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May 26, 2014

Latest Posts from Economist's View

Latest Posts from Economist's View

Paul Krugman: Europe’s Secret Success

Posted: 26 May 2014 12:24 AM PDT

Europe's social safety net is doing its job:

Europe's Secret Success , by Paul Krugman, Commentary, NY Times: ...Europe's financial and macroeconomic woes have overshadowed its remarkable, unheralded longer-term success in an area in which it used to lag: job creation.
What? You haven't heard about that? Well, that's not too surprising. European economies, France in particular, get very bad press in America. Our political discourse is dominated by reverse Robin-Hoodism — the belief that economic success depends on being nice to the rich, who won't create jobs if they are heavily taxed, and nasty to ordinary workers, who won't accept jobs unless they have no alternative. And according to this ideology, Europe — with its high taxes and generous welfare states — does everything wrong. So Europe's economic system must be collapsing, and a lot of reporting simply states the postulated collapse as a fact.
The reality, however, is very different. Yes, Southern Europe is experiencing an economic crisis... But Northern European nations, France included, have done far better than most Americans realize. In particular, here's a startling, little-known fact: French adults in their prime working years (25 to 54) are substantially more likely to have jobs than their U.S. counterparts. ... Other European nations with big welfare states, like Sweden and the Netherlands, do even better. ...
Oh, and for those who believe that out-of-work Americans, coddled by government benefits, just aren't trying to find jobs, we've just performed a cruel experiment using the worst victims of our job crisis as subjects. At the end of last year Congress refused to renew extended jobless benefits... Did the long-term unemployed who were thereby placed in dire straits start finding jobs more rapidly than before? No — not at all. Somehow, it seems, the only thing we achieved by making the unemployed more desperate was deepening their desperation.
I'm sure that many people will simply refuse to believe what I'm saying about European strengths. After all, ever since the euro crisis broke out there has been a relentless campaign by American conservatives (and quite a few Europeans too) to portray it as a story of collapsing welfare states, brought low by misguided concerns about social justice. And they keep saying that even though some of the strongest economies in Europe, like Germany, have welfare states whose generosity exceeds the wildest dreams of U.S. liberals. ...
The truth is that European-style welfare states have proved more resilient, more successful at job creation, than is allowed for in America's prevailing economic philosophy.

Links for 5-26-14

Posted: 26 May 2014 12:24 AM PDT

Growth and Sovereign Debt: What Causes What?

Posted: 25 May 2014 10:26 AM PDT

Reinhart and Rogoff are back in the news lately as a standard of comparison for data errors (is what Piketty did as bad...?).

But they wouldn't have been forgotten in any case. This research reexamines the Reinhart and Rogoff findings, and concludes that high public debt does not cause low growth. It's the other way around, low growth brings about high debt:

Determinants of the growth and sovereign debt correlation, by Matthijs Lof, Tuomas Malinen, Vox EU: Since the outbreak of the financial crisis, the relationship between debt and growth has been an issue of heated debate among both academics and policymakers. Reinhart and Rogoff (2010a) showed a negative correlation between sovereign debt and economic growth, and argued that countries could be confronted with a considerable decline in their growth potential after the debt-to-GDP ratio exceeds 90%.

While the research by Reinhart and Rogoff had a substantial influence in policy circles, their results are controversial. Last year, researchers from the University of Massachusets Amherst revealed a number of computational errors in the calculations by Reinhart and Rogoff (Herndon et al. 2013). After correcting the errors, Herndon et al. disputed the existence of a 90% threshold in the relationship between debt and growth. They did, however, still find a negative (albeit weaker) negative correlation between debt and growth.

Even if a negative correlation between debt and growth seems undisputed, this does not imply that debt is harmful for growth, since correlation does not always imply causation. In fact, Reinhart and Rogoff (2010b) have emphasised the possible bi-directional causality between debt and growth. They argue that high debt may lead to higher taxes and/or lower government expenditure, which is harmful for economic growth, while on the other hand periods of low growth may lead to high deficits and accumulation of debt. Nevertheless, these hypotheses are not backed by a quantitative analysis to establish the relative size and significance of each direction. To decompose the correlation into cause and effect, we apply Vector Autoregressive (VAR) models. Our main result is that debt does not seem to have any significant impact on growth.

Methods and results

We estimate a VAR for sovereign debt and GDP growth on panel data for 20 OECD countries over a period of 55 years, which we obtain from the dataset of Reinhart and Rogoff (2009). Detailed descriptions of the data and model can be found in our recent article (Lof and Malinen 2014). The application of VAR models has several advantages.

  • First, a VAR treats both debt and GDP as endogenous. Both are allowed to have an impact on each other, and these impacts can be separated.
  • Second, a VAR is a dynamic model, such that we can analyse and quantify intertemporal impacts. By computing so-called impulse response functions, we can visualise the long-run impact on both variables after a shock hits one of the variables.
  • Finally, a VAR is a fairly simple model, which is estimated by regressing both debt and GDP growth on both their own and each other's past observations.

Eberhardt and Presbitero (2013b) emphasise the role of nonlinearities and cross-country heterogeneities, to show that there is no robust evidence for a significant effect of debt on growth. Our analysis shows that this holds even in this simple linear framework.

Figure 1 shows the cumulative impulse response functions (CIRF) from the estimated panel VAR. The solid line shows the estimated cumulative impact over a period of 10 years on debt (left column) and GDP (right column), after a positive shock to either debt (top row) or GDP (bottom row). The dashed lines show the 95% confidence interval.

The main result is in the top-right panel:

  • A positive shock to debt (i.e. an increase in debt) seems to have no negative impact on GDP. The point estimate of the impact is in fact even positive, but the confidence interval is so wide that the effect is not significant.
  • On the other hand, the bottom-left panel shows that a positive shock to GDP does have a significant negative impact on debt, which explains the negative correlation between debt and GDP.

Figure 1 Cumulative Impulse-response functions computed from estimated PVAR, for 20 countries over the period 1954–2008


In our article (Lof and Malinen 2014), we elaborate on the robustness of these results. We verify that the results hold for a smaller group of countries for which longer time-series are available, and for different measures of debt. Since we consider a recursive VAR, the order of the variables potentially affects the results. In our benchmark model, we place debt before GDP, such that debt can react to GDP only after a lag, while the reverse effect may occur immediately. The justification behind this assumption is that shocks to debt occur after political decision-making, which takes time. In the article, we also estimate the model with the order reversed. As it turns out, the assumption does not drive our results, as we find similar outcomes with the reverse order.

Threshold effects

Finally, we investigate the idea of a threshold effect, or 'tipping point', in the relation between debt and growth. Reinhart and Rogoff argue that the negative correlation increases after the level of debt exceeds 90% of GDP. Herndon et al. (2013), as well as Eberhardt and Presbitero (2013a) attempt to refute the existence of such a threshold effect.

To analyse this issue in the VAR framework, we divide the sample into high-debt and low-debt countries. First, we label countries as high-debt country when the average debt-to-GDP ratio over the period 1954-2008 exceeds 50%. Next, we look at those countries for which the maximum debt-to-GDP ratio over this period exceeds 90%. Figure 2 reproduces the off-diagonal panels of Figure 1, for these two samples of high-debt countries and for the corresponding samples of low-debt countries. The results are clear:

  • The relation between debt and GDP is remarkably stable across high-debt and low-debt countries.

Consistent with the results in Figure 1, the impact of debt on GDP is insignificant or mildly positive (top row), while the reverse impact of GDP on debt is negative and significant (bottom row). There is no evidence for a negative effect of debt on growth, not even for elevated levels of debt.

Figure 2 Cumulative impulse response functions for different subsamples.


Notes: Left panels: Average Debt-to-GDP ratio>50%. Second from left panels: Average Debt-to-GDP ratio<50%. Second from right panels: Maximum Debt-to-GDP ratio>90%. Right panels: Maximum Debt-to-GDP ratio<90%.


Based on a simple VAR analysis with panel data, we can conclude that there is little evidence for a negative long-run effect of sovereign debt on economic growth. Our findings are consistent with recent studies applying different methods, such as Panizza and Presbitero (2013), as well as Kimball and Wang (2013) who "could not find even a shred of evidence in the Reinhart and Rogoff data for a negative effect of government debt on growth".

Using the negative correlation between debt and growth as a justification for austerity policies could be another example of confusing correlation with causation. While high levels of sovereign debt may surely be a burden for a country, the claim that debt is harmful for growth is not supported by our results.


Eberhardt, M. and A. F. Presbitero (2013a), "Public debt and economic growth: There is no 'tipping point'",, 17 November.

Eberhardt, M. and A. F. Presbitero (2013b), "This Time They are Different: heterogeneity and Nonlinearity in the Relationship between Debt and Growth", IMF Working Paper 13/248.

Herndon, T., M. Ash and R. Pollin (2013), "Does high public debt consistently stifle economic growth? A critique of Reinhart and Rogoff", PERI working paper n° 322, April.

Kimball, M. and Y. Wang (2013). "After crunching the Reinhart and Rogo's data, we've concluded that high debt does not slow growth", Quartz blog, May 29, 2013.

Lof, M. and T. Malinen (2014), "Does sovereign debt weaken economic growth? A Panel VAR analysis", Economics Letters 122/3, 403-407.

Panizza, U. and A. F. Presbitero (2013), "Public debt and economic growth in advanced economies: A survey", Swiss Journal of Economics and Statistics, vol. 149(II): 175-204.

Reinhart, Carmen M and Kenneth S Rogoff (2009), This Time is Different: Eight Centuries of Financial Folly. Princeton University Press.

Reinhart, C. M. and K. S. Rogoff (2010a), "Growth in a Time of Debt", American Economic Review: Papers and Proceedings 100(2): 573–578.

Reinhart, C. M. and K. S. Rogoff (2010b), "Debt and Growth Revisited",, 11 August.

'Unpacking the First Fundamental Law'

Posted: 25 May 2014 10:22 AM PDT

I thought it would be useful to have this note from Jamie Galbraith posted so it can be linked, discussed, etc.:

Unpacking the First Fundamental Law, by James K. Galbraith: In the early pages of Capital for the Twenty-First Century Thomas Piketty states a "fundamental law of capitalism" that α = rxβ, where α is the share of profit in income, β is the capital/output ratio, and r is the rate of return on capital, or the rate of profit. Thus:

r = α/β

Using K for capital, P for profit and Y for both total income and output (which are equal in equilibrium), we have:

α = P/Y and β = K/Y

so that:

r = (P/Y)/(K/Y)

The point of this expression is that r cannot be observed directly, whereas the two ratios on the other side of the equation can be. Yet (clearly) Y is unnecessary, since this expression reduces to

r = P/K

with no loss of generality. So the measure of r requires just two things: a flow of money profits from the national income accounts, and a measure of the stock of capital.
What is K? For Piketty, K is the financial valuation of privately-held capital assets, including land, bonds, stocks and other forms of private wealth, such as housing. One may quarrel (as I have) with the connection of this value to prior definitions of capital, but that is not the issue here.
Financial valuation (FV) can be rendered as the present value of the expected future returns from the ownership of capital assets; for this a discount rate is required. Is the discount rate the same as r? Not necessarily. Keeping them distinct, we have:

K = FV = Σi [ Ε(Pi)/(1+d)i]

where Ε indicates an expected value, d is the discount rate and (i) is a time subscript.
Note that FV depends on d. If the discount rate falls, then the financial value of the capital stock will rise. Since the discount rate bears some relationship to the interest rate, at least in equilibrium, FV and therefore r can be pushed around by monetary policy, so long as monetary policy can influence financial valuations without also affecting current money profits. FV also depends on the current expectation of future flows of profit income, which are, in part, a psychological matter.
Clearly, this concept of capital bears no relationship to the physical construct that normally enters a neoclassical production function or the technological view of the capital/output ratio. Piketty's use of "K/Y" as notation is, in this respect, non-standard. Still, nothing prevents us from measuring r – as Piketty defines it – from the observed profit flow and the financial valuation of the capital stock.
Why, as an historical matter, would r as measured tend to be constant over long periods of time? One answer is now obvious: the expected stream of future profits at any given time depends on current profits. In a boom, things are good and are expected to remain so. In a slump, the reverse. P and FV do not always move together. But they will more often than not. And so the ratio between the two observed variables – which is r -- will normally not change very much. One can surely find exceptions – in the turning points of the business cycle, or when monetary policy drives capital valuations out of synch with current profits. But Piketty's approach of calculating decade-by-decade averages may wash those out, to some degree.
What does the long-run constancy of r have to do with savings or with the creation of new physical capital? Nothing at all. Piketty's r is basically a weighted average of financial rates of return across the yield curve and the risk profile of privately-held capital assets. It is the artifact of current profits and the effect of discounted profit expectations on market values. If the discount rate rises (falls), other things equal, the ratio of current profits to financial values also rises (falls). But if the discount rate is stable, thanks to long-term stability of monetary policy and of social attitudes – or even thanks only to averaging over time – then that r should also be reasonably stable over time is no surprise.
Piketty's next big assertion is that r > g , or that the return on financial valuation is normally higher than the rate of growth of income. And so, he argues, so long as the ownership of financial assets is concentrated, as it always is, this leads to an increasing concentration of income (and therefore wealth) as the normal condition of capitalism.
For the truth of the first sentence, we can (for the moment) accept Piketty's evidence – noting that the entire 20th century is an exception. But the first sentence does not lead necessarily to the second.
First, if part of profits are spent on consumption rather than reinvested in new capital, then (if cc is the rate of capitalists' consumption, including charitable gifts) we could have:

r > g but (r-cc) <= g

It is hard to see how this could lead to a rise in K/Y or in the share of profit in income, purely on grounds of accumulation. And in a simple model, it would not; P/Y falls if (r-cc) < g.
On the other hand, even if (r-cc) < g, it is still possible for increasing financial valuations (a bubble in the capital asset markets, driven by a lower d) to generate increasing concentration of wealth at least for some time. So long as capital is unevenly held, as it always is, bubbles will make some people rich.
And this need not show up in tax data as current (profit) income, since unrealized capital gains are not reported as income subject to tax. But they are wealth. True, bubbles are transient; eventually they burst. But they could be the main thing that we have been dealing with, in short cycles, in most of the wealthy world, for the past 30 years.
Finally, Piketty argues that a slowdown of economic growth, due to slower population growth, must inevitably lead to an increase in the the capital-output ratio. This is a simple artifact of the constancy of r, alongside a drop in g. But, as Jason Furman has asked, would r necessarily stay steady if g declines Looking back at the formula, it all depends on current profits, future expected profits, and the discount rate. If slow growth reduces either current profits or the discount rate, or both, while expectations remain stubbornly high, it's possible that r might decline even more than g.
In short, so far as I can tell, five conclusions may be drawn:
1) The alleged long-run constancy of r is an artifact of no great economic interest.
2) Even it is generally true that r > g, it does not follow that capitalist economies have a necessary tendency toward an increasing share of profit in income.
3) If the share of profit in income is not rising, there is also no obvious reason for wealth to become more concentrated.
4) Yet, wealth inequality can rise in a capitalist economy even if r < g, due to bubbles in financial markets and capital gains that do not count as current income.
5) The effects of a demographic and growth slowdown on the relation between r and g is indefinite. It is not inexorable that slower growth increases the capital-output ratio.
None of this is to deny that rising inequality has occurred. Nor to claim that it doesn't matter. And by yanking mainstream discussion of inequality from the micro to the macro sphere – where it belongs as I have been arguing since the mid-1990s! – Thomas Piketty has done a service to economics.
But his goal was to turn the historical record into fundamental laws and long-range tendencies. Despite strong claims – accepted by many reviewers – it now seems clear that this project fell short.
As a matter of the empirical record, the modern inequality data do not show any inexorable tendencies.
Inequality fell sharply in the two World Wars.*  It rose very sharply in many places beginning around 1980 or in some cases a few years before. And that increase largely peaked in 2000, worldwide. The great rise of inequality in recent years was a consequence of the debt crisis, the collapse of communism, of neoliberal globalization. It was not a long-run phenomenon. Piketty projects that it will resume and continue, but it may or may not.
Since 2000, declining inequality has been observed in post-neoliberal (but still capitalist) Latin America. There is new evidence of declining inequality in China, and also in Europe after 2008, at least if one takes the continent as a whole. In the US, there has been a sawtooth pattern, closely related to the stock market, with inequality peaks in 2000, 2007 and 2013, but little trend since 2000. If one believes the new PPP values, income inequality has also fallen for the world population taken as a whole, thanks mainly to the rise of average income in China. Further, in some cases, income inequality may fall thanks to an old-fashioned Kuznets transition. This seems to be part of the recent experience in China.
Finally, there seems no warrant for the view that annual global capital wealth taxation is required to reduce the rise or the level of inequality. Many other measures, including higher wages, expanding social insurance, health care and housing, debt restructuring, effective estate and gift taxes, and the control of predatory finance can and have worked to achieve the same goal.
Perhaps Piketty's Law will vanish, as quickly as it has appeared?
This is a note for discussion purposes. Comments welcome at The empirical work mentioned is at Other references on request.
* As for why inequality declined during the two World Wars, Piketty lays heavy stress on a decline in K/Y, the capital-output ratio. Numerous graphs (with odd and uneven date-spacing) illustrate this decline for major countries engaged in the wars. But the implicit case that a fall in K/Y had to do (in part) with physical destruction of productive capital makes no sense for any major country in World War I, and only for Germany and Japan in World War II. Moreover, a pure decline in K, whether physical or financial, would have increased, not reduced, r, by Piketty's own definition, and therefore it would have increased, not reduced inequality. [How could Piketty not have seen this?] Further, the fact that all belligerents saw large increases in money incomes, relative to capital valuations, also cannot explain the drop in r relative to g, since Y actually plays no role in the determination of r. (This is a point I did not quite grasp, in preparing my review for Dissent.) So what did cause the fall in inequality? The obvious answer is that money profits P (and also capitalists' consumption) were constrained in the major countries by war-time controls, as a matter of strict policy, while a rapid growth of labor incomes was allowed to proceed. This drove r far below g and so increased the labor share and equalized incomes. Contrary to Piketty's statements in several places, this was no accident. In the United States during World War II, the policy to achieve it was directed by the Office of Price Administration under the direction, in 1942-3, of an economist whose name I do not recall seeing in Piketty's text: John Kenneth Galbraith.

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