Govt Debt and GDP: What Came First the Chicken or the Egg?

     In the old question-the chicken or the egg?-the point is that it may not matter; it's basically unanswerable. In the case of government debt and GDP it turns out that which comes first may have huge consequences.

     We hear so much about concerns about "burgeoning government debt" that It would be natural to assume that the evidence that this is a very grave problem would be the best supported economic idea out there. Actually it turns out that the idea that if public debt gets to say 90% of GDP it's a huge problem has very little hard economic documentation. Many economists bemoan that this has been the one idea that the pundits and politicians have latched onto as it is very unsupported by any rigorous proof.

     As one economist wrote me in an email, "it is likely unpublishable in a top journal due to the fact that they have not developed any techniques to tease out causality in what are suggestive but non-conclusive correlations. For this work to be the *one* thing that politicians decide to take from economics is horrible."

      http://www.nextnewdeal.net/rortybomb/no-90-percent-debt-threshold-hasnt-been-proven

    The trouble with this 90% rule is that all it really amounts to is a correlation. If every time you see A you also see B this doesn't mean by itself that you've proven A causes B. It could be, but there are other possibilities. That B causes A or that both are dependent on another variable or it could be that both cause each other.

     There is no proof that a 90% debt level causes low GDP and it may be that causality here runs the opposite way: in a recession we see swollen deficits and debt due to automatic stabilizers, and lower revenue.

     "As John Irons and Josh Bivens of EPI noted in their review of the GITD paper (my bold):

First, the theory that governs the relation between debt and growth suggests strongly that causality runs more firmly from slower growth to higher debt loads. Slow economic growth, and especially growth that is slower than policy makers’ expectations, will lead to higher levels of debt as revenues fall and as automatic-stabilizer spending increases... Importantly, the timing matters. Persistent slow growth will yield high debt levels, and will thus mechanically yield to contemporaneous combinations of high debt and slow growth...

In short, the statistical evidence strongly suggests that the causality runs from growth to debt, and not the reverse. Given that theory and preliminary investigation agree in this case, it seems clear that the GITD analysis—which looks only at contemporaneous levels of debt and growth—is much more likely to capture causal relationships running from slow growth to high debt. This means there is very little reason for policy makers to think that there is a high-debt threshold that acts to slow growth.

 

       As to Joe Scarborough's gloss: 'Oh my God, this guy, Krugman, denies what everyone serious agrees with" it turns out that the idea that higher debt drives lower GDP has never even been peer reviewed:

      "It's always tough to figure out where consensus among economists lies. But economists don't "regard" the 90 percent mark as definitive; in fact, this study and its claim have never even been peer reviewed by an economics journal."

      What's interesting is that we keep hearing that if were not careful we'll have the 70s. Meanwhile Sumner argues that if we had the correct monetary policy in 2008-NGDPT-then we would have avoided the Great Recession and would have just had "stagflation", ie, the 70s. Mind you Sumner doesn't know what "stagflation" means.

       http://diaryofarepublicanhater.blogspot.com/2013/02/sumner-stagflation-and-econ-textbooks.html

       In fact the signs the austerity buffs always point to-high deficits and debt-weren't present in the 70s. Whatever the reason for the 70s inflation it wasn't because a debt bomb exploded.