The Myths About Government Debt and Deficit as Told By Carmen Reinhart and Kenneth Rogoff

Yeva Nersisyan

In every culture there are a set of myths that are used to bring up future generations. In the US parents tell their children that if they don’t behave the bogeyman will get them. In many other countries it is a “Sack man” who carries naughty children away in a big sack. The myths are numerous and differ from culture to culture but the purpose is to get children to conform to the parental authority. As children trust their parents this is usually fairly easily accomplished. Although we would like to think that once we become adults we are not fed similar half-truths and outright lies, unfortunately it is not the case. One would think that as adults who have the capacity to reason and think critically we could spot those lies and myths. But what to do, if the people whose authority we trust, the so-called scientists and experts in the field are the ones feeding us the myths?

Major crises can be useful in helping people to rethink the way they once thought about the world. During the Great Depression, we abandoned the idea that free markets could work without government intervention. Gradually, as the postwar economy avoided major crises, precisely due to state intervention, people got comfortable thinking that the economy has become inherently stable and that state intervention is no longer necessary. Economists were at the forefront of propagating this myth. We were also led to believe that fiscal policy was neither useful nor necessary. But perhaps the biggest myth that we were all taught is that the government should balance its budget just like a household does, that persistent budget deficits are unsustainable and will lead to stagnant growth and even to sovereign defaults. Thanks to this myth, propagated by professional economists, with nearly 10% of the US labor force unemployed and another 7% underemployed, the public debate is now focused on the false issue of deficits and debt.

A case in point is a recent book by Carmen Reinhart and Kenneth Rogoff, “This Time is Different” that has become a bestseller, making them the ultimate authorities on the issues of debt, default and crises. It has been used by conservatives and progressives alike to argue for lowering government deficits and debt in the midst of the current Great Recession. The media as well as academia have fawned all over this book, to the point where one begs the question whether they have actually taken the pain (it is painful!) to read the book (see here for more on this). This is not particularly surprising, however, considering that orthodox economists don’t have a theory to explain the financial crisis (since their models always excluded the possibility of one). Hence they have been desperate to embrace the “analysis” found in the book just like a drowning person holds on to a straw. A most recent example of the fluff surrounding the book can be found in the NYT by the Economix section writer Catherine Rampell, a deficit hawk herself. Rampell suggests that the book somewhat makes up for the shortcomings of economists, that being the failure to foresee the current crisis. I decided to check out the publications of Reinhart and Rogoff prior to the crises with the hope to find papers that foresaw the current debacle. The closest Ken Rogoff got was to argue that global imbalances were unsustainable. Unless you believe that the current crisis was the result of global imbalances (a strange and flawed but not uncommon proposition) then Rogoff can safely be classified among those economists who were so blinded by their own models that failed to see what was going on under their noses. A similar story can be told about Reinhart.

Reinhart and Rogoff might be commended on the amount of work they have put into assembling the huge database (it covers eight centuries and sixty-six countries, although the focus of the book is crises and defaults since 1800). Rather than closely studying the details of particular crises to gain an understanding of causes and consequences in order to make more general statements, their method is to aggregate particular measures and ratios across countries and over the long sweep of history to obtain data presented in “simple tables and figures” to “open new vistas for policy analysis and research.” Indeed, their book is nothing more than a large database of questionable value. The authors argue in favor of empirical investigations rather than fancy models. I agree with that. But simply having a large amount of data without much meaningful explanation is not very useful. Economic analysis and theorizing doesn’t necessarily have to be mathematical. One can use the narrative approach to explain economic events. Indeed, the narrative approach is in some cases the only way to capture the complexity of the world around us. And while Rogoff and Reinhart have rejected the mathematical modeling, they haven’t offered an alternative in the form of a narrative either. They simply have failed to do much explaining at all.

The crux of the book is that each time people think that “this time is different”, that crises cannot occur anymore or that they happen to other people in other places. True. This is exactly what Hyman Minsky was arguing more than 40 years ago. Reinhart and Rogoff don’t really explain why this perception leads to crises. Minsky, on the other hand, had an analysis of investment and of position taking in assets which led him to conclude that when people get comfortable in the existing situation they tend to overextend their balance sheets and lower the cushions of safety, which inevitably leads to fragility. A fragile financial system is then subject to a crash like the one we experienced in 2007.

The book is mostly on crises driven by government debt. Rogoff and Reinhart claim to have identified 250 sovereign external defaults and 70 defaults on domestic public debt. The problem with their “analysis”, however, is that over the past 800 years (and even over the past two centuries that are the focus of the book), institutions, approaches to monetary and fiscal policy, and exchange rate regimes have changed. For example, before the Great Depression the US was on a Gold Standard, then there was the Bretton Woods regime and finally in the last 40 years the US dollar has been a non-convertible currency. From reading the book it seems that this is not important at all. In reality the monetary regime a country operates on has major implications for government solvency. Aggregating data over different monetary regimes and different countries cannot yield any meaningful conclusions about sovereign debt and crises. It is only useful if the goal is to merely validate one’s preconceived myth about government debt being similar to private debt.

A sovereign government that operates on a non-convertible currency regime spends by issuing its own currency and as it’s the monopoly issuer of that currency, there are no financial constraints on its ability to spend. See here, here and here for more. It doesn’t need to tax or issue bonds to spend. It makes any payments that come due, including interest rate payments on its “debt” and payments of principal by crediting bank accounts meaning that operationally they are not constrained on how much they can spend. Governments operating with a non-convertible fiat currency cannot be forced to default on sovereign debt. They can choose to do so but that’s ultimately a political decision, not an economic/operational one. As far as I can tell Rogoff and Reinhart haven’t identified a single case of government default on domestic-currency denominated debt with a floating exchange rate system.

The need to balance the budget over some time period determined by the movements of celestial objects is a myth. When a country operates on a fiat monetary regime, debt and deficit limits and even bond issues for that matter are self-imposed, i.e. there are no financial constraints inherent in the fiat system that exist under a gold-standard or fixed exchange rate regime. But that superstition is seen as necessary because if everyone realizes that government is not actually financially constrained then it might spend “out of control” taking too large a percent of the nation’s resources. See here for more.

When the Great Depression hit governments didn’t know how to counteract the crisis, to solve the problem of unemployment. Further they were constrained by the Gold Standard (which the U.S. finally abandoned in 1933). Today we know exactly what to do to solve the issue of underutilization of labor resources. But unfortunately we are constrained by myths. I wonder what the economists, who propagate these myths, would say if they were in the ranks of the unemployed. Would they say that Congress should not extend unemployment benefits because it will further contribute to the deficit? Would they say that more stimulus is unsustainable? I suggest we leave them unemployed for a while. They will have more free time to do some Modern Monetary Theory reading and more “economic incentives” (i.e. lack of income to support themselves and their families) to rethink their position. Professional economists are a major impediment on the way to using our economic system for the benefit of us all. And Reinhart and Rogoff are no exception.


25 Responses to The Myths About Government Debt and Deficit as Told By Carmen Reinhart and Kenneth Rogoff

  1. "i.e. there are no financial constraints inherent in the fiat system that exist under a gold-standard or fixed exchange rate regime."I would suggest that there is a financial constraint, which is inflation. When inflation is high, relative government spending needs to be curtailed. When it is low, (as now), the reverse. This isn't rocket science.

  2. Krugman begs to differ on the claim that there are no limits when you can print money. See:http://krugman.blogs.nytimes.com/2010/07/17/i-would-do-anything-for-stimulus-but-i-wont-do-that-wonkish/

  3. "As far as I can tell Rogoff and Reinhart haven’t identified a single case of government default on domestic-currency denominated debt with a floating exchange rate system."Japan 1942 & Russia 1998 come to mind.Nick R.Kyoto

  4. Thanks. Well written…

  5. Bill Mitchell discussed the Russia case (1998) from the MMT perspective, and it doesn't significantly alter the picture described so well here by Yeva Nersisyan. Japan 1942 is obviously a special circumstance.Burk Braun– If inflation is a problem, the federal deficit should generally be reduced. That's simple Keynesianism, right? Of course, there are different types of inflation, and it won't help to simply raise taxes if there is an oil crisis, for example…

  6. Burk and AndyYou obviously haven't read much of our stuff. We've ALWAYS acknowledged the inflation constraint, which for us and most others is not the same as a financial constraint on the ability to spend. And Andy, Jamie's response to Krugman makes this same point that you seem to have somehow missed as well.

  7. Nick:Russia was on a fixed exchange rate when it defaulted in '98, so that isn't a counter example. Japan's default was voluntary as Rogoff reveals here: http://www.pbs.org/newshour/bb/business/july-dec09/makingsense_11-02.html The government simply refused to repay their enemies. You're technically correct, but it had nothing to do with "solvency" or the government's "ability to pay."

  8. "Russia was on a fixed exchange rate when it defaulted in '98, so that isn't a counter example. "Not quite. It was on a dirty float.

  9. Tim, the Central Bank were committed to supporting the currency if it went outside a publicly announced band. That is not a dirty float, its a peg.The choices that the Russian government faced were defaulting on the internal debt or abandoning defense of the exchange rate.

  10. Sorry, Nick and Tim, but you've got Russia wrong. And a "dirty float" is quite a bit different from a floating currency, at any rate. Witness the EMS in the early 1990s.Here's Warren Mosler on Russia from http://www.epicoalition.org/docs/flawed_logic.htmAs a point of logic, the concept of ABILITY to pay being inherently revenue constrained is not applicable to the issuer of a currency. Any such constraints are necessarily self-imposed (including various ‘no overdraft’ legislation in some countries for the Treasury at the Central Bank). The issuer can always make payment of its currency by crediting the appropriate account or by issuing actual paper currency if demanded by the counter party.An extreme example is Russia in August 1998. The ruble was convertible into $US at the Russian Central Bank at the rate of 6.45 rubles per $US. The Russian government, desirous of maintaining this fixed exchange rate policy, was limited in its WILLINGNESS to pay by its holdings of $US reserves, since even at very high interest rates holders of rubles desired to exchange them for $US at the Russian Central Bank. Facing declining $US reserves, and unable to obtain additional reserves in international markets, convertibility was suspended around mid August, and the Russian Central Bank has no choice but to allow the ruble to float.All throughout this process, the Russian Government had the ABILITY to pay in rubles. However, due to its choice of fixing the exchange rate at level above ‘market levels’ it was not, in mid August, WILLING to make payments in rubles. In fact, even after floating the ruble, when payment could have been made without losing reserves, the Russian Government, which included the Treasury and Central Bank, continued to be UNWILLING to make payments in rubles when due, both domestically and internationally. It defaulted on ruble payment BY CHOICE, as it always possessed the ABILITY to pay simply by crediting the appropriate accounts with rubles at the Central Bank.Why Russia made this choice is the subject of much debate. However, there is no debate over the fact that Russia had the ABILITY to meet its notional ruble obligations but was UNWILLING to pay and instead CHOSE to default.

  11. Approaching age 70, it's not for myself that I worry. But when I see projections of the government's payments to lenders, I worry about my grandchildren's prospects. Is that not valid?

  12. You bring up the ultimate paradox. For one, the Great depression was caused, not by the lack of government interference, but because of government interference through the central bank. I note the fictions created by the establishment in this matter. When discussing this idea with a younger friend who is in college (late 30's), he brings up the flaws of Andrew Jackson and his ending the second bank of the US. Bank charters go around the free market and in all cases of financial panic, it is bank chartered outfits that create the mess. The chartering of the Federal Reserve allowed for the creation of more credit than the system could stand. The Fed allows banks to write more and more hot checks until debt has overrun the system. There is no way the bubble could have happened without the accomodation of the Fed and the repeated bailouts begun by Robert Rubin in the 1990's. Maybe this is the proverbial wolf in the henhouse. My friend spoke of the difficulty the US faced between the 1830's and the 1914 chartering of the Federal Reserve. How clouded the truth has become, as the US had gone from a frontier wilderness country to the most powerful industrial power in the world in that period. The truth of the matter was the bankers needed a form of money they could extend booms and as a result, created the ultimate bust. What transpires during a credit boom is a false prosperity built on false money. The politicians become beholden to the continued prosperity. As much as both are to blame, neither Bush nor Obama had much to do with this mess other than to attempt to keep it going, which is what is going on today. Politicians need the fiction to continue or face the prospect of being the next Hoover. Ditto Federal Reserve officials, who operate on the fiction of what caused the last mess. We face the question, not how to get another shot of dope into a debt laden economy with more debt, but how to deflate a debt bubble and not allow the system to collapse. This is a delicate balance, as the entire status quo rests on the presense of false forms of money. It isn't that we have to have gold or silver, as the same problem would be present, most likely to a lesser extent, but that we have some kind of money behind what is represented as money. Instead we have debt collateral, where the house is money, but there is not any money for the interest. In order to run deficits to temporarily cure this mess, one has to buy into the idea that governments can be legitimate debtors who can pile debt into infinity. But, instead what we have is a proposal for another ponzi scheme to continue the support of ponzi finance already in place. The free market manner of solving these problems is to liquidate the bad debt, not to support it. Instead of another attempt to maintain the status quo, government should be more interested in surviving such a liquidation and getting it behind us rather than resurecting a series of bad ponzi schemes. Japan has already shown the attempts being made through reflationary policy doesn't work and any success in Japan has been in the light of the benefit of debt bubbles in the US and now in China, not in the success of its own policies. One cannot have free market capitalism then interfere with the failures and call it free market capitalism. The primary cause of this 80 year debt bubble, deposit insurance and government guarantees, is literally the only solution to the problem. Taking the losses will literally turn the power structure of the US and the world on its head. The entire situation is one of the paradox of our time, that you can only return to prosperity by going broke.

  13. Excellent article! Thanks.It's unnerving seeing Rogoff cruising through the world and lecturing the public about unsustainable government debt by conflating different monetary regimes existing geographically and historically.Every 2 months his smiling face pops up in some German newspaper telling some weird story to scare the shit out of the public. One day it's about the US soon being in the same malaise like the PIGS. Another day it's Greece and the long history of Greek defaults.For me this is nothing but a world wide promotion tour where the authors have concluded the best way to do it is running it worldwide ad infinitum.

  14. Thanks for all the comments.Burke: Yes inflation is the limit, but that is not a financial constraint, it's a real resource constraint. When deficit hawks say social security is a problem, they don't say it's an "inflation" problem, or a real resource problem; they say it's a financial, insolvency problem. Let's first understand what the problem is and then only try to solve it. If it's a real resource issue then the solution should come in the way of spending more on education and technology (to be able to increase the amount of real stuff we can produce) and not by cutting deficits. Here's a good post by Pavlina on distinguishing between solvency and sustainability:http://neweconomicperspectives.blogspot.com/2010/04/do-not-confuse-solvency-with.html2. Is it possible for a country with its sovereign currency to default? Yes, but as I mention in the post that's ultimately a POLITICAL decision not an insolvency driven action. What's important is that a government with its own non-convertible currency CANNOT BE FORCED to default on its debt by markets, credit raters, etc. And it CANNOT default because it ran out of its own currency. As long as its debts are denominated in its own currency that is not a possibility.

  15. PURE TRASH! The entire system is INSOLVENT!How long are we going to pretend it's not?

  16. Hey, Nick R, didn't Russia have a dollar-denominated debt?And Japan simply refused to pay the countries it fought in a war, US probably reciprocated, but it doesn't mean it dafaulted.pg

  17. I don't really understand what all this adds beyond saying that the government (who issues own-currency debt) can always finance its spending/debt by printing more money, which is hardly new information nor amounts to "we don't have to worry about (own currency, floating exchange rate) government debt". What matters is what might be called a "real constraint" which is to do with what happens to the real economy, and is what you start pushing up against when the government goes too far in thinking that it doesn't have to worry about being able to finance (a sufficient proportion of) its debt via taxation revenue. This is just another way of saying: "Yes inflation is the limit, but that is not a financial constraint, it's a real resource constraint." You have merely demonstrated that in when a govt issues debt in its own currency etc. the "financial constraint" isn't the one to look at. Some people (not necessarily anybody here) seem to be taking these points and turning them into an argument that we should regard government debt as unconstrained, and not something ever to be worried about. I don't think that follows.

  18. "operationally they are not constrained on how much they can spend. Governments operating with a non-convertible fiat currency cannot be forced to default on sovereign debt."True that there is no limit to Govt printing of fresh currency (e,cept Inflation considerations) PROVIDED THAT all economic activity is occurring within the territory over which that Govt is Sovereign. The moment there is a significant External Account and near total import substitution is an impossibility, at least in the short run, it is naiive to think there are no limits. You do not have the absolute freedom in a partnership enterprise as you have in a Sole ownership. Govt indeed becomes like a household when there is a significant external account. The real problem is the ridiculously low fiat exchange rate of the Yuan that sucks all dollars into China, and the US distribution of prices having become trapped in that pricing.

  19. What a crock of crap. The writer does not understand that the dollar or currency is a derivative and the underlying foundation of that derivative is the confidence in the system. Look at a share of stock. It's nothing but a derivative of the dollar and its value is based on all kinds of fundamentals including the fact that the issuer cannot dilute the shares of prior holders. Once GM prints infinite shares of stocks, no one will touch it. Same for the dollar.Yeva Nersisyan I don't know your qualifications but you are just another one of those worthless mouthpiece for a fake science.

  20. "Once GM prints infinite shares of stocks, no one will touch it. Same for the dollar."Who said anything about printing infinite dollars? Did you even read the article?

  21. Anonymous said: Who said anything about printing infinite dollars? Did you even read the article? Yes I did. See this quote:"A sovereign government that operates on a non-convertible currency regime spends by issuing its own currency and as it’s the monopoly issuer of that currency, there are no financial constraints on its ability to spend. See here, here and here for more. It doesn’t need to tax or issue bonds to spend. It makes any payments that come due, including interest rate payments on its “debt” and payments of principal by crediting bank accounts meaning that operationally they are not constrained on how much they can spend. Governments operating with a non-convertible fiat currency cannot be forced to default on sovereign debt. They can choose to do so but that’s ultimately a political decision, not an economic/operational one."Whether printing or electronically crediting a bondholder's account for the sovereign, you are still diluting the shares (dollars) of the prior holder of the paper. And electronically crediting is even more insidious than printing. Once that is started, the bondholder will use the credit to move as quickly as possible into hard assets.

  22. The good thing about your information is that it is explicit enough for students to grasp. Thanks for your efforts in spreading academic knowledge.japan

  23. This is just pure crap, I am sorry. You clearly have no concept of what inflation is and therefore make yourself out to be economically illiterate and that makes it almost impossible to take you seriously on this topic.

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