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Nikos Chrysoloras: Eurozone is lost in econometrics

According to the final figures released by Eurostat, public debt in the Eurozone reached 90,6% of GDP in 2012. On the other hand, the Commissions’ winter economic report anticipates that the GDP of the Eurozone will shrink approximately by 0,3% this year. Incidentally, this picture is totally in accordance with an academic study by professors Carmen Reinhart (University of Maryland) and Kenneth Rogoff (Harvard University), namely “Growth in a Time of Debt”, which had “proven” that when public debt exceeds the threshold of 90%, the consequences in countries’ economic development are dramatic. More specifically, the study of Reinhart and Rogoff compares the growth figures in 44 countries over the last 200 years and correlates them to the rate of debt of each country. They conclude that when public debt exceeds 90% of GDP, then the average growth rate falls from +3% to -0,1%.

However, we are now certain that the current conformity of Reinhart and Rogoff’s projections with the situation in the Eurozone is coincidental. As demonstrated in a recent work by academics Thomas Herndon, Robert Poli and Michael Ash, in their article, published in 2010, their colleagues had made clumsy mathematical errors in their calculations, especially for the period after World War II. The truth is that, according to historical data, high debt reduces growth to 2,2% and not to -0,1%. Indeed, in the first decade of the 21st century, countries with a higher debt developed more rapidly. Even Reinhart and Rogoff admitted that they had made “Excel coding errors”. According to their critics, the researchers arbitrarily failed to take into account, in their comparative study, the years when high debt and positive growth rates were noticed. As Reinhart and Rogoff acknowledged in an article in the New York Times, their conclusions regarding the period after WWII were based on a computational error. Additionally, the threshold of 90% is essentially random, since the authors classified the debt of countries in specific categories: 0-30%, 30-60%, 60-90%, and so on. Had the classification been different, e.g. 61,3-91,3%, then the threshold would also have been different. Finally, the critics of Reinhart and Rogoff stress that no clear causal relationship arises between high debt and low growth. In fact, the truth may lie in the opposite direction, i.e. low growth rates lead to high debt. In their article in the NYT, Reinhart and Rogoff argue that the causal relationship between debt and growth is bidirectional, depending on the occasion. This is a crucial clarification with implications for policy makers.

The methodological failures and refutation of an academic work would not be as significant, had it not been used as extensively as a point of reference by the European Commission, in light of justifying the implementation of drastic austerity measures throughout the Eurozone. The argument suggested that high debt nullifies growth, whereas zero growth has negative implications not only for unemployment, but also for social cohesion. The vice president of the Commission, Olli Rehn, in charge of economic and monetary affairs, has repeatedly quoted the “serious academic literature”, according to which the threshold of 90% of public debt is a catalyst for growth and hence for unemployment. For instance, in an interview with the newspaper “Kathimerini,” last November, Mr. Rehn stated -word by word- that “fiscal consolidation in the Eurozone should continue, because we have exceeded the threshold of 90% of debt, which has been found to negatively influence development,” essentially referring to the work in question. When he was asked last week to comment on the invalidation of the arguments put forward by Reinhart and Rogoff, Mr. Rehn answered that “we have cited this study in the past as illustrative, but let’s be clear that we do not design our policies on the basis of any single piece of research. We design our policies on the basis of a holistic assessment drawing on a wealth of studies – but also of course on our own analyses… Our main objective in Europe is sustainable development, and to achieve this we are working on three fronts: a) structural reforms aimed at enhancing competitiveness and creating jobs; b) consolidation of financial sector, in order to restore credit in the economy; c) consistent fiscal adjustment, according to each country’s needs. The crisis is a result of the fact that many European countries have reached unsustainable levels of debt, either private or public, or both in some cases”.

Despite this folding, it is certain that the degradation of the controversial research leaves the Directorate General for Economic and Monetary Affairs exposed, for the second time in a few months, after the tumult caused regarding the incorrect calculation of the effects of fiscal multipliers in implementing austerity measures (the so called “IMF error”). Undoubtedly, Mr. Rehn committed a misdemeanor by trying to provide a “scientific basis” for what was politically feasible. For example, it is certain that, if it had been possible for Greece to secure, right from the beginning, three times more money from its partners for its adjustment programme, the pace of deficit reduction would have been slower and its effects on development smaller. The time and money that a country subject to a “Memorandum” possesses are decided by the other member-states of the Eurozone – not by the Commission. However, for reasons that remain unknown, Mr. Rehn does not claim that the Commission is “doing everything possible” given the resources available, but rather that it is trying to “fit” the Programmes within the principles of economic theory. As a result, Mr. Rehn (and not, for example, the German finance minister Wolfgang Schäuble) has become the main recipient of attacks by Keynesian economists, such as Nobel laureate and columnist of the NYT, Paul Krugman. Something similar is also happening at the moment in Cyprus, where the Commission, despite its serious objections with regard not only to the choice of “haircut” of deposits, but also to the resources available by the Cyprus Memorandum, has decided to vigorously defend the agreement of the Eurogroup. It is certain that the choice of Mr. Rehn to adopt the role of “breakwater” of the Eurozone will weaken him in political terms, making him a scapegoat for decisions made by others, specifically, by the Eurogroup.

The second conclusion from the case of Reinhart and Rogoff is that, once again, the attempt of economists to make clear predictions about the future has proven futile. Although the science of economics is being constantly exposed, academics insist on mathematizing and formulating hypotheses, such as “if X, then Y,” with strict causal relationships. A similar “hubris” is also apparent on the other side, as Keynesian economists who write in the international press tend to systematically “simplify and exaggerate,” by presenting the increase in public spending as automatically connected with development. All other factors that contribute to the growth of GDP, such as productivity, competitiveness, market confidence, the international economic environment, the business friendliness of each country’s legal framework, are relegated as secondary in literature. It is worth reminding that, during the interwar period, the U.S. economy did not come out of recession when it increased its public expenditure, in the context of the “New Deal,” but rather when Japan attacked Pearl Harbor…

At this conjuncture, however, the academic and epistemological debate will be once again politicised. For example, most people will overlook the fact that Poli and Ash, who are responsible for exposing the mathematical error of their colleagues, have pointed out in their article in the Financial Times that they are not in favor of irresponsible spending of public resources and excessive borrowing. In fact, the only example they cite as successful use of budgetary margins to promote development is that of the U.S.A., i.e. the world’s largest economy, which was in a much better fiscal situation than Greece or Portugal before the crisis started, and which has the exclusive privilege to print the world’s reserve currency. Any comparisons with Greece, then, are as misguided as those recommendations calling our country to follow the example of Argentina, i.e. a net exporter of raw materials which had its own currency and simply depreciated it. The sad truth is that Greece was a small and bankrupt country which, by the time that the crisis started, had a deficit of 15,6% and public debt that amounted to 127% of GDP. Therefore, it was not able to follow “expansionary fiscal policy”.

Perhaps the only positive outcome of the dispute over the contested academic research for the policy of the Eurozone, is the fact that it will strengthen the arguments of those who support that the rate of adaption should respond to the economic conditions, although fiscal consolidation is necessary for the confidence of markets and hence for growth. Indications of the formulation of a new consensus in the Eurozone towards this direction are already multiplying. Notably, the president of the Commission, Jose Manuel Barroso, stressed in his address to the annual meeting of all think-tanks in Brussels (Think Tank Dialogue), that the existing policies have reached their limits and austerity alone is not enough, but rather short-term measures to assist growth are necessary. Mr. Barroso added that the European Commission has proposed an extension of the timetables for deficit reduction for many EU countries, whereas he intends to propose similar flexibility for other countries as well. He clarified, however, that final decisions concerning the Eurozone are made by the Eurogroup. Besides, according to the data presented yesterday by Eurostat, fiscal adjustment has been achieved to a large extent, considering that deficit in the Eurozone was 3,7% in 2012, very close to the limit set by the Maastricht Treaty. By the end of 2013, the deficit of the Eurozone will be reduced to 3%, according to current projections. Adjustment has been ultimately achieved. The next big question facing the Eurozone is how to achieve growth. Given the explosive rates of unemployment, the time that European leaders have in order to respond is rather limited…