With unemployment at 7.6% and an output gap of around 6%, it’s (still) not the time to embark on front-loaded spending cuts in the United States.
Figure 1: Log GDP (blue), CBO baseline projection under current law (red), and potential GDP (gray bold). NBER defined recession dates shaded gray. Source: BEA, 2012Q4 3rd release, CBO, Budget and Economic Outlook, February 5, 2012, and NBER.
The Reinhart and Rogoff findings’ impact on policy
Annie Lowrey in Economix muses on the exact impact on policy of the original Reinhart and Rogoff debt/growth results. She concludes that while in the constrained economies of the eurozone (the GIIPS), it’s unclear whether there would have been an impact, it’s a potentially different matter in countries not facing imminent constraints:
A better question is what effect studies like Reinhart-Rogoff might have had in countries that elected to start the process of fiscal consolidation without much pressure from the bond markets or other external financiers.
Britain and the United States are the big question marks there. The Cameron government in Britain — over the protestations of the opposition party and the monetary fund and other groups — has slashed the country’s budget. But it still has not met its own deficit-reduction targets, because the economy has remained mired in recession and automatic spending on social programs has increased. The country still could reverse course and engage in an effort to improve growth rather than an effort to hold down its debts. But thus far it has chosen not to.
The United States has also embarked on a campaign of deficit reduction, though a more modest one. Thus far, the Obama administration and Congress have raised taxes on the wealthiest Americans and agreed to trillions in budget cuts. With the aggressive actions taken by the Federal Reserve, the economy has continued to grow — which will greatly aid the country’s fiscal situation in the long run. How important were academics like Professors Reinhart and Rogoff to that process? My sense is not very, as well, even if policy makers pushing for deficit reduction cited them.
The policy debate, and economic vs. statistical significance
Reinhart and Rogoff have responded to the publication of the Herndon-Ash-Pollin results by noting that the finding of 1% reduction in trend growth above the 90% threshold remains intact (this is the distinction between using median vs. mean differences); moreover, over time, 1% cumulatively becomes important in assessing the impact on the level of GDP. On this last point, I definitely agree.
…at least at the fairly standard threshold of 95 percent confidence, there is reason to believe that any such differences may be yet another chimera. While access to Reinhart and Rogoff’s original data is elusive—making it impossible to definitively verify the veracity of this claim—the widely-circulated Excel snapshot provides us with some data to work with (with the added plus that standard errors of the mean calculated using this approach also use the average-of-averages weighting scheme they employ in their paper). And attempting to replicate the key figure shows that, while the means for the observations in the greater-than-90-percent bin are it is certainly lower than the other bins (see figure), the confidence intervals of all three bins above the 30 percent debt/GDP threshold also overlap. On this (admittedly crude) basis, then, any claim that a 1 percent growth differential over a decade compounds is simply overstating the case made by the data.
The key graph is here:
Source: J. Lim, “How Significant is a 1 Percent Difference in Growth Under Debt?” “Prospects for Development” (18 April 2013). Notes: Source: “World Bank staff calculations, from Reinhart-Rogoff data fragment. Note: Means for each bin are simple averages of all by-country observations within each respective bin, weighted equally by country. Observations for the >90% bin include updated data for New Zealand for all years, averaging 2.58%. 95 percent confidence intervals computed from standard errors for available observations within each mean.”
The question I have is whether one should use the conventional 5% significance levels to make judgments, when dealing with policy issues. (A similar question arose in comments surrounding my work with Yin-Wong Cheung and Eiji Fujii on RMB undervaluation). I don’t think there is a definitive answer — but the fact that the 1% differential is not statistically significant at conventional levels should give pause for thought.
Hope for an impact on policy
So, while we know anecdotes and metaphors carry a lot of weight (perhaps too much) with politicians and policymakers, I do think that these new results should temper the fervor of politicians such as Representative Paul Ryan to brandish the Reinhart and Rogoff results like a cudgel  to rapidly implement front-loaded cuts to discretionary spending (and cut taxes so that even more spending cuts will be necessary to balance the budget in ten years). (At this point it’s important to note that in R&R’s academic writings, the causal interpretation was not pushed; and for sure, spending cuts as the sole adjustment mechanism to reducing the pace of debt accumulation was never implied by the R&R results).