Has Sequestration Saved the U.S. Economy?

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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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  1. Will MacPheat | May 1, 2013

    The author seems to have the standard conservative view that the only way to reduce debt is to reduce spending, but blindly fails to even admit that examining revenue is even a possibility. The reason why our economy is in the sad state it is is because the lower and middle classes have less and less of the economic pie. They thus do not have the money to purchase the goods and services that drive the economy. When the little fish starve, the big fish starve, too, it just takes longer. What separates an economy from a pyramid scheme is that in an economy there are two ways for money to move from the top of the pyramid back down to the bottom. One, is increased wages and benefits by employers (job creators). The rich have always been reluctant to do this. The other method is increases taxes to those at the top, with corresponding social programs for those at the bottom. Those ARE the two choices. One is capitistic, one socialistic. We try to choose neither and will be doomed to economic failure as long as we do so.
    The author seems to have the

    • Mary Donohue | May 1, 2013

      I agree with your common-sense statements, Will MacPheat. In a 70 percent consumer-driven economy, consumers need the ability to purchases goods and services. This means a focus on returning to policies that encourage growth within our borders.

      Historically, our country thrived under progressive tax structures under which employers reduced their tax liabilities via investing within our borders, including increased wages and benefits that empower employees to spur economic growth.

  2. Curtis Edmark | May 1, 2013

    In the face of all this, the stock market has reached new highs. How? Retirees who need fixed income have abandoned their fixed income investment due to low yields for higher risk / higher return investments.

  3. Archy | May 1, 2013

    To address the title's question: That's a silly question – of course it hasn't.

  4. PHIL@STEINSCHNEIDER.COM | May 1, 2013

    Mr. Hutchinson,

    As always, you hit the nail right on the head. I need to make a few comments, however.

    First, the Personal Responsibility and Work Opportunity of Act of 1996 may appear to have been a great idea, but in reality, it seems to have pushed an enormous amount of people onto the Social Security Disability roles, which is precipitating the approaching day of insolvency for the entire Social Security system.

    Frankly, I've capitulated. I think it very noble that people continue fighting to do the right thing, but it's an uphill battle. By not allowing the Keynesians to have their way, we're simply keeping the entire debate alive.

    Instead, we should all become Keynesians now. In this way, shamans like Paul Krugman and other celebrity "Stimulustrians" would be allowed to own the outcome of their pseudo-religious money-printing cults. In fighting against their dogma of economic painlessness, aren't we, as perceived iconoclasts, simply helping to prop up their arguments? By throwing in the towel and allowing these people to have their way, we can plan for the eventual currency collapse, invest for it, and profit from the inevitable endgame.

    In the meantime, we're simply blocking the path of "progress." It's time we got out of the way, like Sisyphus giving up on the boulder, and let the damn thing roll all the way down the hill. Only then will the Austerians have a chance of being vindicated.

    I personally believe that even the Stimulustrians will suddenly become more conservative if Austerians step aside. After all, no one could be stupid enough to sincerely believe that unbridled money-printing will solve a country's debt problems—or are they? Let's find out.

    • Paul De Lange | May 1, 2013

      Exactly what the US needs right now is a currency collapse. Most export driven countries has consistently manipulated their currencies to be relatively weak compared to the USD because it gives them a competitive advantage for various reasons. But a stronger currency is also the result of the success and strength of the US economy.

      The latest massive Japanese stimulus is designed to give Japan a weak yen again, but the ECB, the FED and many others are doing the same thing. The only way out of this long term destructive fight is to take currency manipulation out of the equation for competitive economic advantage. End Result: one world currency to which everybody subscribe and adhere to. But we are not there by a long shot.

  5. John Duggar | May 1, 2013

    Actually, Martin, the quote is "The higher the monkey climbs, the more we see of his behind"–much more poetic, without diminishing the message!

  6. Nathaniel Lawson | May 1, 2013

    Richard (Dick) Cheney, that famous economist once publically said, deficits didn't matter". It's amazing I purposely paid off all debt, credit cards, signature loans and car loans and my overall credit rating dropped. Because I didn't have any outstanding charges my credit card utilization dropped from an "A" rating to a "C" rating according to Transunion. Go figure…

    • DD | May 1, 2013

      Just goes to show what a load BS this all is! Your credit rating should be in the 800s providing you have no debt and pay utility bills or such like on time. Something very wrong with this picture!

  7. Neil | May 1, 2013

    '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.'

    The British government did not grow the Industrial Revolution; it evolved through the drive and entrepreneurship of individuals free to exercise their skills and energy through untrammeled capitalism, turning Britain into an industrial power. Governments do not grow economies.

    '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.'

    What about the massive US aid received by Britain after the war, aid which it chose to squander on social welfare and founding the entitlement culture which besets it today. Interest rates are beyond the control of governments, sooner or later the real cost of money always asserts itself.

    • Walter Baltzley | May 1, 2013

      Do not forget to account for new sources of CHEAP ENERGY…namely coal for steam power. Economic growth is driven by ENERGY

  8. Bill Brown | May 1, 2013

    Carmen Reinhart and Kenneth Rogoff's 2010 paper "Growth in a Time of Debt" has been discredited. It was not submitted for peer review and the reason is now known. They "cooked the books". They sent the Excel spreadsheet to PhD graduate student who discovered both major mistakes in the formulas and that they excluded 3 countries that did not support their conclusion. Once you fix the problems, growth still exist at these high debt levels.

  9. Leslie Belden | May 1, 2013

    The author doesn't have merely the "standard conservative" view that reducing spending will reduce debt. I see the same thing he does, and I'm looking at it from the Marxist materialist view: if it doesn't work, it isn't good.

    Even a devout but clear thinking collectivist who doesn't want to go back to laissez faire capitalism knows better than to go back to laissez faire central planning, and the Fed is Central Planning, on steroids, as the saying goes. At the very least, liberals and conservatives need to go back to the drawing board, because the commonwealth is not being served by their leviathan debt torqueing.

    But they can't see the monkey's butt, because their heads are up it. That's where they go to look at their portfolios, which would collapse if the spending stopped.

    My only complaint with Mr. Hutchinson's article is that I believe the British debt of the seventies was not cured "with low interest rates and inflation," or with US aid, but with North Sea oil. As for the rest of it, I've read other articles about the "error" and this one is the only one that indicates a grasp of what it actually was.

    As for the lack of peer review, and I'm not saying I think there was any lack, perhaps Reinhart and Rogoff bypassed their ideologue peers with portfolios, because they knew the universities only consider papers they can get on their PC apps.

    • Walter Baltzley | May 1, 2013

      "I believe the British debt of the seventies was not cured 'with low interest rates and inflation', or with US aid, but with North Sea Oil…" BAM!! Hit the nail square on the head. Economic growth is driven by ABUNDANT, CHEAP ENERGY.

  10. Leslie Belden | May 1, 2013

    @ Bill Brown–do you really want to go there? I mean Reinhart and Rogoff cooking the books as a defense for QE and the Fed's statistics on "growth," and unemployment? How about fractional reserve banking, and the fact that the EDP gets pumped up by debts being traded as "equities," and the bank commissioners (employees of the banks) deciding that those "equities" should be considered "capital" in the indefensibly little bit of liquidity the banks have?

  11. Paul De Lange | May 1, 2013

    Well said! But there is one component missing. Not only will massive government debt (which in reality is collective country debt) cause growth to collapse but couple this with massive private debt and the result will be even more troubling. When government on all levels and private citizens run out of money to spend due to high debt loads an economic collapse is all but inevitable. Whether it is at 89% or 90% or 95% or 110% does not really matter. The point is that at some stage the debt becomes unmanageable and when you reach that stage it is too late. Ask the Greeks. Only massive debt write offs and subsequent fall out will cure the problem. Whether it is by forced bankruptcy or by defaulting (Iceland) or voluntary assumed haircuts (ask the European banks about how they "voluntarily" did this), forced austerity is the name of the game.

    At this stage the Fed is pumping money and keeping interest rate artificially low. If having to have super low interest rates is not an indication of severe financial stress nothing is. If the Fed buying most of the Treasury's bonds (one arm of government buying another arm of the government's debt) because nobody else will, is not an indication of severe financial stress I don't know what a flashing red light is.

    Lets reduce this argument to a simple truth and only use one person as an example. It works just as well if you multiply this to millions of people and governments.

    If a person start making debt he can afford to do so and he will even prosper. If he continues to take on debt the interest payments continue to creep up and those payments take an ever increasing slice of his income until the interest burden becomes so large that he starts to struggle to make interest payments and maintain his standard of living. It is at this stage that the red lights should start to flash. Exactly where that level is, is debatable. (Krugman debate) and not at all clear cut. Much depend on the existing interest rate level, the amount of the debt, the income of the person and the standard of living.

    A wise guy will sit down and take stock of what needs to be done. A wise guy will voluntarily assume some responsibility, cut back on luxuries and bring down his debt to a level where he can again afford it. Or even better try to get debt free.

    A dumb guy or reckless guy will put his head in the sand and hope for the best. He will try all the tricks in the book to maintain his spending and lifestyle because he is entitled to a good life. He will begin to juggle debts and refinance ever so often, getting in deeper and deeper. He will blame everybody else for his financial difficulties but he will not cut back. Heaven forbid that he loose his job. At this stage this guy must have super low interest rates to enable him to service his debts. At this stage he must have super easy revolving credit just to be able to survive. At this stage his bankers become very nervous but at the same time they have to lend him money otherwise he will not be able to repay them. He will also threaten them with non payment if they don't lend him money at favorable rates. His bankers will start shifting their loan loss risk to other people calling it AAA assets. This guy will now do anything to stay on life support. He will lie, cheat, tell half truths and deny he is in financial trouble. But alas soon he will just give up, stop paying his credit cards, have his car, house and boat repossessed, leave a huge overdraft unpaid and go on to food stamps paid for not with government income but with government borrowings.

    The big question now is at what stage does the US government and the US consumer find themselves? Because acting like the wise guy they are not. Does it really matter whether they are 90% or 100% in trouble or somewhere in that vicinity. Or do they want to insist on a precise figure and still try to push the envelope a bit more.

    Only time will tell.

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