Sunday, 26 May 2013

The economic illiteracy of Rogoff and Reinhart.

The mistakes made by R&R are so numerous that it’s difficult to keep up with them. But here is just one, which I’ll examine in detail. It’s this passage of theirs:
“Nevertheless, given current debt levels, enhanced stimulus should only be taken selectively and with due caution. A higher borrowing trajectory is warranted, given weak demand and low interest rates, where governments can identify high-return infrastructure projects. Borrowing to finance productive infrastructure raises long-run potential growth, ultimately pulling debt ratios lower.”
Unfortunately the latter idea seems to be supported by Martin Wolf, who I thought was bright enough to know better.
So Rogoff’s basic claim is something like: “productive public sector investments expand GDP and repaying a given amount of debt from and expanded GDP is clearly easier than repaying from a smaller GDP”. Sounds sensible doesn’t it? Well it’s actually nonsense.
First, the decision to go for what R&R call “high return infrastructure investments” SHOULD NOT have anything whatever to do with whether an economy is in recession or not. Indeed EXACTLY THE SAME goes for private sector investments.
That is, if an investment makes sense or is “high return”, and the economy is NOT IN RECESSION, that investment should still be made, shouldn’t it?

Why do recessions occur?
Recessions occur because the private sector saves too much (i.e. spends too little). Incidentally, that’s “save” in the sense of accumulate money rather than accumulate physical goods or investments like houses.
So in that scenario, government has to net spend more to make up for private sector caution. And that in turn results in the private sector accumulating savings: in the form of government debt or extra monetary base (and it doesn’t matter which, as pointed out by Milton Friedman, Keynes and numerous other economists).
But note that phrase “accumulating savings”: the deficit gets at the fundamental cause of the recession, that is, what the private sector regards as an inadequate level of savings.
Now suppose the private sector after a while decides that its savings are commensurate with a rate of spending that brings full employment (and that could be due to increased private sector confidence or the aforementioned extra savings or both). In that scenario, government can stop running a deficit, and simply leave the level of debt or monetary base where it is.
There is no need to “repay” the debt, and just leaving the debt where it is costs government nothing (assuming the REAL or inflation adjusted rate of interest is around zero, which is where it currently is in the case of the US, Germany, Japan and the UK).
Another alternative is that the private sector gets OVER-CONFIDENT, and it is indisputable that the private sector goes into “over-confidence” mode from time to time. In that scenario, government will need to rein in private sector savings. I.e. it will need to raise taxes and grab savings off the private sector.
But that’s not “repaying a debt” in the normal sense of the phrase. It’s simply a case of government saying to private sector entities, “give me some more money else you go to prison”. And moreover, that extra tax DOES NOT COST the private sector anything in the sense that it’s simply a measure which is implemented to as to stop the private sector OVER SPENDING, the result of which would be excess inflation, which in turn would make the private sector WORSE OFF.
And that all applies REGARDLESS of whether output per head is increasing due to R&R’s “high return investments”. That is, EVEN IF output per head was not expanding at all because for example the pace of technological improvement had temporarily ground to a halt, the above points about savings, confidence, etc would still apply.
Ergo . . . Rogoff’s point about “high return” public sector investments is looking increasingly irrelevant.

The final nail in Rogoff’s coffin.
Next, let’s suppose government does actually spot some “high return” investments, and borrows money to make such investments. Will that do anything for the recession?
Well, assuming government just borrows and invests, the result will be that interest rates rise. And a reasonable assumption thee is that government investment will just crowd out private sector investment. So the IMMEDIATE effect on aggregate demand and employment will be ZERO. I.e. the investment is of no immediate use for exiting the recession.
Of course, where government DOES BORROW and invest (or simply expands its non-investment type spending) with a view to exiting a recession, the central bank is highly unlikely to ACTUALLY LET INTEREST RATES RISE. So the reality is that if government does borrow so as to invest in “high return” public sector investment, there will indeed be a “recession exiting” effect.
But as just intimated, that has ABSOLUTLY NOTHING to do with whether the money borrowed is spent on investments or non-investment type spending.

Rogoff’s “high return” investment point is a COMPLETE IRRELEVANCE.

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