fiscal cliff brinksmanship reducing confidence and thus discouraging spending; but this ignores the weak after-tax real wage conditions and higher out-of-pocket medical costs for the bottom 90% and the self-reported less spending by the top 10% for whatever reason.
    Peak Boomer demographic drag effects kick in this year and last into ’22-’24 on a rate of change basis as occurred in Japan since ’96-’98.
    The combination of demographic drag effects, debt, high energy prices, and fiscal constraints will further reduce the trend rates of post-’07 real GDP and GDP per capita hereafter.
    In this context, the tax increases will likely reduce real GDP and thus reduce receipts, resulting in no material improvement in fiscal deficit conditions.
    Yet, with the avg. yoy, 3-, and 5-year rates of real GDP per capita since ’00 and ’07 at 0.7% and -0.15%, 0.9% and -0.17%, and 1% and 0% respectively, real GDP per capita is trending around the margin of error of the estimates for inventories and the deflator, suggesting that forecasting models are not sensitive enough to anticipate or capture an annualized q-q or a cyclical contraction at a ~0% trend rate.
    The economy is operating so close to a trend rate of ~0% in real terms per capita that an annualized quarterly contraction is more likely than otherwise.

  3. Ricardo

    IMF Working Paper
    How Big (Small?) are Fiscal Multipliers? by Ethan Ilzetzki, Enrique G. Mendoza and Carlos A. Végh
    …the study sorts the sample into “country-episodes” where the total central government debt to GDP ratio has exceeded 60 percent for more than three consecutive years. This is the case for the US from 2007 to the present. For the high-debt country-episodes the impact fiscal multiplier is close to zero and the long-run multiplier is -2.30. This means that $1.00 of additional government spending has no effect on impact but in the long run destroys $2.30 of total output in the economy.

  4. Menzie Chinn

    Ricardo: Once again, it is often useful to read the entire paper. Check results for exchange rate regime. Also, while gross debt is probably a good representation for many countries, net debt is better for the US. Also check results for government investment for the US. Also…well, just read the paper.

    By the way, see this post and this post.

  5. tj

    I agree with 2slugs on this one.
    We have a permanent increase in payroll taxes, relative to the existing state of the economy. This is a permanent decline in take home pay of around $50 – $150 per month for the majority of US households, relative to the existing state of the economy.
    I doubt that many households were treating the FICA tax holiday and the Bush tax rates as temporary, so the net impact on growth will be similar to that of a permanent payroll tax increase, relative to the existing state of the economy.
    I appreciate the comparison to a virtual state where all Bush tax cuts expire, but it’s no longer useful. If GDP declines by 0.5% in 2013, will the government report an increase in GDP of 0.5% relative to the counterfactual where all the Bush tax cuts expire? I don’t think so.

  6. Steven Kopits

    The conclusion section from the paper cited by Ricardo above:
    4 Conclusions
    This paper is an empirical exploration of one of the central questions in macroeconomic
    policy in the past few years: what is the effect of government purchases on economic activity? We use panel SVAR methods and a novel dataset to explore this question. Our most robust results point to the fact that the size of fi…scal multipliers critically depends on key
    characteristics of the economy studied.
    We have found that the effect of government consumption is very small on impact, with
    estimates clustered close to zero. This supports the notion that …fiscal policy (particularly on
    the expenditure side) may be rather slow in impacting economic activity, which raises ques-
    tions as to the usefulness of discretionary …fiscal policy for short-run stabilization purposes.
    The medium- to long-run e¤ects of increases in government consumption vary considerably.
    In particular, in economies closed to trade or operating under fi…xed exchange rates we fi…nd a
    substantial long-run effect of government consumption on economic activity. In contrast, in
    economies open to trade or operating under ‡flexible exchange rates, a fi…scal expansion leads
    to no signi…cant output gains. Further, fi…scal stimulus may be counterproductive in highly-
    indebted countries; in countries with debt levels as low as 60 percent of GDP, government
    consumption shocks may have strong negative effects on output.
    Finally, the composition of government expenditure does appear to impact its stimulative
    effect, particularly in developing countries. While increases in government consumption
    decrease output on impact in developing countries, increases in government investment cause an increase in GDP.
    With the increasing importance of international trade in economic activity, and with
    many economies moving towards greater exchange rate fl‡exibility (typically in the context of
    infl‡ation targeting regimes), our results suggest that seeking the Holy Grail of …fiscal stimulus
    could be counterproductive, with little benefi…t in terms of output and potential long-run
    costs due to larger stocks of public debt.
    Moreover, fi…scal stimuli are likely to become even
    weaker, and potentially yield even negative multipliers, in the near future, because of the
    high debt ratios observed in countries, particularly in the industrialized world.
    On the other hand, emerging countries – particularly large economies with some degree
    of “fear of fl‡oating” – would be well served if they stopped pursuing procyclical …fiscal policies.
    Indeed, emerging countries have typically increased government consumption in good times
    and reduced it in bad times, thus amplifying the underlying business cycle – what Kaminsky,
    Reinhart, and Végh (2004) have dubbed the “when it rains, it pours” phenomenon.
    The inability to save in good times greatly increases the probability that bad times will turn into a full-‡edged …fiscal crisis. Given this less-than-stellar record in fi…scal policy, an a-cyclical …fiscal policy –whereby government consumption and tax rates do not respond to the business cycle –would represent a major improvement in macroeconomic policy.
    While occasional rain may be unavoidable for emerging countries, signi…cant downpours would be relegated to the past.

  7. Joseph

    Steven, you are behind the times. Your IMF paper is out of date. Olivier Blanchard, head economist at the IMF takes it all back and says that:
    “The main finding, based on data for 28 economies, is that the multipliers used in generating growth forecasts have been systematically too low since the start of the Great Recession, by 0.4 to 1.2, depending on the forecast source and the specifics of the estimation approach. Informal evidence suggests that the multipliers implicitly used to generate these forecasts are about 0.5. So actual multipliers may be higher, in the range of 0.9 to 1.7.”
    http://www.nasdaq.com/article/imf-revising-budget-cutting-metrics-20130103-00936#.UOYyundP_50
    http://www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf

  8. Lois

    For a state like Illnois, the payroll tax reset is a disaster: “[A] planned 2 percent increase in Social Security payroll taxes could cost Illinoisans up to $6 billion in take-home pay.”
    “Illinois is already spiraling in a mix of unpaid bills, unfunded liabilities, interest costs and credit downgrades,” Topinka said Friday in a news release.
    Illinois has a $9 billion backlog of bills owed to vendors and a worst-in-the-nation pension program deficit.
    [Wisconsin’s lookin’ pretty good right now…]
    http://newsbusters.org/blogs/tom-blumer/2012/12/30/while-its-prudent-midwestern-neighbors-get-negative-press-nearly-insolve

  9. JBH

    Fact: The US financial system is being flooded by more base money than ever in history. The monetary transmission mechanism is broken, or otherwise this base money would transform into inflation. Eventually it will. As it is, asset bubbles grow larger by the day. The most notable is the bond market bubble. It is now on the order of magnitude of the housing and credit market bubbles of 2006, and its bursting will create havoc similar and proportionate to its size. No state can create infinite base money without the market at some point wresting control from the monetary authorities.

    Fact: The monetary arm of the government is, in the psychological meaning of the word, enabling the fiscal arm. The debt instruments that fund the trillion dollar annual deficits are now directly, and indirectly via MBS purchases, being purchased by the Fed in such quantity that the government itself is buying all newly issued debt. This is tantamount to a one-legged man trying to levitate by lifting his remaining good leg.

    Fact: This cannot but affect economic growth. Already the US is in the Reinhart Rogoff region where long-term growth potential is lower by a percentage point. Current data show all developed nations with gross debt to GDP above 90% growing significantly less than when debt was not this high. What are we to make of the fact that in calendar years two, three, and four of this expansion US real growth averaged an historic low (for an expansion) 2.1%, and on a declining trend? This despite the most massive monetary and fiscal stimulus ever seen!

    The monetary excess, trillion dollar deficits, and unmistakable downtrend of economic growth cannot but affect the federal debt. The debt is on trajectory to reach between $21 and $26 trillion ten years from now. Currently the interest cost on the debt is $360 billion at an average interest rate to the Treasury of 2.2%. No forecaster I’m aware of expects rates to remain unchanged between now and 2022. The CBO expects rates over 2 percentage points higher. The implied interest cost on the debt will then exceed $1 trillion annually. Under the assumption that the deficit is cut by $60 billion per year with nominal growth averaging 4%, the debt to GDP ratio will be little changed from today’s 102%. That is, we will still be in the Reinhart Rogoff region a decade from now and years beyond.

    Observation: What is important to policy decisions is the cumulative multiplier during the expansion phase of Reinhart Rogoff episodes. No study has yet been done on this to my knowledge. Monetary and fiscal are inextricable intertwined. The value of the fiscal multiplier depends on monetary enablement. When the Fed exits its historically unprecedented policy, asset bubbles will collapse, financial strains will appear throughout the system, interest-sensitive sectors will slow greatly as demand has been borrowed from the distant future in this artificial environment, and misallocation of capital will become evident in project failures like Solyndra but far more widespread. My point is that unintended consequences are coming which will severely erode future growth so that estimates of the fiscal multiplier in the literature are uniformly upward biased. It is always the long-term cumulative multiplier that is important except in the throes of a deep recession where for a brief moment the short-term takes precedence.

    Moreover, the central banks of Europe and Japan are effectively insolvent. The banking system of Europe is still leveraged Lehman-like and effectively insolvent. The interest cost of Japan’s sovereign debt is 45% of central government revenues and is on fast track to absorb 100% of tax revenues within three years. This will precipitate an exodus of global investors from JGBs leading to potential default. And the euro currency is a near-certainty to break apart since currency realignment is the only way to resolve the eurozone’s most fundamental structural imbalances. A number of years from now estimates of the US fiscal multiplier will be factoring in these consequences, to the further degradation of the cumulative multiplier.

    The cumulative multiplier is the thing most relevant to the policy issues of this newly debt constrained world.

  10. 2slugbaits

    JBH The monetary transmission mechanism is broken, or otherwise this base money would transform into inflation. Eventually it will.
    Well, no. That is not a “Fact”. That could happen if the Fed badly mismanages the unwinding of the QEs; but I don’t think there is any reason to believe the Fed is that grossly incompetent. You and the rest of the usual suspects have been preaching the old “inflation any day now” psalm for the better part of four years, and you’ve been flat out wrong because your economic model is wrong.
    The monetary arm of the government is…enabling the fiscal arm.
    Here’s a better way to describe things. Normally we depend upon the Fed to take charge of macroeconomic stabilization; however, in the face of a zero lower bound the Fed’s conventional tools are limited. In some theories the Fed could (if it had the will) adopt extraordinary measures. Absent those extraordinary measures it falls on the fiscal authorities to do the heavy lifting. But neither side really wants to do go “all in”, so we end up with a half-assed fiscal stimulus program (which has completely dissipated by now) and a half-hearted series of QE experiments. So the monetary and fiscal authorities are doing something of an “After you my dear, Alphonse” kind of dance.
    Already the US is in the Reinhart Rogoff region where long-term growth potential is lower by a percentage point. Current data show all developed nations with gross debt to GDP above 90% growing significantly less than when debt was not this high.
    Did it ever occur to you that maybe countries get into high debt-to-GDP ratios because they are first in economic trouble and that it is not necessarily the debt that is causing slow economic growth? You seem to have the cart before the horse. The debt-to-GDP ratio is a long-run problem. The current problem is weak aggregate demand, and you solve that problem with a strong fiscal kick. Suppose we added $0.5T in immediate stimulus spending. Over the next 10 years that would represent about one-quarter of one percent of accumulated GDP. Obsessing about one year’s deficit is just stupid.
    the debt to GDP ratio will be little changed from today’s 102%.
    Today’s debt-to-GDP ratio is ~73%, not 102%. The relevant debt is the debt held by the public, not the total debt.
    Moreover, the central banks of Europe and Japan are effectively insolvent.
    I have no idea what this means. Central banks can print money (or create electrons) at will. Europe’s problem is monetary union without political union. Japan’s problem is an aging demographic that refused to get in the habit of paying income taxes during their working years.
    The cumulative multiplier is the thing most relevant to the policy issues of this newly debt constrained world.
    The cumulative multiplier is just the integration across time of the separate impact multipliers. Maybe I’ve misunderstood your earlier views, but I always got the impression that you pooh-poohed the idea of fiscal multipliers as just so much Keynesian voodoo. Are you a recent convert?

  11. JBH

    Slugs (aka Menzie): Eventually — “finally; ultimately; at some later time.” And of course the Fed is grossly incompetent. Its role in causing the crisis is sufficient condition for that.

    Reinhart Rogoff – Their studies are about the aftermath of debt crises. In the US, there was already a high level of debt going into 2008. The crisis resulted in trillion dollar deficits as far as eye can see. Gross debt to GDP is now 102% and rising. Now Act II. In the out years after the 90% debt ratio is surpassed, potential GDP is from then on crimped. This is couched in terms of a 1% reduction in the growth rate, but more nuanced studies will find a gradated nonlinear impact. Once the debt ratio is above the 90% threshold, it is the horse. As for the cart, not a ghost of a chance real growth over the next decade will reach 2%.

    Today’s debt-to-GDP ratio is 102%. Reinhart Rogoff use gross debt. At first I was put off that they didn’t use debt held by the public. But I’ve come around to gross being an OK variable. The correlation between net and gross is exceptionally high, so their main finding would be little affected had net debt been available to them historically as was gross.

    Take the ECB. Marked-to-market at the proper debt ratings, say per Egan Jones, the ECB’s asset book of Greek, Spanish and other questionable sovereign debt is worth less than its liabilities. The ECB is an insolvent institution. The euro may or may not stay together. The pyramid of potential contributors to recapitalize the ECB is greatly shrunken. There is no guarantee the few strong countries left will be willing to recapitalize the ECB. The equation is political as well as economic. How much will the citizenry of Germany, Austria, etc. stand for? Alone, Greece’s leaving the euro will vaporize all the ECBs capital. Then when Spain leaves the game will be over. Over a quarter of the ECB’s assets are periphery country debt, and the ECB is leveraged in excess of 30-to-1. Central bank systemic risk is a topic only now being addressed. We are living through an out-of-sample experience. As for the Bank of Japan, look at the trajectory of interest cost on the debt, now 45% of tax and other revenues and rising rapidly. Japan’s debt is 24 times central government tax revenue. Moody’s, S&P, and Fitch rate Japan’s debt AA-. An accurate rating would put JGBs 6 or 7 notches lower at junk status.

    The multiplier is not well understood empirically. It varies with the situation. Notably the multiplier is quite high at the trough of severe recessions. The initial condition (today) is quite different than back in 2008 – one of high debt and four years into an expansion. Postwar studies of US data do not capture this. How could they? Debt shows up only 4 times in the index to the General Theory; not one mention germane to the matter here. The multiplier is low in expansions, and in a high enough debt region the cumulative multiplier turns negative (according to the few studies that address fiscal stimulus in a high debt environment). If Reinhart Rogoff are right on their basic result, fiscal stimulus at this point in the expansion is like giving sugar to a diabetic. The doctor is a hero for a few years, yet the misguided prescription never shows up on the death certificate as primary cause of early death.

  12. acerimusdux

    The working paper cited by Ricardo isn’t out of date, it’s less than 2 years old. It’s a simple enough paper, the obvious issues with it being:

    1. The data set is limited to countries reporting quarterly data; this means for most countries only around 10 years data is available, and only 5 countries is there more than 20 years data in the data set (US, UK, France, Canada, Australia).

    2. The study uses an SVAR approach. Essentially, VAR is used to identify changes in government spending that are not predicted by changes in GDP. Any remaining correlation is assumed to be from the impact of spending on GDP.

    3. The study makes no attempt to separately identify periods of recession, so if the data set is dominated by periods when countries were not in recession, then the average multipliers produced by a regression analysis will mostly reflect fiscal multipliers for countries not in recession (when for example, you might have crowding out).

    4. The conclusions in the final section of the paper seem to leave out one of the most important conclusions in the section on exchange rate regimes:

    “Once monetary policy is controlled for, we …find that consumption does respond positively
    to government consumption shocks, but only when the central bank accommodates to the fiscal shock.”

    And more specifically with regard to the average response of central banks in their data:

    “Monetary authorities operating under predetermined exchange rates lower the policy interest rate by a statistically significant margin, with the short-term nominal interest rate declining by a cumulative 125 basis points in the two years following a government consumption shock of 1% of GDP. In contrast, central banks operating under ‡exible exchange rates increase the policy interest rate by a statistically significant margin, with interest rates increasing an average of 60 basis points within the two years following a …fiscal shock of similar magnitude.”

    In other words, there’s nothing really surprising in the results in that paper. It’s basically what you would expect in an open economy IS-LM model (a Mundell-Fleming model).

    It may be more relevant to 2008-2011 conditions though to ask how such a model would behave in a liquidity trap with an accommodative central bank.

  13. 2slugbaits

    Slugs (aka Menzie):
    I’m flattered. Menzie should feel insulted.
    In the US, there was already a high level of debt going into 2008.
    Thanks to the Bush tax cuts, Bush’s unfunded prescription drug plan, and Bush’s unfunded wars. If you voted for Bush then you’re hardly in a position to scold folks about the debt.
    The crisis resulted in trillion dollar deficits as far as eye can see
    Get your vision checked. Which “crisis” are you talking about? The Bush tax cut fiasco or the recession? The recession is cyclical and deficits will come down as the economy improves. In fact, deficits as a percent of GDP have been coming down. The Bush (now Obama) tax cuts contribute to the structural deficit, and that’s what you should be worried about.
    Reinhart Rogoff use gross debt. They are wrong because intragovernmental debt does not have a fixed term structure; i.e., it only comes due when the government decides to cash in the bond. For example, schemes like moving to chained GDP are really just ways of stretching out the term structure of the SS Trustee bonds. That’s not something you can do with debt held by the public, which does have a fixed term structure.
    Your ECB comments are all over the ballpark. Spain is not Greece. Greece got where it is because the Greeks refused to tax themselves. Spain got where it is because the Germans adopted a beggar-thy-neighbor policy before the introduction of the euro and then refused to grant the same courtesy after the monetary union. Prior to the global recession Spain was not running large deficits. What the Spanish and Irish experiences tell us is that Tea Party style austerity makes a bad situation worse, not better. And Japan offers a case study of why it’s important to tax yourself like an OECD country if you want to live the lifestyle of an OECD country. An income tax rate of 5% just doesn’t cut it. Another lesson for the Grover Norquist crowd.
    The reason the multiplier is low in expansions is because the central bank works very hard to sterilize the inflationary effects of fiscal stimulus. That is irrelevant today because we are at the zero lower bound and likely to be there for quite awhile. Eventually there will come a day when the Wicksellian rate moves into positive territory. That will be the time to start fiscal contraction while letting the Fed handle macroeconomic stabilization.
    fiscal stimulus at this point in the expansion is like giving sugar to a diabetic
    Well, sometimes you’re supposed to give sugar to a diabetic. The doctor’s job is to manage sugar levels.
    Interest rates will rise for one of two reasons. The first reason is that economic expansion is crowding out private sector investment. With firms sitting on trillions in cash that is hardly the problem today. What the economy needs is crowding in via government spending. The second reason interest rates might increase is if bond markets believe the US will not pay its bills. That’s a political issue, not an economic one. Based on the pure economics there is no reason that the US cannot pay its bondholders. We have a lot of headspace for higher tax rates, we control our own currency, etc. If we default on a bond payment it will because of political insanity. That’s why our bond rating fell, not because of the debt-to-GDP ratio. Getting rid of the economically illiterate Tea Party idiots in Congress would be a good place to start.

  14. acerimusdux

    JBH:
    “interest-sensitive sectors will slow greatly as demand has been borrowed from the distant future in this artificial environment”

    In a sense I think this is backwards. What I mean is that we have record levels of financial wealth, which essentially means we are borrowing demand from the present and trying to transport it to the future. Perhaps governments are trying to counter this through increased debt financing, but the underlying problem is an excessive accumulation of financial wealth (non-tangible assets).

    The better solution would be for governments to reduce this excess through taxation.

    On the issue of Central Bank balance sheets, the liabilities for central banks are mainly currency and reserves. So they won’t tend to go insolvent in the manner other institutions do; the real danger there occurs when there are insufficient marketable assets left on the balance sheet to be sold when there is a need to reign in the money supply. So the real risk is that the CB loses control of the money supply.

    And the real risk of government debt here is if the markets lose faith in the government obligations. At that point, sales of government bonds would have no stabilizing effect. In all cases though, the critical factor here is whether the government has sufficient credibility and authority to raise taxes enough to be able to pay it’s debts.

    On that account I wouldn’t worry much about the US over the next decade, but if we were to continue on the present course for the next 20 years, I think we might well be in trouble.

  15. JBH

    Slugs (aka Menzie): Eventually — “finally; ultimately; at some later time.” And of course the Fed is grossly incompetent. Its role in causing the crisis is sufficient condition for that.

    Reinhart Rogoff – Their studies are about the aftermath of debt crises. In the US, there was already a high level of debt going into 2008. The crisis resulted in trillion dollar deficits as far as eye can see. Gross debt to GDP is now 102% and rising. Now Act II. In the out years after the 90% debt ratio is surpassed, potential GDP is from then on crimped. This is couched in terms of a 1% reduction in the growth rate, but more nuanced studies will find a gradated nonlinear impact. Once the debt ratio is above the 90% threshold, it is the horse. As for the cart, not a ghost of a chance real growth over the next decade will reach 2%.

    Today’s debt-to-GDP ratio is 102%. Reinhart Rogoff use gross debt. At first I was put off that they didn’t use debt held by the public. But I’ve come around to gross being an OK variable. The correlation between net and gross is exceptionally high, so their main finding would be little affected had net debt been available to them historically as was gross.

    Take the ECB. Marked-to-market at the proper debt ratings, say per Egan Jones, the ECB’s asset book of Greek, Spanish and other questionable sovereign debt is worth less than its liabilities. The ECB is an insolvent institution. The euro may or may not stay together. The pyramid of potential contributors to recapitalize the ECB is greatly shrunken. There is no guarantee the few strong countries left will be willing to recapitalize the ECB. The equation is political as well as economic. How much will the citizenry of Germany, Austria, etc. stand for? Alone, Greece’s leaving the euro will vaporize all the ECBs capital. Then when Spain leaves the game will be over. Over a quarter of the ECB’s assets are periphery country debt, and the ECB is leveraged in excess of 30-to-1. Central bank systemic risk is a topic only now being addressed. We are living through an out-of-sample experience. As for the Bank of Japan, look at the trajectory of interest cost on the debt, now 45% of tax and other revenues and rising rapidly. Japan’s debt is 24 times central government tax revenue. Moody’s, S&P, and Fitch rate Japan’s debt AA-. An accurate rating would put JGBs 6 or 7 notches lower at junk status.

    The multiplier is not well understood empirically. It varies with the situation. Notably the multiplier is quite high at the trough of severe recessions. The initial condition (today) is quite different than back in 2008 – one of high debt and four years into an expansion. Postwar studies of US data do not capture this. How could they? Debt shows up only 4 times in the index to the General Theory; not one mention germane to the matter here. The multiplier is low in expansions, and in a high enough debt region the cumulative multiplier turns negative (according to the few studies that address fiscal stimulus in a high debt environment). If Reinhart Rogoff are right on their basic result, fiscal stimulus at this point in the expansion is like giving sugar to a diabetic. The doctor is a hero for a few years, yet the misguided prescription never shows up on the death certificate as primary cause of early death.

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