Tag Archives: growth

Will Europe Finally Join the QE Bandwagon?

Europe has struggled to rebound from the Great Recession.  A few years ago, it appeared that the EU and the United States were recovering at roughly the same pace, as shown by this graph of World Bank data on GDP growth rates.  In 2012, the EU dropped off of the path to recovery, posting a -0.4% growth rate, while the United States continued to chug on at around 2% growth per year.  This divergence was largely a product of the two different policy approaches taken by the central banks of each economy.  In the US, the Fed engaged in three separate rounds of large monthly bond purchases, or quantitative easing, with the goal of expanding the money supply and lowering interest rates.  In contrast, the European Central Bank responded with the European Financial Stability Facility to provide liquidity to EU members, and several European states undertook austerity policies.  It may be slightly naive to attribute all of the US economy’s recovery to quantitative easing, but it certainly appears to have been incredibly effective.

So why did the EU not even attempt quantitative easing while the Fed was rolling out several rounds of it?  One big obstacle that the ECB faces is the fact that it is composed of a multitude of national central banks, making it more difficult to coordinate asset purchases.  However, it appears that the time may have finally come for the European Central Bank to enlist the help of quantitative easing.  As reported in the Wall Street Journal, the ECB’s executive board has proposed a 12-month (at minimum) round of QE, composed of asset purchases of 50 billion euros per month.  The bank’s governing body will meet Thursday to discuss the proposal.  As noted by MIT professor Athanasios Orphanides in the Journal article, “the potentially open-ended nature of the program—the idea the ECB could continue beyond a year—is a bright spot that could give the program additional power”, since many economists believe one of the core strengths of quantitative easing is the effect on the market that expectations of aggressive future monetary policy can have.

As news of the potential ECB actions broke, the euro fell against the dollar – good news for the multitude of European states that rely heavily on exports to fuel their economy.  Italian prime minister Matteo Renzi was one of those who welcomed the news, who claimed that he dreams of parity between the Euro and the Dollar in an interview with the Wall Street Journal earlier today, believing that it would grant Europe greater economic flexibility.  However, it is not good news for everybody – German officials oppose the ECB plan, as noted in the first Journal article, since German taxpayers have concerns that they would be responsible for the more risky debt of other European countries.  Nevertheless, it appears to be the case that the ECB will carry out quantitative easing, having tried almost everything else, in an attempt to resuscitate the stagnant European economy.

Reflections on Reinhart and Rogoff I: Why Time Series Aren’t Enough

After crunching Reinhart and Rogoff’s data, we’ve concluded that high debt does not slow growth. That was the conclusion of a joint Quartz article with Miles Kimball in which we looked at post war data on sovereign debt and growth in advanced economies. Miles’ recent foray back into the debate made me reflect upon our previous work together.

Upon further reflection, I’m not sure I still believe in that title. Not because I now believe that debt to GDP ratios above 90% slow growth, but rather because I’m unsure if long time series provide meaningful information about the effect of debt on growth at all. Given the rarity of high debt episodes, time series data is either too sparse or takes data from drastically different policy regimes to be reliable.

Below is a plot of the overall paths of debt/GDP ratios in countries that passed the 90% threshold after winding down war debts. There are only 5 countries: Belgium, Greece, Ireland, Italy, and Japan (Note that the US is not included as the sample ends in 2009).

Therefore the sentence “whenever a country has hit 90% of debt to GDP” can easily be replaced by the phrase “when these handful of countries hit 90% of GDP in these specific years”.

This does not bode well for inference. One could look at each of these countries and provide a highly idiosyncratic story for why debt blew up and growth lagged. Japan was a story of fiscal policy in a liquidity trap. Greece was a story of “macroeconomic populism” in a time of stagflation. You might have specific beliefs about the governments in each of these countries, above and beyond their attitudes towards debt. These idiosyncratic components matter a lot, and as such there is no power (in the statistical sense) to detect a negative association between debt and growth. Indeed, growth was all over the place. Ireland boomed, Japan stalled, and the others were in the middle.

The fact that debt is very slow moving also means that when you compare different levels of debt and subsequent growth rates, you’re looking at very different time periods. Ashok states this forcefully after my article with Miles:

This means comparisons on different levels of debt take place on very different economic structures. When we talk about the America with 30% debt-to-annual-GDP (the first bin in R-R), we’re talking about an America before modern floating exchange rates, strong unions, extremely high taxes, and declining inequality — each of which adjusts the causal mechanism in question.

This problems caused by looking at such diverse time periods get worse if you try to look at even older data. To deal with the rarity of high debt episodes, Reinhart and Rogoff look all the way back to the 1800’s. But macroeconomic institutions were very different back then! For starters, countercyclical fiscal policy and fiat currencies were not nearly as prominent. Yet these are two critical issues that would change the way debt affects predictions of growth.

In a world of countercyclical fiscal policy (i.e. stimulus packages), rapid onsets of debt coincide with policies that induce more growth in the future. If instead debt is not associated with fiscal policy, then increases in debt are likely from exogenous factors that are worse for future growth. Recent experience with the Eurozone also suggests that having your own currency has tremendous effects on whether high debt levels are associated with financial distress. If there’s no monetary authority to backstop the debt, then increases in debt truly might have large negative effects on growth.

So if you have a strong prior that fiscal and monetary policies matter for the relationship between debt and growth (as I do), then thousands of observations from the Gold Standard era are nonetheless uninformative about how much current observed levels of debt matter for future growth.

But the entire question of causality remains unresolved! If governments are incompetent along many dimensions, debt being only one, then the association between debt and growth might just be a matter of generally incompetent governance. Without a proper instrument for debt, these long time series say nothing about how much high debt levels actually hurt growth. The time series evidence provides no guidance on how to weigh the cost of debt against the benefits of countercyclical fiscal policies.

So is there any way out? I think the answer has to lie not with bigger data sets, but rather theory and smaller case studies that help us shed light on potential mechanisms between debt and growth. For example, Krugman emphasized in his 2013 IMF seminar that the effect of debt depends crucially on whether the sovereign is borrowing in its own currency. Externally denominated debt puts a constraint on monetary policy. Therefore the effects of debt on growth might depend on whether monetary policy is still able to operate. This played out dramatically in the 1997 East Asian debt crisis. Crises near the end of the interwar Gold Standard also highlighted what can go wrong when central banks are forced to allow deflation that raises the real value of debts.

These examples suggest that debt buildups in countries such as the US or the UK are unlikely to pose major risks in the short run while debt buildups in countries without independent monetary policies — such as Greece, Italy, or Spain — are. With a more in depth analysis of theory and mechanisms, more recent examples from modern economic regimes can provide better guidance for policy.

Crosslinked from medium.