The Smart Money: Lies, damned lies, and statistics

Posted Wednesday, April 24, 2013 in Analysis

The Smart Money: Lies, damned lies, and statistics

This is a chart showing the differences between the Reinhart-Rogoff findings and the corrected findings.

by Gina Hamilton

Now, this week's column might be a little too much "inside statistics" for you, but since what happened had a huge effect on how the whole world came out of (or didn't come out of) the 2008 Great Recession, it serves as a cautionary tale that everyone really ought to know about.

There are theoretically two ways to cure a recession ... feed it or starve it.  Which you choose to do is based on a number of factors, but in general, conventional wisdom until the recent Greenspan era was that if your major problem was unemployment, you fed the recession ... that is, you went into temporary debt, stimulated the economy, and worried about the debt when your workforce was fully employed.  The Great Depression, and all the little recessions that happened from then until about 1990 were based on this model.  Once the economy was sufficiently stimulated, you could increase taxes to pay off the debt incurred, and nobody minded all that much because things were much, much better.

The other theoretical method ... and I say theoretical because although this method has been tried, it hasn't actually worked anywhere ... for ending a recession is to starve it out.  This method supposedly works when the major problem in the recession isn't unemployment, but is rather inflation, caused by a "boom and bust" cycle.  In an inflationary cycle, you need to cut spending so that government dollars aren't adding to the other dollars in the economy that are chasing too few goods.  Then, the theory goes, prices normalize, fewer businesses enter the boom cycle (adding to unemployment), but the economy turns in the direction of the skid instead of fighting it, and eventually things work out.  This led to the jobless recoveries of the 90s and 2000s.

It's not a bad idea, and it should work, it just hasn't.  No one is really sure why.

But those two ideas are at least sound and based in economic theory.  What is happening in this recession isn't sound and isn't based in any theory, and now, we discover, it's based on bad mathematics to boot.

I refer to the notion of austerity.

Although Congress hasn't been able to shove complete austerity down America's throat, owing in large measure to the fact that it seemingly can't do anything else, either, in Europe, it's another story.  Austerity ... ostensibly to bring down debt ... has led to massive unemployment in nation after nation in the eurozone, and is tipping the whole continent into Recession Part C.  How Europe got into this mess is a charming bedtime tale in and of itself, but that would take a book to explain.  The short answer is that the banks, released from regulatory oversight, made a whole lot of bad bets, and the people in the countries where the banks are based are going to be forced to pay off the markers.

Now, debt is an issue, but as we have seen in the "feed a recession" model, it tends to be a temporary problem when you can inflate your own currency and later raise taxes to cool the currency off.  Which is what the U.S. is doing in a  half-hearted way, sans the raising taxes part.  But Europe is in a funny place, because although the problems are local ... in Greece, Portugal, Cypress, and so on ... the currency isn't.  It would be like if the U.S. had to ask Canada and Mexico for permission every time we wanted to add money to the economy by increasing our debt.  And the big countries - Germany and France - don't want their currency inflated to pay for bad bank bets in other countries.

By now, surely, the big powers in Europe know that austerity will eventually come back to bite them on the rear end, too.  But it can be very difficult to admit error and try to fix the problem.

Why would anyone believe that austerity would work to cure a recession?

The answer is poor research and bad mathematics, and a sneaking suspicion that the books were cooked for ideological reasons.

Here's the story.  Back in 2010, a couple of economists,  Carmen Reinhart and Kenneth Rogoff, released a paper.  Entitled "Growth in a Time of Debt", the paper made some pretty weird leaps of logic, which, although completely unsubtantiated, were latched onto by people whose belief system was such that they didn't believe in "feeding a recession", even though that was clearly called for in this situation. 

The main finding of the paper was that "...median growth rates for countries with public debt over 90 percent of GDP are roughly one percent lower than otherwise; average (mean) growth rates are several percent lower." Countries with debt-to-GDP ratios above 90 percent have a slightly negative average growth rate, in fact.

In other words, debt ... not unemployment or inflation ... was suddenly the primary problem, even though 70 years of a growing, stable economy, even when debt was very high (many times higher than it is today as a percentage of GDP) seemed to say conclusively that the real problem in any recession was unemployment, not debt.

But that was exactly what people who yearn for a small government wanted to hear, so even though it wasn't true, that became much of the world's economic focus since the paper was released in the US and in Europe.  (China's problem is how to "starve" their recession a little bit while keeping their workers working.) Paul Ryan's "Pathway to Prosperity" budgets, part one, two, and three, are based on this erroneous notion.  The European austerity model is based on it. 

And now, three years later, someone finally got around to peer reviewing this paper, and discovered that the Reinhart and Rogoff numbers couldn't be replicated.  And finally, Reinhart and Rogoff offered to share their spreadsheets. A surprise awaited the replicating teams.

There were three main problem with the original research. First, Reinhart and Rogoff selectively excluded years of high debt and average growth. Second, they used a debatable method to weight the countries. Third, there also appeared to be a coding error that excluded high-debt and average-growth countries. All three bias in favor of their result, and without them you don't get their controversial result.

In short, austerity doesn't work to cure recessions.  It makes a recession worse, as much of Europe is learning to its sorrow.  Will Congress learn that as well? Or will ideology trump common sense?

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