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

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.