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Austerity on trial in Tokyo

Austerity on trial in Tokyo

Experiment begins with approval of Japan’s bold stimulus policies

Reinhart and Rogoff debacle gives impetus to turning tide

by Trevor Greetham, Advisory Board

Tue 23 Apr 2013

The revelation of some sloppy analysis by austerity academics Carmen Reinhart and Kenneth Rogoff has thrown open the old division between the US administration and Europe over the wisdom of front-loaded spending cuts. The G20 discussion at the weekend apparently focused more on this difference in attitude than on Japan's leap-frog to top stimulus nation and the concomitant devaluation of the yen. Events in Japan may yet settle the debate. If the Abe government succeeds in borrowing its way out of debt the policy world will be turned upside down.

Reinhart and Rogoff's book 'This Time is Different' famously concluded that high levels of government debt are a cause of significantly weaker GDP growth. By implication they suggested a tipping point could be reached in which an economy falls into a spiral of ever weaker growth and higher debt until the markets force it into default. Politicians in Europe have used this finding to support a single-minded focus on upfront spending cuts and tax rises.

It turns out there were some serious analytical shortcomings. Key errors included a failure to include all of the countries in the calculation of average growth, a simple Excel spreadsheet error spotted by a student, an averaging approach that gave too much weight to brief episodes in tiny countries and a simplistic grouping into cohorts that resulted in the much quoted 90% excessive debt threshold. This figure is often cited as a hard limit before negative dynamics set in, but it turns out to be a product of the three broad groupings they used: 0-30% debt, 30-60% and 90%+.

After necessary corrections, the drop in the future growth outturn they observed at high levels of public debt was no longer statistically significant. The most important implication of this is that it adds weight to rival economist Paul Krugman's assertion that the causality between debt and economic weakness is in the opposite direction. It seems natural that a large state causes crowding out of the private sector and an increased vulnerability to economic shocks and this is why Reinhart and Rogoff were not surprised by their original findings. However, statistical analysis shows a far stronger causal relationship the other way around and for obvious reasons. A weak trend of growth, for whatever reason, causes government debt to rise as tax revenues drop relative to the less flexible government outlays.

History may eventually conclude that European attempts to cut government debt since the financial crisis actually caused it to rise. Past periods of fiscal retrenchment, for example in the UK under Margaret Thatcher in the early 1980s, saw monetary policy ease to offset the negative economic impact of spending cuts. The key thing today is that many major economies have interest rates stuck at the zero lower bound and a private sector trying to pay down debt. Quantitative easing has had mixed results. The only effective stimulus may be fiscal.
Japan's two lost decades offer a case study of what can go wrong. But Japan may also show the world a way out of the debt trap. Since their property and stock market bubble burst in 1990 it has been weak growth more than failed stimulus that has seen the public debt burden spiral to more than 200% of GDP. It will be of great importance to watch what happens in Japan over the next few years. If, contrary to conventional wisdom, fiscal stimulus leads to economic recovery and a fall in public debt then by implication Europe's austerity could be shown to be the problem, not the solution.

Trevor Greetham is Director of Asset Allocation, Fidelity Worldwide Investment and a member of the OMFIF Advisory Board.

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