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Tuesday, April 30, 2013

Basic Economic Theory Over Mindless Empiricism

A couple of years back, to be precise in May 2010, Prof. Carmen Reinhart and Prof. Kenneth Rogoff of Harvard University, analyzing time-series data on central government debt, inflation and growth from 44 countries, spanning up to 200 years, published a paper—“Growth in a Time of Debt”—stating that nations, be they developed or developing, that had a debt to Gross Domestic Product greater than 90 per cent are in danger of witnessing a fall in their average growth rate by about one percentage point. They also stated: “Seldom do countries grow their way out of debts.” Therefore, they “suggest that traditional debt management issues should be at the forefront of public policy concerns.”

The findings of Reinhart and Rogoff are of paramount importance to policy makers, particularly in the context of post-global economic crisis, when countries were debating whether to spend more to give a stimulus to their sagging economies to grow or to observe austerity. Their findings had indeed, provided further support to the demand for austerity made earlier by the study of Albert Alesina and Silvia Ardagna, the validity of which was, of course, questioned in 2010 by the findings of a study carried out by IMF.  

Nevertheless, the findings of Reinhart and Rogoff came handy to the ‘austerians’—who are known for their strong belief that fiscal policy has no role in stimulating growth in real GDP; wages are more flexible and likely to adjust downwards to prevent real wage unemployment; and therefore money supply must be controlled even if required by imposing spending cuts, to keep the inflation low—to beat the Keynesians like Paul Krugman who have been all along demanding more of government spending, ignoring even the widening fiscal deficit, as a stimulation to kick-start the economy out of  recession trap and create employment. 

Indeed, Keynesians argue that in a recession, people tend to respond to the threat of fall in employment by saving more, which means a fall in aggregate demand and a bigger fall in GDP. It is to obviate this paradox, Keynesians advocate expansionary fiscal policy. Yet, the so-called elite of the market economy, citing the paper of Reinhart and Rogoff, insist that fiscal policy has no role in stimulating growth in real GDP and hence hammer the policy makers to rein in fiscal deficit. In the process, the policy makers of the US could not go all out in stimulating growth and in turn employment, for at least, that is what the Keynesians cried for during the last two years and are continuing to shout at Federal government demanding more action for creating employment.

Interestingly, as this tussle is on, Thomas Herndon, Michael Ash and Robert Pollin of the University of Massachusetts came up with a publication in the first week of this month, stating that Reinhart and Rogoff committed a simple miscalculation and data exclusion, the correction of which, when effected, gave an altogether different result to them: the average growth in GDP of high debt countries is not negative as claimed by the original study of Reinhart and Rogoff, but would be 2.2 per cent. Thus, the whole understanding of the role of expansionary fiscal deficit in stimulating growth is reversed.

Obviously, this has generated heated debate across the countries among academicians and politicians. There have been accusations that Reinhart and Rogoff, by virtue of “selective exclusion” of relevant data and by “unconventional weighting of summary statistics”, committed a serious error, though it “served as an intellectual bulwark in support of austerity politics.” Though Reinhart and Rogoff admitted calculation error, they have strongly disputed the accusations, stating that whatever thy might have said to policy makers was based on their “entire experience and knowledge of the literature, never just on our own work.”  

That said, we must admit that such omissions and commissions do happen in archival research when a huge chunk of data is crunched by the research assistants in Excel sheets. Even otherwise, in the field of social sciences, it is quite difficult to establish the cause-and-effect relationships between variables, as many variables can affect the situation, and the scope of their replicability is all the more difficult owing to the researcher’s inability to keep all other intervening variables constant or to control them. Secondly, seldom does any researcher from social sciences try to replicate others’ findings.

Against this backdrop, the effort of the graduate student of MIT, Thomas Herndon, who tried to replicate the study of Reinhart and Rogoff, is highly laudable. Equal credit must also be given to Reinhart and Rogoff for willingly cooperating with the graduate student, who questioned the validity of their findings, by making the original data they have used available to the student for further scrutiny that resulted in the very reversal of their findings.

Now, the big question that really matters is: What does this whole episode teach us? One answer could be: policy makers, ignoring the basic economic theory, should not overly rely on mindless empiricism while dealing with real-life economic situations, which are unique by themselves. Academic studies apart, commonsense cannot be sacrificed, for commonsense says that when economy is depressed and unemployment is rampant all around, people resort to cutting their spending further, as a result of which there would be a fall in the income as a whole for the economy. This leads to a plunge in employment. This in turn perpetuates depression in the economy, as is now being experienced by countries like Greece, Spain, Portugal and the US. So, it calls for the governments to resort to above-normal spending to sustain the economy till private investment flows in. In fact, government spending through deficit financing will not in any way affect private investment, but will only put unemployed resources to work. It thus generates additional income. This in turn raises aggregate demand in the economy, which in turn stimulates private investment. Once private investment starts taking effect, the economy automatically jumps out of recession. Then, the government can withdraw from above-normal spending and move towards reducing its fiscal deficit.

Here, it is important to note that above-normal government spending and larger budget deficits are not a prescription for all times. It is only when the economy is in depression that one should undertake such off-the-beaten-track measures. Now that the intellectual argument for austerity has lost its credibility, one hopes that the governments, particularly of the Euro countries and the US, might do something soon to kick the world economy out of depression.


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