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Asset management

29 April 2013

Economist Insights Re-set and Re-creation
The conclusion of Professors Reinhart and Rogoff that high levels of debt (above 90% of GDP) are associated with much lower rates of growth has been seized upon by austerity-minded politicians. Others disagree and, as the debate on the relationship between debt and growth rages among economists and commentators, we can only wonder whether politicians have sufficient courage and honesty to take action now to address future debt burdens. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

A ‘high-profile academic dispute in economics’ may sound like an oxymoron but just such a dispute has been filling up column inches in many newspapers. The research in dispute is the highly influential work by Professors Carmen Reinhart and Kenneth Rogoff on debt, best known for their book “This time is different”. Austerity-minded politicians have seized upon Reinhart and Rogoff’s conclusion that high levels of debt (above 90% of GDP) are associated with much lower rates of growth – even near zero. Another group of academics (Thomas Herndon, Michael Ash and Robert Pollin) have argued that various exclusions and errors mean that the associated growth rate is more like 2% than zero. The academic debate has been far more polite and constructive than the debate between commentators and soon the politicians are likely to join in as well. The results of the debate are important but they are not the be-all and end-all. Firstly, an association is not causation and numerous academics have differing views on whether high debt causes slow growth or slow growth causes high debt (or whether the relationship changes). Secondly, statistical relationships like this are necessarily limited by the available data and we do not have data for any other periods when so many advanced economies all tightened fiscal policy simultaneously and in the face of subtrend growth. If debt is deemed too high, then to get debt down countries will normally need to tighten fiscal policy. The change in the budget balance from one year to the next can be described as ‘fiscal thrust’. Historically, fiscal thrust was usually positive when growth was above trend and negative when growth was below trend (chart 1). In part this was due to the automatic stabilisers, stronger growth means higher taxes and lower unemployment payments and vice-versa for slower growth.

In the last few years, growth has been very weak so tax take is still low and unemployment benefits are still being paid – yet still the fiscal thrust is positive, showing a big tightening. This is a clear divergence from the past.
Chart 1: Change of pattern Annual change in government net lending/borrowing as a percent of GDP (fiscal thrust) in advanced economies, and periods of sub-trend GDP growth
2 1 0 -1 -2 -3 -4 -5 -6 1981 Sub-trend growth 1983 1985 1987 1989 1991 Fiscal thrust 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

Source: IMF World Economic Outlook, UBS Global Asset Management Note: Trend is determined by a Hodrick-Prescott filter on the IMF data

When one country tightens policy, even if that country faces sub-trend growth, it would hope that there would be some compensating improvement in net exports. But when all your trading partners are also tightening and slowing down, your exports are more likely to be falling than rising. Experiences with localised tightening may not tell us much about experiences with widespread tightening. This argument lends some support to those commentators and politicians who would wish to see less fiscal austerity.

The challenge is that the purported ‘first best’ option of slower fiscal tightening may not actually be a viable option. Suppose that the leaders of Italy or Spain had made this argument a few years ago to justify a slower pace of austerity. They might even have argued that by supporting growth now it would be easier to bring down debt later. The problem is that the market would have doubted the promise of more tightening later – and historical experience would have justified such scepticism. Bond yields would have risen and the government would have faced much higher borrowing costs, pushing debt and then borrowing even higher. The government would then have been forced to either default or tighten policy – and would be worse off than if it had simply gone for austerity initially. Does this mean that politicians are trapped by the market into imposing austerity that nobody wants? The answer is only yes if politicians cannot credibly tighten in the future. In an ironic twist, the unsustainable future debt burden that will come from an ageing population actually creates an opportunity for politicians to do this if they have the courage. Many countries have seen a spike up in debt following the financial crisis, as shown by the hypothetical country in the illustrative example below (chart 2). Most countries have proposals to get their debt stabilised and then falling over the next few years but if they go for ‘austerity now’ but do not address the long-term obligations associated with ageing then debt will inexorably rise again. If they delay but their promises of future cuts are non-credible, debt will simply continue to rise as borrowing costs go up.
Chart 2: Path-etic Illustrative example of a representative country’s debt to GDP ratio under different scenarios 160 140 120 100 80 60 40 20 0 2000 2003 2006 2009 2012 2015 2018 2021 2024 2027 2030 2033 2036 2039 2042 2045 2048

In contrast, if politicians are willing to come clean and legislate now to reduce those future obligations, then the market will be more likely to give the politicians the benefit of the doubt. After all, if you are going to invest in a 30-year government bond, do you want to lend to a country that has austerity now but spiralling debt when that bond comes due in 30 years? Would you not be more willing to lend to a country that lets debt rise now but ensures that it is sustainable when the bond matures in 2043? Despite what a cynical reader might expect, there are some examples of countries taking steps to deal with future debt. Australia legislated mandatory contributions in personal pension schemes (‘superannuation funds’) so that the future liabilities are actually funded. There are also some surprising examples, such as the changes Italy has implemented in the pension age to prevent rising longevity increasing the burden on the state. There would be another important advantage to taking this approach. Quite simply, successive generations of politicians in most developed countries have promised ever greater pensions and medical benefits to future retirees. Effectively they have promised this cohort of soon-to-be pensioners an ever greater slice of the economic output of the country. This will simply be unsustainable, so governments will default. They will either do so by stealth, by changing rules, by inflation, or by restricting access later on or simply cutting the benefits when the time comes to pay out. It would be far more honest to simply admit the problem today so that people can adjust their working and saving decisions to compensate. But this would take far more courage and honesty from politicians than has been shown to date.

History

Austerity now

Credible delay

Non-credible delay

Source: UBS Global Asset Management

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