Has Sequestration Saved the U.S. Economy?

There's a Jamaican saying, "the higher the monkey climbs up the tree, the more his butt is exposed."

The point being that the more we rise, the more vulnerable we become.

That has truly come to pass for a pair of superstars of the dismal science. And it could have a big impact on how successfully (or unsuccessfully) we can get the U.S. economy back on the rails.

Well Up a Tree

You rarely think about economists as celebrities. And that's likely because most of the things they talk about aren't subjects that beg celebrity status.

But a pair of Harvard economists has been stuck in the spotlight again, this time for all the wrong reasons.

Carmen Reinhart and Kenneth Rogoff's 2010 paper "Growth in a Time of Debt" showed that growth rates collapsed in countries whose public debt to GDP ratio rose above 90%. This enforced the notion that you can't borrow your way out of recession; austerity had a crucial place in facing weak economic conditions.

This had huge financial and political implications, especially as the country tried to unmire itself from a financial and economic train wreck. There was evidence that austerity was the only way to get back on track and stimulus was the road to ruination.

Then last week it was announced that there was a spreadsheet error in their research - five countries had been left out of their sample accidentally.

The oversight didn't invalidate their conclusion, but it's been used by stimulus proponents to claim that austerity isn't the cure it was thought to be and to push for more state spending.

Given where that spending will lead, the Reinhart/Rogoff fat finger blunder must surely qualify as the most expensive spreadsheet error in world history.

The Price of Fame

Reinhart and Rogoff had made their names by their 2008 book "This Time It's Different," an excellent study of financial crashes through history that was superbly timed to catch the bewilderment of the political class following the 2008 crash.

This helped get their 2010 paper a receptive audience. It seemed to show a sharp dividing line at a 90% public debt to GDP ratio; if debt levels rose above that line, the average growth rate turned negative.

Unfortunately, with the extra five observations included, the negative growth rate was replaced with modest positive growth. There was still a strong correlation between high public debt levels and lousy growth, but there wasn't a sharp dividing line at which growth disappeared altogether.

But the Reinhart/Rogoff research should not have been conclusive either way. With only 44 countries in their entire data set, only 20 of them "advanced," there were nowhere near enough observations for a statistical conclusion to be valid.

And even after their error was corrected, their overall conclusion that growth declines as debt increases remains true - and is fairly obvious for those who believe in free market economics. Economies cannot be expected to put up good growth rates if they are burdened by immense loads of public sector debt.

Can You Get Out of the Debt Hole?

The two greatest debt loads that have ever been conquered were both by Britain, at about 240% of GDP twice, in 1815 after the Napoleonic Wars and in 1945 after World War II.

The strategies used to overcome the debts were diametrically opposite.

After 1815, the British government of Lord Liverpool cut public spending to an infinitesimal level, balancing the budget through the rapid economic growth that became the Industrial Revolution.

In 1819, over the loud objections of Nathan Meyer Rothschild, they returned to the Gold Standard, making sterling the universal transaction currency and London the world's financial center.

The result, after an initial double-dip recession, was a boom that grew the economy rapidly, thereby reducing the debt burden to modest levels in only a couple of decades. Middle-class savers prospered as never before.

In 1945, Britain went in the opposite direction. It did little to cut public spending, instead imposing draconian levels of tax on the populace for several decades while tolerating low interest rates and a steadily accelerating level of inflation that reached 25% in 1975.

The debt was reduced by the low interest rates and inflation, with the government basically rescuing itself at the expense of middle class savers. Growth was lousy, especially compared to other European countries.

The Reinhart/Rogoff error has been used by opponents to discredit "austerity" cuts in public spending - actually there has been very little austerity, only some moderation. The EU Commission has announced that the whole austerity approach has been wrong, and Italy has formed a government committed to returning to the public spending gravy train.

What little chance there was of reining in deficits has been lost. Meanwhile, even the ECB, the last holdout against Bernankeism, is hinting that it will cut interest rates further from the current 0.75%, while the U.S., Japan and Britain are all committed to further money printing.

This will not end well, and its ending will be far more painful than the modest "austerity" that is now being abandoned (incidentally I regard the U.S. sequester as by far the best stroke of economic policy since the 1996 welfare reform, since it has forced genuine spending cuts to be made, albeit modest ones).

Higher spending will come, and will be financed by ever-larger doses of "quantitative easing" by the world's central banks. Thus the Reinhart/Rogoff spreadsheet error, by providing an excuse for abandoning the last vestiges of common sense, will prove hugely expensive.

Stick with the Midas Metal

As for individual investors, there's one clear recommendation: Gold.

Don't believe the hype about the recent gold crash, which was the result of mindless market panic abetted by massive gold-bear commentary from the media (and maybe some sneaky central bank dumping by Bernanke and his chums).

Gold is already recovering from that crash, and with today's crazed policies being intensified rather than modified, it has a lot further to go. And in my next article I'll be talking about how to take advantage of this bargain sector.

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