“I can see now where the source of my mistake lay: I reasoned as if society was a sentient being, whose national debt had to be seen as a mere transfer between different parts and organs of a single entity, governed by an all seeing planner, whose job is to maximize a social welfare function.”

Economists, especially in Europe, seem to be divided into two irreconcilable camps over the question of ‘growth versus austerity’. From 2008 to 2012, the talk was all of consolidating public budgets, increasing taxes, closing down or merging unsafe banks, selling their assets at fire-sale prices, cutting down on pension and health entitlements, firing public employees, reducing trade union privileges and opening labor markets to competition—the classic panoply of measures the IMF used to demand of Third World countries when it moved in to rescue them. This time and for the Eurozone, the IMF was content to play second fiddle: the rescuers were Germany and other northern and central European countries; the peccant countries they had to rescue were those on the outer fringes of the Eurozone. The expectation was that this hard medicine would bear fruit at the latest in 2013 and bring renewed growth and employment after four years of contraction. Unexpectedly, and for reasons we hope to discover someday, there was a second dip in the recession. Public opinion, especially in countries suffering from high unemployment, became restless. In despair many Europeans leaders turned their eyes towards the United States, hoping to learn the lessons of its money-printing Federal Reserve and bond-issuing Treasury. The European Central Bank chief Signor Draghi promised to do “whatever it takes” to save the euro; Signor Monti was dealt a sharp lesson by Italian voters; the French President and the Spanish Prime Minister demanded growth-fostering measures to ease public deficit reduction; the European Council set in progress a program to help employ young people; and the European Community as a whole launched a plan to better rail and road transport on the Continent. Frau Merkel was cast into the role of a Dickensian Gradgrind who wanted everybody to stick to “Facts! Facts! Facts!” The policy climate had changed.

These moves were dictated by political convenience, but the change in policy direction was reinforced by the effect of a scientific dispute that reverberated beyond the confines of Academia; an econometric mistake committed by Harvard economists Carmen Reinhart and Ken Rogoff seemed to put the austerity camp in disarray. At least this is how Paul Krugman, in line with many others, presented his case for a deficit financed stimulus.

The Reinhart-Rogoff slip up

The controversy went like this. Reinhart and Rogoff (2010) had come to the not-so-surprising conclusion that an excessive accumulation of public debt tended to reduce the rate of growth of a country. They went further. They thought they could see a threshold in the historical series of their sample of countries, whereby a debt equivalent to more than 60% of GDP in developing economies and of 90% for advanced economies was accompanied by a non-linear reduction in growth. Though Reinhart and Rogoff in their paper (2010) allowed for the possibility that the causation could go from low growth to high debt due to falls in tax revenues, the implication was that it was debt that led to lower growth when it went over the threshold of 60% and 90%. This is how, in discussions about austerity versus stimulus, I myself, along with many others, understood the results.

Three young economists from the University of Massachusetts, Drs. Herndon, Ash and Pollin (2013), criticized the Reinhart and Rogoff results regarding debt and growth by pointing out a number of statistical mistakes which led them to conclude that “when properly calculated, the average real GDP growth rate for countries carrying a public debt-to-GDP ratio of over 90 percent is actually 2.2 percent, not -0.1percent” as Reinhart and Rogoff claimed. More importantly for the case in hand, “average GDP growth at public debt/GDP ratios over 90 percent is not dramatically different than when public debt/GDP ratios are lower”. (2013, Introduction) The three critics underlined that this took much of the sting from the arguments (which I used abundantly) against increasing public debt in a crisis.

For an easy-to-understand overview of the Reinhart-Rogoff controversy, see the EconTalk podcast Stevenson and Wolfers on Happiness, Growth, and the Reinhart-Rogoff Controversy, June 24, 2013. See also an earlier podcast Reinhart on Financial Crises with Carmen Reinhart on their earlier book, This Time is Different.

As is often the case, Reinhart and Rogoff were not really the out-and-out defenders of austerity that they were represented to be. One of the conclusions of their deservedly famous book This Time is Different (2009) was that financial crises were always followed by an “explosion” of public debt mainly due to falling tax revenues, but they did not proceed to link public debt causally with lower growth. They simply noted that full recovery from financial upheavals of the kind the advanced world was now suffering usually took pretty long to arrive.1

Ken Rogoff in fact was not remiss to call for extraordinary remedies for the recession following the present crisis. Thus, in December 2008 he prescribed a short burst of inflation, on the order of 6% for two years, as “extremely helpful in unwinding today’s epic debt morass”.2 I personally would be a much more single-minded budget cutter than Rogoff and less indulgent with bursts of inflation.3

Enter Paul Krugman

In April 2013 Krugman published an article in the New York Review of Books with the title “How the case for Austerity has crumbled”. He wanted to put the last nail in the budget cutters’ coffin by pointing to the mistakes of the Reinhart and Rogoff 2010 article on debt and growth, an article he added with some exaggeration that “may have had more immediate influence on public debate than any previous paper in the history of economics”. The mistakes discovered by Hendon, Ash and Pollin seemed to have destroyed the whole case for austerity as the way to solve the debt crisis. The only means to restart growth and reduce the weight of the debt accumulated during the crisis was to finance public expenditure indiscriminately with debt. Krugman also unfairly accused Reinhart and Rogoff of stark disregard for research ethics for not sharing their data. I find it difficult to see how Hendon, Ash and Pollin could have built their case without the Reinhart and Rogoff data. It is a long time since Krugman gave up research for sensational journalism.

The Reinhart and Rogoff reply, apart from the polemical fireworks, is interesting in that it revisits some points from their 2009 book. Number one, recoveries from deep systemic financial crises “are long, slow and painful”. Two, post-crisis circumstances dictate that debt must be dealt with, but not too fast. Three, the real danger is not a spike in debt over the 90% threshold, but in the possibility of “debt overhang”. Ironically, it was Krugman who in 1988 invented the notion of ‘debt overhang’ as that which a country suffers when its debt is so large that all the proceeds from national investment are appropriated by debt-holders. Krugman also seemed to have passed over an Economic Perspectives article written by Reinhart and Rogoff with Reinhart’s husband (2012) in which attention was drawn to the fact that when public debt stayed at levels above 90% of GDP for five years, the overhang phenomenon lashed in and kept growth levels below the trend for at least ten years in a majority of the 26 episodes in advanced economies since 1800.

Fallacies regarding the public debt

The economist who clarified the question of public debt more than any other was James Buchanan, the recently deceased Nobel Prize laureate. We need his help to understand why the total amount of public debt matters for the personal and constitutional welfare of the residents of a country.

Buchanan’s first book, originally published in 1958 under the title Public Principles of Public Debt has become a classic of financial theory. He there overturned the orthodox view of public debt prevalent at the time and still held by many fiscal theorists today. This orthodox and misguided view he summed up in three mistaken propositions.

  • 1. The creation of public debt does not involve any transfer of the primary real burden to future generations.
  • 2. The analogy between individual or private debt and public debt is fallacious in all essential respects.
  • 3. There is a sharp and important distinction between an internal and an external public debt. (Buchanan, page 5)

Now, I must be frank with my readers. Until I carefully re-read Buchanan for this essay I was one of those macroeconomists who held by these three tenets of fiscal orthodoxy. I have proclaimed my adhesion to them even in print! I can see now where the source of my mistake lay: I reasoned as if society was a sentient being, whose national debt had to be seen as a mere transfer between different parts and organs of a single entity, governed by an all seeing planner, whose job is to maximize a social welfare function. Internal debt issues were simple transfers of funds among parts of the national society. The debt only weighed on the national welfare when it was due to foreigners.

The Ricardian equivalence mistake

The first proposition has the authority of David Ricardo (1817) behind it. Under certain very strict assumptions, the national public debt is discounted by individuals as if it were a tax. When individuals are supposed to care for their descendants as much as for themselves, then it does not matter whether a war or a public project is financed by taxes or by bonds. In so far as individuals were rational and their time horizon was infinite, the bond would be fully discounted by the buyer and equivalent to a tax on his wealth; the tax-payer would save the full present value of the future service of the bond. Ricardo himself said that this extreme conclusion was only partially true, but for him financing a present expense with bonds on the whole did not shift the burden to future generations.4 Ricardo’s main object was to decry public expenditure in all its shapes and forms, so he wanted to underline that the way it was financed was of little import. (Buchanan, 1999, page 81)

Buchanan then gave an illuminating definition of what ‘future generation’ really meant.

I shall define a “future generation”as any set of individuals living in any time period following that in which the debt is created. […] An individual living in the year t0 will normally be living in the year t1 but he is a different individual in the two time periods. […] I shall not be concerned whether a public debt burden is transferred to our children or grandchildren as such. I shall be concerned with whether or not the debt burden can be postponed. (Buchanan, page 28, paragraph 2.4.6.)

It is not how the moneys are used that matters but the shifting of the burden from one ‘generation’ to another. Buying a bond voluntarily is no sacrifice for an individual who prefers to save a given sum rather than consume it. Neither is it a sacrifice for the people enjoying the results of the public investment thus financed. The sacrifice falls on the future ‘generation’ being taxed to return the funds to the bond holder. This generation will be different from the original one which received the benefits and was freed from the obligation to repay.

For an introduction to Ricardian Equivalence, see “Does It Matter How You Pay for a State Dinner? A Lesson on Ricardian Equivalence”, by Morgan Rose. Library of Economics and Liberty, Sept. 12, 2001.

One conclusion of this analysis is that the operations of privately and publicly indebting oneself are strictly analogous except for the fact that in the case of public debt the burden of repayment may fall on someone who did not have the full enjoyment of those funds. Whether the funds are well employed or not is immaterial.

External and internal public loans

With the present crisis, the conviction has spread among specialists that foreign debt is more dangerous and less manageable than domestic loans. For those who conceive of national societies as wholes, when there is no external creditor, debt is owed by one part of the social body to another. Buchanan quoted Philip E. Taylor as saying that

to the extent that public debt is held by citizens of the debtor government, “we owe it to ourselves.” […] If on the other hand the debt is owed to citizens or governments of other societies, payments on the debt represent deductions from national product.5

The question very properly asked by Buchanan is who is part of the ‘generation’ having to service an internal debt, and is he the same as the one who enjoyed the proceeds of the loan? The fallacy stands out in another quotation of Buchanan’s, this time a passage from Arthur Pigou (1949). “But interest and sinking funds on internal loans are merely transfers from one set of people in the country to another set”.6 Thank you very much! Sets of citizens are interchangeable for the all-wise central planner.

Daniel Gros of CEPS has tried to show that, empirically speaking, foreign debt is quite another proposition from domestic debt. As an explanation he adduces that foreigners do not have the remedy of voting for “the higher taxes or lower expenditure needed to service the debt.” And he proceeds with the usual remark that in the case of domestic debt “a higher interest rate or risk premium just leads to more redistribution within the country (from taxpayers to bond holders)”. The case is different for debt owed outside the country; “higher interest rates lead to a welfare loss for the country as a whole because the government has to transfer resources abroad.” (Gros, page 1)

These are well rehearsed arguments based on the fallacious idea that it is the country as a whole and not individuals who service public debts. Dr Gros’ paper, however, is more interesting than most because he has regressed sovereign debt spreads on current account deficits. He has shown a remarkable correlation indicating that investors are wary of nations with a high proportion of debt when it is foreign owned and they show a large current account deficit. Inversely, he notes the remarkable case of Belgium with public debt nearly equivalent to 100% of GDP but low spreads throughout the crisis. Even more remarkable and well known is the case of Japan with the highest public debt rate among advanced nations, very low interest rates and no financial crisis—rather continuous immobility in the doldrums.

By reducing the service of domestic public debt to a question of redistribution between inert taxpayers and bond holders, the real nature of the problem is hidden from view. Individual taxpayers and bondholders vote according to their own personal interest. In this case

… the community must compare one debt form which allows a higher income over future time periods but also involves an external drainage from such income streams with another form which reduces the disposable income over the future but creates no net claims against such income. […] [With an] external loan […] income in a future period would be higher than in the internal loan case by precisely the amount necessary to service the external loan. (Buchanan, pages 62-63, paragraph 2.6.15.)

The second case is an accurate description of the Japanese plight over the last twenty years, with extra low interest rates and spreads and very little growth.

How much public debt

The amount of debt a government will issue is of course related to how much public expenditure is considered proper. This discussion does not properly belong in this essay, except to say that the matter of what the state ought to do is usually discussed from the outside, as if the community were an organic entity with a single value scale embodied in a social welfare function. “…in this case”, says Buchanan, “the fiscal problem reduces to one of simple maximization […] by some omniscient decision maker”. This cannot be the case in a democracy where the process is king.

The task of the expert here becomes that of showing how the decision-making process itself might be improved, how information concerning alternatives can be increased, and how individuals can be presented with “fair” alternatives. (Buchanan, page 119, paragraph 2.12.10.)

We are still left with the question of how much public debt an economy can sustain. Again the combination of taxes, inflation and public debt is one to be decided in the democratic process, with no expert presuming to “play God”, as Buchanan used to say.

We have seen the extreme case of ‘debt overhang’. There are earlier limits to deficits and debt issue. When replying to Krugman, Reinhart and Rogoff7 recalled situations of “debt with drama” which we have witnessed in Europe, when markets simply ceased to accept sovereign paper and the government found itself incapable of supplying its services. Whatever Krugman may believe, debt equivalent to 100% of GDP is in the end unsustainable. Even in the case of the United States, which enjoys the privilege of being the world’s banker, there may come a moment when raising taxes will not be enough to defend the dollar and singeing cuts in expenditure will have to be made. There is a limit to the burden of pensions, health services, and public works that present generations can leave for later taxpayers, who may refuse to pay the bill. In the end, a debt is a debt is a debt.


Barro, Robert J. (1974). “Are Government Bonds Net Wealth?”. Journal of Political Economy, vol. 82, no. 6, pgs.1095-1117. PDF file.

Buchanan, James (1999). Public Principles of Public Debt. Liberty Fund, Inc. Online at the Library of Economics and Liberty.

Gros, Daniel (2013): The Austerity Debate is Beside the Point for Europe. CEPS Commentary. Centre for European Policy Studies, Brussels (8 May).

Herndon, Thomas, Ash, Michael and Pollin, Robert (2013): “Does High Public Debt Consistently Stifle Growth? A Critique of Reinhart and Rogoff”. Working Paper Series nr. 322 (May). Political Economy Research Institute, University of Massachusetts Amherst.

Krugman, Paul (2013): “How the Case for Austerity Has Crumbled”. New York Review of Books (May).

Lerner, Abba P. (1948): “The Burden of National Debt”, in Lloyd A. Meltzer et al.: Income, Employment and Public Policy. New York.

Pigou, A. C. (1949): A Study in Public Finance. 3rd. edn., London.

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

Reinhart, Carmen M. and Rogoff, Kenneth S. (2010): “Growth in a Time of Debt”. American Economic Review: Papers & Proceedings, nr. 100 (May).

Reinhart, Carmen M. and Rogoff, Kenneth S. (2013): “Letter to PK” (May 25) Carmen M. Reinhart Author Website.

Reinhart, Carmen M., Vincent R. Reinhart, and Kenneth S. Rogoff (2012): “Public Debt Overhangs: Advanced-Economy Episodes since 1800.” Journal of Economic Perspectives, 26(3): 69-86

Rogoff (2008): “Inflation Now the Lesser Evil”, Project Syndicate.

Warsh, David (2013): “Footnote to a Current Controversy”. Economicprincipals.com, (May 26).


Reinhart and Rogoff (2009), Chapter 14 distill the following recovery periods from a long history of financial crises. On average, real housing prices tend to decline by 35% over six years; equity prices, 56% over three and a half years; unemployment increases by 7% over four years; output falls by more than 9% in two years; and after the financial crises of the period after World War II government debt, helped by falling tax revenues and calls on the public Treasury, tended “to explode” with average rises of 86%.

Rogoff (2008), quoted by Warsh (May 2013).

Cf. David Warsh (2013) verdict on Rogoff.

This theorem was taken up by Barro (1974) to show that issuing public debt to use the proceeds for anti-cyclical investment was useless, since the amount borrowed and spent by the Government to revive a depressed economy would be fully discounted by the purchaser of the bonds who would not see them as wealth.

Philip E. Taylor, The Economics of Public Finance (Rev. ed.; New York, 1953), p. 187, as quoted in Buchanan (1958) page 59, paragraph 2.6.3.

Pigou (1949), page 30, as quoted in Buchanan (1958) page 59, paragraph 2.6.3.

Reinhart and Rogoff (2013).


*Pedro Schwartz is Rafael del Pino Professor of Economics at the Universidad San Pablo CEU Madrid, where he directs the Center for Political Economy and Regulation. A member of the Royal Academy of Moral and Political Sciences of Spain, Schwartz is a frequent contributor to European press and radio on the current financial and corporate scene. Schwartz is the author of two previous books, La economía explicada a Zapatero y a sus sucesores and En Busca de Montesquieu: la democracia en peligro, and he has a book forthcoming in English, Democratic Capitalism: Progress and Paradox.

For more articles by Pedro Schwartz, see the Archive.