Mike Callaghan is Director of the Lowy Institute's G20 Studies Centre.
The controversy over mistakes in a research paper by Harvard Professors Carmen Reinhart and Kenneth Rogoff is a sad indictment on the state of the public debate on economic policy.
Reinhart & Rogoff's work was never the sole justification for single-minded fiscal austerity, nor should their mistakes now be seen as undermining support for fiscal consolidation. Yet Reinhart & Rogoff's research is being discussed as if their work alone turns global economic policy. It is akin to those who seek to summarise policy choices into catch phrases, such as 'growth versus austerity' or 'currency wars.'
Perhaps it is the rise of Twitter that has contributed to people increasingly communicating in headlines, wanting to summarise nuanced policy debates into black and white. But it also reflects the desire to have an academic study remove the need to make complex and difficult policy choices. As Hugh Jorgensen points out, there is no magic cut-off level of debt to GDP. There never was. It depends on the circumstances facing the country.
Oliver Blanchard at the IMF has pointed out that at the start of the crisis, the median public debt to GDP ratio in advanced economies was about 60%. By the end of 2012, it was close to 100%. One of the lessons from the crisis is that macroeconomic shocks can seriously undermine what was previously considered a sustainable fiscal position. And as we have seen, the ratio of official debt to GDP can hide some very large contingent liabilities. Hence Blanchard concludes that more comprehensive measures of what constitutes public debt may be required, as well as a lowering of what is considered to be a 'prudent' ratio of public debt. It is not a simple issue that can be captured in a single debt ratio.
Moreover, what constitutes a sensible level of public debt to GDP will depend on interest rate levels. Very high interest rates can make even low levels of public debt unsustainable. [fold]
The pressing issue confronting most advanced economies is not a cut-off point for public debt levels, but where their debt to GDP ratios are heading. The concern over US debt was not that it had reached a magic danger zone, but that on current policy settings it was continuing to expand indefinitely. At some point it would inevitably reach the level where investors would say 'enough is enough', and risk premiums and interest rates would rise. But no one knows what that level is; it all depends on the circumstances.
What is clear —and this is recognised by most critics of Reinhart and Rogoff — is that advanced countries have to reduce their debt to GDP levels. But at what rate should public debt be reduced?
Countries need to have fiscal policy settings that support growth as much as possible in the short term, including perhaps with further stimulus, while at the same time reassuring markets that a credible consolidation plan exists and will bring debt back to more prudent levels in the long term. Debt has to be financed. If markets start to question the sustainability of a country's debt levels, they will require a higher interest rate to finance the debt. If confidence is totally lost, a country will be cut off from markets. To restore confidence, countries may be forced into a faster pace of fiscal consolidation, regardless of the impact on activity. So the existence of credible, medium-term consolidation plans is important in order to maintain market confidence and in turn the ability of countries to control the pace of their fiscal consolidation.
Another consequence of the trend to reduce the public policy debate into catch phrases is that only one policy area is considered at a time. At one point the focus is on fiscal policy, at another time the flavour of the moment is the consequences of unorthodox monetary policy settings and concern over currency wars. What is missing is a debate on the comprehensive policy package needed to strengthen public finances, restore growth and create jobs.
This will require appropriately timed fiscal consolidation efforts that support growth while ensuring that debt levels are reduced to more prudent levels in the long term, accommodative monetary policy tailored to each country's circumstances, and most importantly, structural reforms that liberalise product and labour market, promote competition and encourage new sources of demand.
But is hard to break this down into a catch phrase or a headline.
Image by Flickr user eldh.