Economist Stephen Cechetti has become a worthy nominee for the title of World’s Most Dangerous Man since taking the helm at the Bank of International Settlements (BIS). His latest piece of co-authored research (pdf) is, like most in the government debt threshold genre, world-class garbage. Don’t let the mysterious cloak of macro-econometric symbology and mathematical trappings fool you. It’s craptacular nonsense.
Unfortunately, it provides yet another club with which austerity proponents can bludgeon the world. It will be used to reinforce the shoddy inferences drawn by Carmen Reinhart and Kenneth Rogoff that are now guiding fiscal authorities the world over toward unnecessarily austere and counterproductive policies. Watch for these two memes to follow in the wake of this paper—I guarantee that they will get plenty of spin:
- Beyond 80% to 100% of GDP, government debt is bad for growth!!!
- Total non-financial debt has ”risen relentlessly” to 310% of GDP in developed economies!!!
When you hear someone repeat those, consider pointing the following out to them, or at least remind yourself:
- The authors admit that their inferred impacts are “very imprecisely estimated.”
- Like Reinhart and Rogoff, they fail to distinguish between sovereign, currency monopolist governments and all other economic sectors.
- They do not offer any sound theoretical foundation for their analysis (more on that below).
- They claim but do not even test for (much less prove!) causation.
- Like Reinhart and Rogoff, their use of impassioned prose makes it plain that this work is politically rather than academically motivated—which might explain items one through four.
The paper also provides the rather bizarre spectacle of PhD economists trying to lay out a macro framework that accounts for debt while still assuming away the significance of money (where it comes from, how it’s used, etc). Yes, Knut Wicksell may have done a similar thing 100 years ago, but he did it in order to come to a deeper understanding of money and monetary policy (and I suspect that he would be horrified by the incompetence currently on display among macroeconomists of all political stripes).
Cechetti and crew aren’t doing anything remotely like that. Instead, they’re on a political crusade that seeks to preserve cherished and nearly (nearly?) religious concepts of mainstream macroeconomists and political powers-that-be about fiscal prudence, and to impose this malformed dogma on the rest of humanity.
In laying out an extremely casual theoretical underpinning—in a way that called to mind for me a really bad, amateur garage band jam session—Cechetti and his co-authors state:
…the ability of the public sector to sustain a given level of debt depends on its ability to raise revenue or its fiscal capacity – something that could become compromised if the private sector is already highly indebted…
It’s rare that you get such a solid foundation for proclaiming the ignorance of an established, mainstream macro economist, but Cechetti and team have laid out the pad and poured the cement—so here goes.
If the world were still on a gold standard, where net new financial assets had to literally be dug out of the ground with each passing day in order to support nominal spending and saving desires, then Cechetti’s assertion might hold up. It would also hold up if new money were delivered regularly to earth by alien cargo ships, or took on some other form of manna from heaven.
But the world is not on a gold standard. And new money is not dug out of the ground or delivered unto us by mysterious outsiders (even though some people think of central bankers that way).
It is created when the Treasury deficit spends, in which case the Federal Reserve (Fed) adds newly created dollars to recipients’ accounts.
Money is sometimes created out of Fed initiatives as well, but not under its normal operating procedures (though paying interest on reserves has now added that element). Rather, the Fed adds new dollars only when it does not exchange them for an existing, monetarily equivalent financial asset.
That last one is a crucially important qualification. The Fed rarely ever adds net financial assets to the system, even though we’ve been conditioned to believe that they do by the misunderstandings that mainstream macro perpetuates regarding the money (or non-interest-bearing debt) and interest-bearing debt of a sovereign government.
Almost all of the net additions to financial assets have come about via Treasury (i.e., fiscal) deficits, and that’s true for all developed countries (save the European Monetary Union, which took design suggestions from economists like Cechetti to heart and is now reaping the whirlwind).
From a purely technical standpoint, those funds hit recipients’ accounts without the Treasury having to borrow one thin dime. And despite the shrill emanations from deficit- and debt-phobes, that doesn’t harm our children or grandchildren any more than gold mines producing gold used to. (Though granted, those who were hapless inhabitants of resource-rich colonies, worked in mines, or were exposed to the residuals of cyanide-based and other extraction technologies were most definitely impacted by gold mine production. Fortunately, today’s additions to the money stock come at a much lower social cost.)
Armed with this small bit of knowledge, one doesn’t need a PhD in economics to know that lumping sovereign governments in with other levels of government, corporations, and households when studying the economic effects of debt is just plain stupid, and a waste of resources to boot.
But mark my words—Cechetti and/or his co-authors will jet-set and hobnob with these findings, and enjoy the benefits that come to those who protect what is sacred, no matter how wrong or harmful. Perhaps my criticism is beyond the pale, but as I’ve argued previously, people in positions of power and influence over policymakers have a sacred (yes, it’s that important) duty to act in the best interests of their fellow human beings. Like some others in their profession, Cechetti and his co-authors have committed gross negligence in publishing this self-serving piece of garbage that perpetuates the economic errors and toxic policy prescriptions of our day. And it’s not quite cricket that professional liability doesn’t apply to those who advise or work in governments.
UPDATE 2011.09.07 – In far more gentlemanly fashion than me, Martin Wolf called the Reinhart-and-Rogoff-inspired debt meme into question in his Financial Times column yesterday (hat tip to Rob Parenteau):
Another noteworthy objection – grounded in the seminal work of Prof Rogoff and Carmen Reinhart of the Peterson Institute for International Economics in Washington – is that growth slows sharply once public debt exceeds 90 per cent of GDP. Yet this is a statistical relationship, not an iron law. In 1815, UK public debt was 260 per cent of GDP. What followed? The industrial revolution.
To be honest, their work was a very solid piece of data-gathering, and enjoyed an unusually powerful marketing push for its genre. But seminal? I don’t think so.
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