Debt: Not So Bad, After All?
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Debt: Not So Bad, After All?


Japan and other heavy government borrowers may breathe a sigh of relief after an American student tore holes in the philosophical basis underpinning austerity policies.

Set the challenge of replicating research by Harvard professors Carmen Reinhart and Ken Rogoff, University of Massachusetts Amherst student Thomas Herndon found mistakes in their data concerning the impact of debt on a nation’s growth. For debt-laden nations in the Asia-Pacific region, the miscalculation could indicate that debt is not quite the drag originally claimed.

According to the Reinhart and Rogoff paper, Growth in a Time of Debt, economic growth slumps when a nation’s debt level rises above 90 percent of gross domestic product. Net government debt in Japan as a percentage of GDP reached 134 percent in 2012, near crisis-hit Greece’s 155 percent, while some forecasters have estimated China’s debt at up to 100 percent of GDP.

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The picture across the rest of the region is not so troubling, however. The International Monetary Fund has estimated average net government debt for Asia’s emerging economies to be at 59 percent of GDP in 2012, while Australia had a debt ratio of only 12 percent, South Korea 32 percent and New Zealand 26 percent.

Yet, U.S. Republican politician Paul Ryan, EU commissioner Olli Rehn and others have used the Reinhart and Rogoff research to argue for aggressive action to curb government debt, a debate with implications extending beyond the eurozone. Critics of Japanese Prime Minister Shinzo Abe’s reflationary policies have warned of a debt blow-out, despite the apparent initial success of Abenomics in reigniting growth prospects.

Others have warned against austerity policies, including economist Paul Krugman, who has asserted that monetary expansion is unable to overcome the negative effects of fiscal austerity when economies are in a liquidity trap.

With reference to Japan, Krugman suggests that the danger lies in being overly cautious on fiscal and monetary policy, rather than fearing an inflation or asset bubble.

“Japan’s experience is perfectly consistent with [a liquidity trap], with nothing in there to suggest that fiscal stimulus has somehow backfired…What Abenomics seems to be is an attempt, finally, to do what should have been done long ago: combine temporary fiscal stimulus with a real effort to move inflation up,” he recently wrote.

Herndon vs. Harvard

Herndon’s fact checking of the Reinhart and Rogoff research found that the Harvard professors had included only 15 of the 20 countries studied in their key calculation, with Australia missing along with other data errors.

While Herndon and his professors still found a correlation between debt and growth, the relationship was not quite as negative as the study proclaimed.

In a statement to the BBC, Reinhart and Rogoff said, “We do not…believe this regrettable slip affects in any significant way the central message of the paper or that in our subsequent work.”

Herndon has reportedly criticized austerity policies, but other economists have supported the Harvard research.

Tokyo-based economist Martin Schulz of Fujitsu Research Institute told The Diplomat that he was “hardly excited” by the story concerning “tricky empirical estimates.”

“So far, the evidence seems to show that public debt does matter – from some point. [Reinhart and Rogoff’s] 90 percent number seems to be as good or bad as any, simply because the impact depends on the situation of the economy. The eurozone, for example has a 60 percent debt/GDP limit in its constitution,” he said.

“In a strong growing emerging economy, for example, public debt can be positive as long as it contributes to the efficient build-up of productive infrastructure. In a slow growing ageing economy, much lower levels of public debt might matter because public debt tends to go into consumption (pensions) of an older generation, potentially hurting the prospects of a shrinking younger generation.”

He added, “Since I am working on such issues in Japan, the most indebted and fastest ageing economy around, I wouldn’t bother about plus or minus 10 percent in their estimates. On the contrary, my research points out that in an ageing economy much lower levels of public debt might start to hurt, as they do in Italy for example, because they further limit productivity growth that would be necessary for the younger generation to finance their and the current generation’s retirement hopes.”

As the eurozone has showed, the consequences of the debate are far from academic.

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