Academic case for austerity shown to have been deeply flawed – Change of direction the only credible response from policy-makers

This is an extraordinary story. The key academic study used to justify austerity in recent years in countries such as Ireland has been exposed as profoundly flawed.

The authors of the study made mistakes by omitting several countries that should have been included, by using a wrong mathematical formula in its spread-sheet and by providing unusual weights to various countries. The end result is that when corrected the data shows the opposite of what was originally claimed.

 This is more than a trifle ironic as this flawed study has been cited to support their case for austerity by a wide range of policy makers ranging from European Commission Vice President Olli Rehn to President Obama’s Treasury Secretary during his first term in office Timothy Geithner.

Here’s the whole story. (All the original material may be accessed at the end of this update.) In January, 2010, two Harvard economists published an academic paper that addressed the biggest policy question the world was facing i.e. should public spending be reduced to stop the rise in a nation’s borrowing or should the state invest resources to generate economic growth as the pathway out of recession? The paper was titled “Growth in a Time of Debt” and was written by Carmen Reinhart and Kenneth Rogoff.  The main conclusion from Reinhart-Rogoff was that countries with a debt-to-GDP ratio above 90% have had a negative growth rate (i.e. they declined), on average, since 1946. 

Having studied a sample of 20 advanced economies over the post-war period Reinhart-Rogoff claimed that average annual GDP growth ranged between about 3% and 4% when the ratio of public debt to GDP was below 90%. But average growth collapsed to -0.1% when the ratio rose above a 90 per cent threshold.

This notion had and continues to have huge implications for Europe, where debt-to-GDP ratios are near the theoretical danger zone. It was especially important for countries such as Ireland whose debt/GDP ratio was heading towards 100%+ at that time.

This study by Reinhart-Rogoff has provided the major academic basis for austerity policies of recent years in the EU and the USA. It has been cited by politicians ranging from Olli Rehn to Timothy Geitner as pointed out already. It has also been cited approvingly by politicians such as George Osborne, the UK chancellor and Paul Ryan, the US congressman who was the Republican Party’s candidate for Vice President in the November 2012 election.

On April 16, 2013 a new study was published which shows that Reinhart-Rogoff made a series of mistakes that have profound implications for policy on austerity. This paper, written by three economists at the University of Massachusetts, (Thomas Herndon, Michael Ash and Robert Pollin) tried to replicate Reinhart-Rogoff’s 2010 results and found them guilty of excluding data, spreadsheet errors and unorthodox weighting of certain countries.

The new study finds that Reinhart-Rogoff omitted crucial data from Australia, Canada and, particularly, New Zealand, which changed the entire conclusion of their paper. When this and other mistakes are corrected the average growth rate for countries with debt-to-GDP ratios above 90% was +2.2%, not -0.1% as Reinhart-Rogoff claimed. The academic basis that has been used to justify the on-going insistence on austerity has now been shown to be false.

Just three days after the Herndon-Ash-Pollin study was published the finance ministers of the G20 countries (which include the EU, Germany, France, UK and Italy) agreed to move away from the idea of setting specific national debt targets. This is a major change of direction – as recently as three years ago, the G20’s richest nations pledged to cut their deficits in half by 2013. Now the EU is not just re-thinking austerity, but promising to reverse direction.

There is an additional problem with the Reinhart-Rogoff thesis. It may well have got the direction of the causation backwards i.e. it may well be that low economic growth leads to high levels of government debt, not the other way around. That is material for another day.  The key issue is that on of the main pillars of the academic justification for austerity has been discredited.

Writing in the Financial Times on April 19, 2013 Ash and Pollin state:

“Of course, one could say that these were special circumstances due to the 2007-9 financial collapse and Great Recession. Yet that is exactly the point. When the US and Europe were hit by the financial crisis and subsequent collapse of private wealth and spending, deficit-financed government spending was the most effective tool for injecting demand back into the economy. The increases in government deficits and debt were indeed historically large in these years. But this was a consequence of the crisis and a policy tool for moving economies out of the deep recession. The high levels of public debt were certainly not the cause of the growth collapse.

The case for austerity has never relied entirely on Prof Reinhart and Prof Rogoff. But the other major claims made recently by austerity hawks have also not held up well. Focusing on the US case, austerity supporters circa 2009-10 consistently argued (frequently in this newspaper) that the large US deficits would lead to dangerously high inflation and interest rates. Neither of these predictions came true. In fact, both inflation and the interest rates on US Treasuries were at historic lows in the four years, 2009-12, during which government deficits were at their peak.

It is also not true that the large deficits have created an unsustainable burden on US government finances. In fact, since 2009, the US government’s interest payments on debt have been at historically low levels, not historic highs, despite the government’s rising level of indebtedness. This is precisely because the US Treasury has been able to borrow at low rates throughout these high deficit years.

We are not suggesting that governments should be free to borrow and spend profligately. But government deficit spending, pursued judiciously, remains the single most effective tool we have to fight against mass unemployment caused by severe recessions. Recent research by Prof Reinhart and Prof Rogoff, along with all related arguments by austerity proponents, does nothing to contradict this fundamental point.”

Social Justice Ireland renews its call to Government to increase its investment programme substantially. Without investment there won’t be jobs; without jobs there won’t be prosperity; without prosperity we’ll be stuck in austerity.  This has been our publically stated and often-repeated position since 2009.

John Maynard Keynes got it right in 1937 when he argued that "the boom, not the slump, is the right time for austerity at the Treasury". Since then many governments have proved Keynes right by trying austerity during a slump and failing to rejuvenate their economies. President Roosevelt did it in the USA but was rescued by WWII. Our own leaders at this time are doing the same and having the same dreadful results. Time our leaders learned some basic economics. Come to think of it, time some economic commentators also learned basic economics.

'Growth in a Time of Debt' by Carmen M. Reinhart and Kenneth S. Rogoff published January 2010 may be downloaded below.

'Does High Public Debt Consistently Stifle Economic Growth? A Critique of Reinhart and Rogoff' by Thomas Herndon Michael Ash and Robert Pollin' published April 15, 2013, may be downloaded below