The Reinhart and Rogoff debate: does debt matter?

Debt accumulation needs to be related to prospective economic growth and where the NPV of future returns (growth) is less than the present value of the debt and equity, the difference will be adjusted for in GDP growth until the two are in parity.

I would have to say that overall debt must matter and that much recent press commentary has got its hands on the wrong stick.   But how much debt matters depends on a number of dynamics.

The Herdon, Ash and Pollin critique of RR’s work is based on data from 1946 to 2009.   It must be remembered that the 20th century was a period that benefitted from tremendous technological advances, educational and demographic changes, all factors that would have required large increases in the growth of capital and hence debt accumulation. 

Also while many of today’s developed economies started the 1946 – 2009 period off with very high post war sovereign debt levels, they were also starting off from a period of depressed economic activity.  Debt to GDP ratios would naturally be elevated.  Consumer debt levels and financial system debt levels were on the other hand much reduced and much less significant.

Debt allocated to productive capital, whether this be manufacturing and services or government funded infrastructure and education (et al) is important in supporting economic growth. 

Growth provides the future income to repay the debt, both reducing debt as a % of GDP and increasing he ability to pay off debt.  It must therefore be true that high growth is likely to be associated with high levels of debt accumulation and vice versa for low growth scenarios. 

But what of scenarios where debt is accumulated to drive growth forward where little more appears to be possible (as now), or where debt is accumulated in over valued and less or non productive assets (US real estate, Chinese infrastructure projects, Japanese real estate pre 1990s)), or where growth is raised, for a significant period above its balanced growth rate, as consumption is leveraged and saving reduced (as in the US and other developed economies before the 2007 crisis), or where there has been a demographic shift (Japan low birth rate)? 

High debt does not necessarily mean low growth, as we note from the Chinese experience where debt has been used to fund gross fixed capital investment, but it can definitely mean increased risk of poor to negative growth rates where future growth is lower. 

Indeed, the adjustment from too much debt to a debt level which can be accommodated by lower growth rates is likely to result in much weaker, if not negative growth for a period of time..     

Slower technological change, structural economic imbalances (too much consumption, too little investment in one economy and too little consumption and too much investment in another) with high levels of debt, slowing demographics and other factors can change the impact of high debt levels on economic growth.   High debt levels with weak growth drivers and significant structural economic imbalances impeding growth are likely to significantly impact economic growth.

Indeed, much of the recent increase in sovereign debt loads has been the result of taking on financial sector/consumer asset focussed debt and in supporting consumption while unemployment is high and output low.   It has not been generally used to finance growth in the productive capital base per se.

I think the relevance of high debt to expected growth rates still applies: adjusting for structural economic imbalances and their associated debt loads across the economy will impact economic growth for some time. 

If high levels of debt were not indeed some vitiating element in the growth equation then neither would debt reduction be.  

I nevertheless disagree with those who used the RR paper to argue for austerity, because as I have noted in my Capitalism in Crisis series, it is virtually impossible to reduce debt without significant adverse impact on GDP growth.   But this also means that the process and term of adjustment is long and likewise exposed to significant risks.

Debt accumulation needs to be related to prospective economic growth and where the NPV of future returns (growth) is less than the present value of the debt and equity, the difference will be adjusted for in GDP growth until the two are in parity.

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