Economists’ academic work and late-night comedy rarely go together, but a few nights ago Stephen Colbert capped a string of very lively media articles and blogs with a lengthy, comical segment on the Reinhart-Rogoff affair.
How did an academic economic research paper become the subject of late-night comedy? Back in 2010 Harvard economists Kenneth Rogoff and Carmen Reinhart (hereafter “RR”) published a paper on the relationship between public debt and economic growth. The paper quickly became very influential in policy-making circles, concluding that there seemed to be a correlation between countries with public debt levels above 90% of GDP and significant decreases in GDP growth. But last month economists Herndon, Ash and Pollin (“HAP”) uncovered an Excel spreadsheet error in RR’s original analysis that unleashed a firestorm of criticism of the paper’s original conclusions.
Given that RR’s work has been one of the most quoted pieces of economic analysis in recent memory, the controversy is attracting unusual media and political attention. The paper has played a central role in the ongoing debate around austerity and the best way to conduct fiscal policy in a persistently low-growth environment.
Instead of dissecting RR’s original work, I’d like to highlight three lessons for investors watching the debate and asking how it may influence their investment decisions.
1. Beware of simple rules of thumb
One of the key attractions of RR’s original analysis was the apparent simplicity of the results, including the 90% “threshold” of debt-to-GDP as a way of evaluating a country’s economic health and future prospects.
It is of note that the 90% threshold was an estimate subject to both statistical error as well a wide range of possible interpretations. [1] But it has not been uncommon over the last three years to see this “rule of thumb” applied by many investors as a simple way of accounting for public debt in their investment decision-making process. A cursory look at the data shows that whatever the general relationship may be between public debt and economic growth, the specifics in each case can be quite different from the average.
To illustrate, consider the case of Germany, the United States and Spain shown in the charts below [2]. Spain entered the financial crisis period with the lowest public debt burden of the three countries, but it has also suffered the worst growth decline and equity market performance of this small group. In contrast, the United States has showed the best performance in terms of equity-market returns and has experienced economic growth close to that of Germany. This is notwithstanding of the fact that it has the highest public debt burden of the three countries.
