of the most ridiculous moments in modern British economic history was when 364 economists wrote a letter to The Times slamming Margaret Thatcher’s economic policies. The year was 1981, and she was desperately trying to get rid of extreme inflation, to sort out the public finances and deal with a nasty recession.
Her strategy wasn’t entirely right, and could have been improved, but it ended up working and the economy eventually roared back to growth. But the 364 economists – which included the likes of Sir Mervyn King – didn’t see that. They were hardline Keynesians, and their model of the way the world worked simply couldn’t accept that Thatcher’s seemingly mad policies could possibly be best.
Reading the IMF’s latest lament about the British economy last night – and its increasingly shrill call for the government to slow down its austerity programme – reminded me of that earlier battle. The IMF’s take on the economy is almost as wrong as that of the 364 economists in their day, in my view. Its guesstimates should not be taken seriously. Traditional macroeconomics, with its spuriously precise output gaps, excessive aggregation, ridiculously naive view that tough decisions can realistically be delayed by real world politicians until the “optimal” moment, simplistic approach to the structure of capital and belief in the possibility of endless demand-management is no longer that useful. We need new models and a new framework.
Far more problematic for supporters of austerity was a paper by Thomas Herndon, Michael Ash and Robert Pollin which yesterday attacked research on the effect that public debt has on growth by Harvard’s Carmen Reinhart and Kenneth Rogoff. This research is hardly the main reason why many of us support reducing the deficit, but it has been extensively cited by the chancellor, as well as in this column. Herndon and colleagues claim to have found a basic Excel error in the paper, and also question some of the choices of data, at the very least casting severe doubt on the findings. A few hours later, the authors hit back: while they failed to respond to all of the issues, they argued that their critics don’t actually disagree that higher debt is bad for growth. They also cite some of their own subsequent research, together with Vincent Reinhart, which shows that episodes when the national debt is over 90 per cent of GDP for five years or more are associated with 1.2 per cent lower growth.
But even if Reinhart and Rogoff’s original work is no longer useful – we will have to allow the dust to settle on the academic row before being sure – others have come to the same conclusions. Stephen G Cecchetti, M S Mohanty and Fabrizio Zampolli’s The Real Effects of Debt, published in September 2011 by the Bank of International Settlements, analyses OECD countries between 1980 and 2010. It also finds that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85 per cent of GDP; for corporate debt it is 90 per cent of GDP and for household debt it is also around 85 per cent. “The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems,” the authors argue.
There is also an extensive literature that shows that elevated levels of public spending (consumption expenditure, not capex) and elevated levels of tax as a share of GDP are bad for growth. The bottom line is clear: don’t listen to those who argue that we can go on borrowing vast amounts at no risk to the economy.
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