Mainstream Macro's Employment Alongside Regime Debt Neutrality

Carmen Reinhart has written an interesting article -- "The Perils of Debt Complacency." It's involvement is in all probability non for the reasons Professor Reinhart intended. From my perspective, the article consists of a jumble of empirical observations, that comport no relation to her policy message. This allows me to infer what I recall is her theoretical framework. My justice is that she believes that authorities debt levels are "medium-term neutral" -- a technical term that I possess got only made up. (The concept may already be nether to a greater extent than or less other name, but since I am non an academic, that's non my problem.) Unfortunately for mainstream macro believers, they likewise believe inward this concept.

The Straightforward Interpretation of the Article

Since I possess got written a mass on authorities finance, it would possess got been real piece of cake to possess got the article at human face upward value, in addition to travail to ground her assertions. I believe that such an approach is pointless; a non-expert reader has no way of judging the relative importance of the diverse points, in addition to may only possess got the ascendency of a Harvard professor.

The next are what I recall are the key empirical observations that she makes inward the article.

• "I cannot read How to Pay For the War in addition to conclude that Keynes thought that high state of war debts were a “scarecrow” for the United Kingdom. In fact, the apparatus of the Bretton Woods arrangements that Keynes afterward helped to arts and crafts were designed to ease a hard transition out of debt."
• "Our query considered 26 high-debt episodes betwixt 1800 in addition to 2011, looking both at increase rates in addition to at levels of existent (inflation-adjusted) involvement rates. In 23 of these high-debt episodes, increase was lower, in addition to inward 8 increase slowed fifty-fifty every bit existent involvement rates remained nigh the same or edged lower. Japan’s debt overhang (entirely domestic currency debt), which nosotros draw dorsum to 1995, illustrates this pattern."
• "Our 2012 study identified 3 ongoing public-debt overhangs that began inward the mid-1990s – Greece, Italy, in addition to Japan. Relative to other advanced economies, these 3 economies are the worst increase performers (see chart). To endure sure, a country’s economical functioning depends on many factors. But the sentiment that it is depression increase that causes debt to rise, though of import when assessing the cyclical feedback effects, tin hardly explicate the two-decade sense of these 3 countries."
• "Skidelsky needs no reminder of the historical record, but it bears noting that to a greater extent than than a dozen advanced economies received debt relief inward ane shape or to a greater extent than or less other during the depression of the 1930s."

Anyone familiar amongst the Modern Monetary Theory literature (and my mass fits inside the Modern Monetary Theory framework, although I used to a greater extent than mainstream terminology) would forthwith betoken out that she is lumping countries that command the currency they number debt inward amongst those amongst external constraints (euro area, Gold Standard). This theoretical job has been raised innumerable times over the past times years when debating the locomote of Reinhart in addition to her co-authors; she continues to completely ignores those complaints.

Instead of chasing the tail of rebutting the interpretation of empirical observations, I volition instead follow a dissimilar tack: what does she possess got to believe inward lodge for her observations to endure coherent amongst to a greater extent than or less shape of a theoretical framework. I depict my justice below -- which likewise describes most modern mainstream ("neo-classical") thinking nigh financial policy. Since the residual of the mainstream shares these assumptions, it may endure reasonable for her to assume that these are self-evident truths that demand to endure plugged into an op ed.

To endure clear, I am using my ain definition here, in addition to this is non based on an extensive textual analysis of Professor Reinhart's article. Therefore, I am non proverb that she agrees amongst the entirety of my description of "medium-term debt neutrality." Although this mightiness endure unfair, Professor Reinhart could maybe write a theoretically coherent op ed adjacent fourth dimension then every bit to construct clean upward the interpretation.

Medium-Term Neutrality

The next is wide definition for the concept, which needs to endure tailored to your precise theoretical framework.

Definition Government debt is medium-term neutral if the authorities tin laid the (expected) grade of authorities debt [or the debt-to-GDP ratio] to whatsoever arbitrary grade over the medium term[see note], piece respecting behavioural constraints [for example, inflation target, avoiding depression, etc.] in addition to "target" economical variables volition ever converge to coherent steady province levels every bit a final result of monetary policy. The supposition is that at that topographic point are no "structural changes" to the economy.

Technical notes:

• The "medium term" is vague; if ane wants to endure to a greater extent than precise, the definition is specified inward price of a fixed horizon; that is, nosotros tin speak nigh "5-year neutrality." For example, I would usage "5-year authorities debt neutrality" every bit the "medium term." The horizon does matter; I dubiousness that the economic scheme is "5-year neutral" (as discussed below), but I am agnostic on "20-year neutrality."
• The "target economical variables" depends upon the usage. As an example, I would propose the unemployment charge per unit of measurement in addition to inflation.
• "Structural changes" would endure changes to authorities policies that are non covered past times criterion economical models; non-structural changes would changes to involvement rates, or tweaking "the" taxation charge per unit of measurement inward an aggregated model.

Influenza A virus subtype H5N1 to a greater extent than intuitive version of the definition is that the authorities tin steer the authorities debt-to-GDP grade to whatsoever grade it wishes, piece at the same fourth dimension respecting the inflation target, avoiding economical collapse, in addition to without making "structural changes" to the economy. If you lot wishing to usage to New Classical terminology (which volition brand post-Keynesians wince), inflation volition render to target, the unemployment charge per unit of measurement to NAIRU, in addition to the output gap to naught -- regardless of the path of financial policy. (This invariance is the final result of fundamental depository financial establishment stabilisation policies.)

Depending on your views nigh New Keynesian theory, such steering is essentially costless. Even if financial policy changes displace short-term changes to demand, monetary policy (and the expectations nigh monetary policy, yadda, yadda, yadda) volition start those financial policy changes. In other words, the government-debt-to-GDP ratio inward the medium term is only the final result of whims of financial policy maker, in addition to they exercise non matter. It is purely an aesthetic choice, such every bit my selection betwixt wearing a leather jacket or a lumber jacket.

Since steering authorities debt ratios does non matter, nosotros tin meet why Professor Reinhart believes that she is liberate to apply observations taken from countries amongst currency pegs to countries that possess got command over their currencies ("currency sovereigns"). To render to my previous example, whether or non I am a currency issuer has no bearing on whether I vesture a lumber jacket or a leather jacket.

Furthermore, if nosotros assume that authorities debts levels exercise non possess got a positive number on growth, reducing the debt ratio purely on precautionary grounds seems only reasonable.

Theoretical Disagreements

From a post-Keynesian viewpoint, it is real piece of cake to heighten rigid objections to medium-term authorities debt neutrality. As individual inside the post-Keynesian camp, why the concept fails is self-evident, in addition to does non demand explaining. Interested readers volition possess got to aspect inward my other writings (or elsewhere inward the literature) for to a greater extent than background.

• The private sector holds authorities debt every bit business office of the liquidity administration for their portfolios. Larger portfolios entail a larger liquidity buffer. As nosotros saw inward the early on post-war period, high holdings of authorities bonds assist stabilise the financial system. (To endure fair, this betoken relies upon coherent policy choices. The determination of the New Keynesian encephalon trust running our fundamental banks to hold policy rates below investors' required rates of render forces those investors to destabilised their portfolios. Influenza A virus subtype H5N1 mutual thread inward industrial accident reports was that disasters are caused past times operators deciding to close off automatic stabilisers.)
• Fiscal policy matters. The thought that the effective multiplier on authorities spending decisions is naught (even taking into job organisation human relationship the activeness of monetary policy) is viewed every bit self-evidently wrong.
• "You can't instruct at that topographic point from here." This is related to the previous. The determination to launch an austerity programme when the economic scheme is weak tin force the economic scheme into a near-permanent slump (for example, meet the euro periphery), which way that nosotros cannot render to the same medium-term outcome every bit the "no austerity" scenario. Mainstream models assume that the model province volition render to "equilibrium" past times at to the lowest degree the medium term. Mainstream economists do verbalize over "hysteresis," which captures this effect. However, "hysteresis" is only a fancy way of proverb "mainstream models are theoretically deficient."
• Within the post-Keynesian literature, ane tin meet statements to the number that the authorities debt grade is out of authorities command ("endogenous.") I believe that is sure truthful inward the brusque term (keeping inward heed that governments tin tweak deficits during an expansion). In the medium term, I believe that the authorities tin steer its target debt grade -- but it needs to brand structural changes inward lodge to make such an objective. The declaration that authorities debt levels are endogenous implicitly assume no such structural changes are made.

Mainstream Theory Accepts Debt Neutrality

Although private mainstream economists may brand statements that contradict medium-term debt neutrality, they are cutting against the grain of their theoretical framework. As a result, such arguments are at best confusing.

• If nosotros convey the criterion Dynamic Stochastic General Equilibrium (DSGE) from earlier the Financial Crisis (for example, Smets-Wouters), financial policy disappears completely; "Ricardian Equivalence" is invoked to explicate this. In such models, the model economic scheme is obvious neutral amongst honor to authorities debt on whatsoever fourth dimension frame.
• Even inward models which target financial policy, the debt grade does non actually matter. Take every bit an instance "Optimal Fiscal Policy." I am non an skillful on that literature, but the sole usage of authorities debt is the number of involvement payments on taxation rates inward equilibrium. Within the theory, a criterion final result is that the "optimal policy" authorities should hike taxes inward the brusque term, to drive internet authorities debt negative. (Which presumably represents the fundamental authorities hoarding private sector debt.) Such a policy would endure considered self-evidently insane past times post-Keynesian economists, in addition to frankly, most real-world politicians.
• The "zero lower bound" literature created a usage for financial policy inward DSGE models (when the policy charge per unit of measurement is stuck at zero). However, inward the medium term, it should endure possible to drive the policy charge per unit of measurement away from zero, in addition to nosotros are dorsum into the regime where authorities debt is over again neutral. 

As a result, most mainstream complaints nigh Reinhart's policy advice (which is unclear to me --- nosotros should wring our hands in addition to wail nigh the unfairness of the world?) cease upward beingness only tactical disagreements. "Sure, nosotros should trim back debt levels, but austerity right at nowadays is a bad thought because [insert reason]."

The theoretical irrelevance of authorities debt levels likewise helps explicate how attitudes towards authorities debt alter according to the political cycle.

• Democrat-leaning economists tin force for infrastructure spending when at that topographic point is a Democratic president, but yelp nigh "bond marketplace vigilantes" in addition to "debt sustainability" when a Republican president cuts taxes.
• Republican-leaning economists by in addition to large abhor anything associated amongst government, peculiarly debt, but tin excuse deficit-increasing taxation cuts past times Republican presidents on provide side grounds ("tax cuts to task creators are self-financing"). 

Since authorities debt levels exercise non affair from their theoretical perspective, such an apparent inconsistency is easily explained.

Concluding Remarks

Although it would endure piece of cake to dispute Professor Reinhart's interpretation of events, I believe it would endure to a greater extent than useful to create upward one's heed what framework makes such an interpretation reasonable. The fundamental job is that mainstream economic science refuses to convey financial policy seriously. Government debt neutrality is a rigid property; only assuming it to endure truthful is non a peculiarly "scientific" approach.

See Also:

• Understanding Government Policy

(c) Brian Romanchuk 2016