Chad Stone is chief economist at the Center on Budget and Policy Priorities.
Policymakers and pundits who have pushed budget austerity in the face of a sluggish economic recovery and stubbornly high unemployment found intellectual cover in a highly influential study by economists Carmen Reinhart and Kenneth Rogoff purporting to show that countries pay a sharp economic growth penalty if they allow their public debt to rise above 90 percent of gross domestic product (GDP). As it turns out, that result is hogwash.
A trio of economists at the University of Massachusetts Amherst recently found embarrassing computational mistakes and questionable methodological choices in the Reinhart-Rogoff study. Financial Times' columnist Martin Wolf provides a smart and balanced adjudication of the debate that has ensued. Check it out, or just watch Steven Colbert.
That there's no hard-and-fast 90 percent threshold does not mean that countries can't invite trouble by running irresponsible budget policies, or that there's no loose, historical statistical correlation between debt levels and economic performance. At a minimum, however, one has to ask which way the causation runs – does high debt cause poor economic growth or does poor economic growth lead to higher debt?
Actually, sometimes it's one, sometimes the other. Countries that pursue irresponsible budget policies put future economic growth at risk and may provoke a financial crisis. But, conversely, an economic downturn produces higher debt even if policy remains unchanged (as struggling individuals and businesses pay less in taxes and struggling families automatically receive more in public benefits) – and sound policies to soften the effects of a recession will likely lead to even more debt in the short term. As Europe, even more than the United States, is learning, misguided austerity can produce weaker economic growth and less deficit reduction than policymakers expect.
In short, circumstances matter. Let's look at U.S. government debt over the past 70 years. This week: Part 1, from high debt levels at the end of World War II to large projected surpluses in 2001. (My Part II, on the post-2001 period, comes next week.)
The chart below shows federal budget deficits or surpluses and U.S. debt held by the public (basically, total federal borrowing driven by all past deficits, minus surpluses) as a share of GDP. (The recent run-up in deficits and debt – which I will tackle next week – stands out, but note that it pales in comparison with what happened during World War II.)
The World War II episode is a data point in the Reinhart-Rogoff analysis because the U.S. economy suffered a recession at the end of World War II while the debt was still high. Of course, the nation was also converting from a wartime economy to a peacetime economy at the time, and government spending fell from 42 percent of GDP in 1945 to 15 percent in 1947. That likely was much more important than the high debt level.
Now, note what followed over the next three decades. The economy grew faster than the debt and then stabilized at less than 30 percent of GDP in the 1970s even though the government ran deficits in 25 of the 30 years from 1950 to 1979 and the dollar value of the debt rose from $219 billion to $640 billion. (The foolish and meaningless debt limit also had to be raised numerous times along the way.) The larger deficits during this period were typically associated with recessions rather than sharp policy changes.
Starting in the mid-1970s, debt began to grow faster than GDP. The signature policies of the Reagan years – tax cuts and a defense build-up – produced larger deficits in the 1980s than were common earlier. An early effort to control deficits–the "Gramm-Rudman-Hollings" annual deficit targets, enforceable by the threat of across-the-board budget cuts known as sequestration–failed. The deficit targets were unrealistic, and policymakers were divided over cutting spending versus raising taxes.
The impasse ended in 1990 when President George H.W. Bush withdrew his "no new taxes" pledge and cut a bipartisan deal with congressional Democrats to replace Gramm-Rudman-Hollings that included, along with immediate tax increases and spending cuts, two longer-term deficit-control measures: caps on discretionary spending and pay-as-you-go (PAYGO) requirements for tax cuts or entitlement increases.
The economy didn't cooperate immediately, and deficits and debt rose in the 1990-91 recession and the "jobless recovery" that followed. Subsequently, however, a combination of good policy (including an increase in tax rates on the richest households in 1993), adherence to the deficit control measures in the 1990 agreement, and good luck (an economic boom) produced the remarkable turnaround that generated a balanced budget, a falling debt-to-GDP ratio in the late 1990s, and projections that current policies would continue to produce budget surpluses and declining debt.
That all ended in 2001. For my interpretation of what happened next and what lies ahead, tune in next week.
Clarification, 4/25/13: An earlier version of this blog post inadvertently omitted the last paragraph.