Archive for category: Commentary

May 6, 2013

The economics commentariat – and no small part of the political debate – has been consumed in the past few weeks with controversy surrounding a piece of research by my Harvard colleagues (and friends) Carmen Reinhart and Kenneth Rogoff. The article, published in 2010, had been widely interpreted as showing that economic growth is likely to stagnate in a given country once the ratio of its government debt to gross domestic product exceeded a threshold of 90 per cent. But scholars at the University of Massachusetts have demonstrated – and the duo have acknowledged – that the two professors accidentally omitted some relevant data in forming their results, thanks to a coding error. Questions have also raised with respect to how they weighted observations and which data they used.

Many have asserted that the debate undermines the claims of austerity advocates around the world that deficits should be reduced quickly. Some have gone so far as to blame Profs Reinhart and Rogoff for the unemployment of millions, asserting that they were crucial intellectual ammunition for austerity policies. Others believe that, even after review, the data support the view that deficit and debt burden reduction is important in most of the industrialised world. Still others say the controversy has called into question the usefulness of statistical research on economic policy questions.

Where should these debates settle? First, the whole experience should change the way we approach economic and statistical research. Profs Rogoff and Reinhart are rightly regarded as careful, honest scholars. Anyone close to the process of economic research or financial markets will recognise that data errors such as the ones they made are distressingly common.

Indeed, an internal investigation by JPMorgan into the $6bn loss it made last year on the “London whale” trade found mistakes not unlike those made by Profs Reinhart and Rogoff. Simple errors in a model meant that the bank dramatically underestimated the risks that it was running. In future, authors, academic journals and commentators need to devote more effort to replicating significant research results before broadcasting them widely.

More generally, no important policy conclusion should ever be based solely on a single statistical result. Policy judgments should be based on the accumulation of evidence from multiple studies done with differing approaches. Even then, there should be a reluctance to accept conclusions from “models” without an intuitive understanding of what is driving them. It is right and understandable that scholars want their findings to inform the policy debate. But they have an obligation to discourage and, on occasion, contradict those who would oversimplify and exaggerate their conclusions.

Second, all participants in policy debates should retain a healthy scepticism about retrospective statistical analysis. Trillions of dollars have been lost and millions have been unemployed because the lesson was learnt from 60 years of experience between 1945 and 2005 that “American house prices in aggregate always go up”. This was not a data problem or misanalysis. It was a data regularity – right up until it wasn’t.

The extrapolation from past experience to future outlook is always deeply problematic and needs to be done with great care. In retrospect, it was folly to believe that with data on about 30 countries it was possible to estimate a threshold beyond which debt became dangerous.

Even if such a threshold existed, why should it be the same in countries with and without their own currency, with very different financial systems, cultures, degrees of openness and growth experiences? And there is the old chestnut that correlation does not establish causation. Any tendency for high debt and low growth to go together might reflect the way that debts can rapidly accumulate as a consequence of slow growth.

Third, while Reinhart and Rogoff’s work, even before the recent replication efforts, did not support the claims made by prominent figures on the right in the US and UK regarding the urgency of deficit reduction efforts, the joy taken by some on the left from their embarrassment is inappropriate.

It is absurd to blame Reinhart and Rogoff for austerity policies. The political leaders advancing austerity measures made their choice of policy first, and then cast about for intellectual buttresses. While there may be no threshold beyond which debt becomes catastrophic, and while the British and US experiences both suggest that fiscal contraction in a slack economy where interest rates are near zero is inimical to growth, it is a grave mistake to suppose that debt can or should be accumulated with abandon.

On all but the most optimistic forecasts, further actions will be necessary almost everywhere in the industrial world to assure that debt levels are sustainable after economies recover.

This is not the time for austerity, but we forget at our peril that debt- financed spending is not an alternative to cutting other spending or raising taxes. It is only a way of deferring those painful acts.

The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary

April 15, 2013

With the release of the president’s budget, Washington has once again descended into partisan squabbling. There is in America today pervasive concern about the basic functioning of our democracy. Congress is viewed less favorably than ever before in the history of public opinion polling. Revulsion at political figures unable to reach agreement on measures that substantially reduce prospective budget deficits is widespread. Pundits and politicians alike condemn gridlock as angry movements like Occupy Wall Street and the Tea Party emerge on both sides of the political spectrum, and partisanship seems to become ever more pervasive.

All this comes at a time of great challenge. Profound changes, as emerging economies led by China converge toward the West, will redefine the global order. Beyond the current economic downturn, which is surely the most serious since the Great Depression, lies the even more serious challenge of the rise of technologies that may well raise average productivity but displace large numbers of workers. And a combination of the share of the population that is aged and the rising relative price of public services such as healthcare and education pressure future budgets.

Anyone who has worked in a political position in Washington has had ample experience with great frustration. Almost everyone involved with public policy feels that much is essential yet infeasible in the current political environment. Yet context is important. Concerns about gridlock are a near-constant in American political history and in important respects reflect desirable checks and balances; much more progress is occurring in key sectors than is usually acknowledged; and American decision making, for all its flaws, stands up well in global comparison.

It is a commonplace that the missing center makes political compromise impossible. Many yearn for a return to what they imagine as an earlier era when centrists in both parties had overlapping opinions and negotiated bipartisan compromises that moved the country forward. Yet fears about the functioning of our government like those expressed today have been recurring features of the political landscape since Patrick Henry’s 1788 assertion that the spirit of the revolution had been lost. It’s sobering to consider the degree of concern about paralysis that gripped Washington during the early 1960s when the prevailing diagnosis was that a lack of cohesive and responsible parties precluded the clear electoral verdicts necessary for decisive action. While there was a flurry of legislation passed in the 1964-66 period after a Democratic landslide, what followed were the cleavages associated with Vietnam and then Watergate, all leading to President Jimmy Carter’s famous declaration of a crisis of the national spirit. Whatever the view today, there was hardly high rapport in Washington during the term of Ronald Reagan.

Intense division and slow change have been the norms rather than the exceptions. While often frustrating, this has not always been a bad thing. Probably there were too few not too many checks and balances as the United States entered the Vietnam and Iraq wars. By my lights and that of many others, there should have been more checks and balances on the huge tax cuts of 1981, 2001 and 2003 or on unpaid-for entitlement expansions at any number of junctures. Most experts would agree that it is a good thing that politics thwarted the effort to establish a guaranteed annual income in the late 1960s and early 1970s or the effort to put in place what would today be called a single-payer healthcare system in the 1970s.

The great mistake of the gridlock theorists is to suppose that all progress comes from legislation and that more legislation consistently represents more progress. While these are seen as years of gridlock, consider what has happened in the past five years. The United States moved faster to contain a systemic financial crisis than any country facing such a crisis has moved in the last generation. Through all the fractiousness, enough change has taken place that without further policy action, the debt-gross domestic product ratio is expected to decline for the next five years. Beyond that the outlook depends largely on healthcare costs, but growth there has slowed to the rate of GDP growth for three years now, the first such slowdown in nearly half a century. At last, universal healthcare is in sight. Within a decade, it is likely that the United States will no longer be a net importer of fossil fuels. Financial regulation is not in a fully satisfactory place but has received its most substantial overhaul in 75 years. Most public schools and those who teach in them are for the first time evaluated on objective metrics of student performance. Gay marriage has become widely accepted across the states.

No remotely comparable list can be put forth for Japan or Western Europe. Yes, change comes rapidly to some of the authoritarian societies of Asia. But it may not endure and may not always be for the better. Anyone prone to pessimism would do well to ponder the alarm with which the United States viewed the Soviet Union after Sputnik or Japan in the early 1990s. It is the capacity for self-denying prophecy of doom that is one of America’s greatest strengths.

None of this is to say that we do not face huge challenges. The challenges, though, are less of getting to agreement where the answer is clear than of finding solutions to problems like rising inequality or global climate change, where the path is uncertain. That is not a problem of gridlock — it is a problem of vision.

March 17, 2013

In economic policy what is good for one is not good for all

Europe’s economic situation is viewed with far less concern than was the case six, 12 or 18 months ago. Policy makers in Europe far prefer engaging the US on a possible trade and investment agreement to more discussion on financial stability and growth. However, misplaced confidence can be dangerous if it reduces pressure for necessary policy adjustments.

There is a striking difference between financial crises in memory and financial crises as they actually play out. In memory, they are a concatenation of disasters. But as they play out, the norm is moments of panic separated by lengthy stretches of apparent calm. It was eight months from the South Korean crisis to the Russian default of 1998, six months from Bear Stearns’ demise to Lehman Brothers’ fall, and there were several 30 per cent stock market rallies between 1929 and 1933.

Is Europe out of the woods? Certainly a number of key credit spreads, particularly in Spain and Italy, have narrowed substantially. But it is far from clear that market conditions have improved. Investors are still limited. Restrictions limit the ability of pessimistic investors to short European debt. Regulations enable local banks to treat government debt as risk free. This allows them to access funding from the European Central Bank on non-market terms. And there is the suspicion that, in extremis, the central bank would come in strongly and bail out bond holders. Remissions are sometimes followed by cures and sometimes by relapses.

A worrisome indicator in much of Europe is the tendency of stock and bond prices to move together. In healthy countries, when sentiment improves stock prices rise and bond prices fall, as risk premiums decline and interest rates rise. In unhealthy economies, as in much of Europe today, bonds are seen as risk assets, so they move just like stocks in response to changes in sentiment.

Perhaps it should not be surprising that Europe still looks to be in serious trouble. Growth has been dismal, with eurozone gross domestic product still below its 2007 level. Forecasts predict little if any growth this year.

For every Ireland, where there is a sense that a corner is being turned, there is a France, where the sustainability of current policy is increasingly questionable.

The controversy surrounding the decision by European authorities to conduct a bail-in that imposes levies on Cypriot bank depositors gives an indication of the degree of fragility in Europe. The idea that converting a small portion of deposits into equity claims in an economy with a population barely over 1m could be a source of systemic risk suggests the current situation rests on a hair trigger.

All of this is compounded by political uncertainty. Italy’s election was inconclusive even by its own standards. Scandals and staggeringly high unemployment are taking their toll in Spain. France is much calmer about its situation than are many outside observers. And Germany’s primary concern is avoiding turmoil before federal elections in September. There is little doubt that, given a choice, all eurozone countries would prefer almost any kind of macroeconomic unorthodoxy to the breakdown of monetary union. But this is insufficient. There is the serious risk that as nations pursue parochial concerns, the political and economic situation will deteriorate to a point that is not remediable.

Structural reform in the most troubled economies is essential, and the work of building a stronger institutional foundation for monetary union must go on. But the key to success will be the recognition that in economic policy – as in life – what is good for one is not good for all.

It is true, as German policy makers constantly point out, that fiscal consolidation and structural reform were key to Germany’s rise from being the “sick man of Europe” to its current position of strength. What they do not recognise is that there cannot be exports without imports. Germany’s export growth and huge trade surplus were enabled by borrowing by the European periphery. If the debtor countries of Europe are to follow Germany’s path without economic implosion there must be a strategy that assures increased external demand for what they produce. This could come from a German economy that was prepared to reduce its formidable trade surplus, from easier monetary policies in Europe that spurred growth and competitiveness, or from increased deployment of central funds such as those of the European Investment Bank.

Invocation of necessity is not a strategy. As any student of Germany’s experience of the 1920s knows, requiring a nation to service large debts by being austere in a context where there is no growth in demand for its exports is far from being a viable strategy.

European policy makers, the International Monetary Fund and external policy makers with a stake in the European outcome need to recognise that the history of financial crises is a history of missed opportunities. New business is always more exciting than unfinished business. And where matters are controversial, forced moves are easier for policy makers than unforced moves because they can be portrayed as moves of necessity rather than choice. So outsiders avoid confrontation and insiders embrace drift. The consequences could be grave.

The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary