Last week, my colleague Daniel Morillo wrote that investors would be remiss in writing off Reinhart and Rogoff’s larger body of work merely because of a spreadsheet error in the economists’ widely cited paper on the relationship between economic growth and debt.
In my opinion, both investors and policy makers would also be remiss in writing off the influential paper itself. While Reinhart and Rogoff have publicly admitted mistakes in their methodology, their paper’s basic conclusion still holds: Excessive government debt is likely to be an impediment to a country’s growth.
In fact, their major finding that economic growth fell by about 1% when gross government debt-to-GDP was high has been corroborated by several other studies. This historical association between excessive debt and slower growth has three important implications for the future of the US economy and market.
- The United States is in the Reinhart and Rogoff danger zone. The United States, with gross debt-to-GDP of more than 100%*, is clearly already at risk of debt-related slow growth.
- The United States isn’t likely to exit the danger zone anytime soon. As Reinhart and Rogoff point out, high debt-slow growth episodes tend to last for a very long time. This is likely to be the case for the United States considering that as more and more baby boomers qualify for Social Security and Medicare, the US debt problem is likely to grow significantly worse by the end of this decade, especially if there continues to be little progress on longer-term entitlement and tax reform.
- US Earnings could suffer as a result. A 1% drop in economic growth would have enormous implications for US corporate earnings. In fact, top-line corporate growth is largely a function of economic growth.
To be sure, economists at the University of Massachusetts were correct to highlight the Excel error in Reinhart and Rogoff’s analysis. In addition, they provided a very useful service by reminding everyone that economics is not physics and doesn’t lend itself to exact thresholds and airtight relationships. That said, in a world in which developed market debt now averages roughly 100% of developed country GDP, both policy makers and investors ignore Reinhart and Rogoff’s paper at their own peril.
Source: Reinhart & Rogoff, BlackRock research
*An interesting footnote to this debate: The government’s calculation for US GDP is about to be revised in a way that will bring this figure down. While I’m sure this represents an improvement in methodology, here’s a rhetorical question: Would the government have revised their GDP calculation had it made the number worse?