In the current media- and pundit-manufactured hysteria about the government budget deficit and sovereign debt, much has been made of a relatively recent book by Rogoff and Reinhart.  It purports to find patterns of default by surveying 800 years of sovereign defaults.  R&R conclude that somehow, magically, an 80% debt-to-GDP ratio will virtually ensure sovereign default, crisis, pain, suffering, and general mayhem.  I find it interesting that they reach this conclusion by noting that somewhat over half of the crises they study had ratios above that.  Strange that they never test the hypothesis by asking how many times have nations exceeded that threshold and NOT come to grief (Japan the last 20 years anybody?).  I obviously was not impressed with the book or it’s scholarship.  I’ve been meaning to blog about it, but Yeva Nersisyan at New Economic Perspectives says what I’ve been thinking…

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).

Jim, again here.  I have read the book.  I was greatly unimpressed.  Yes R&R have assembled a huge database (there contribution would be useful if they open-sourced the data files), but their analysis is greatly lacking.  They treat 800 years of history as if there’s never been any change in institutions – kind of strange when banking itself is only a few hundred years old.  Most important, though, is that R&R cannot recognize that the gold standard disappeared some 40 years ago.

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.