It’s always dangerous when followers of an insular cult gain positions of power. Unfortunately, that appears to be the case with the Washington Post editorial board and the Federal Reserve Board Cultists.
The Federal Reserve Board Cultists adhere to a bizarre belief that the 19 members (12 voting) of the Federal Reserve Board’s Open Market Committee (FOMC) live in a rarified space where the narrow economic concerns of specific interest groups don’t impinge on their thinking. According to the cultists, when the Fed sits down to decide on its interest rate policy they are acting solely for the good of the country.
Those of us who live in the reality-based community know that the Fed is hugely responsive to the interests of the financial sector. There are many reasons for this. First, the twelve Fed district banks are largely controlled by the banks within the district, which directly appoint one third of the bank’s directors. The presidents of these banks occupy 12 of the 19 seats (5 of the voting seats) on the FOMC.
The seven governors of the Fed are appointed by the president and approved by Congress, but even this group often has extensive ties to the financial industry. For example, Stanley Fischer, the current vice-chair, was formerly a vice-chair of Citigroup.
The third main reason why the Fed tends to be overly concerned with the interests of the financial sector is that its professional staffers are often looking to get jobs in the sector. While jobs at the Fed are well-paying, staffers can often earn salaries that are two or three times higher if they take their expertise to a bank or other financial firm. As economic theory predicts, this incentive structure pushes them toward viewpoints that often coincide with those of the industry.
The net effect of these biases is that the Fed tends to be far more concerned about the inflation part of its mandate rather than the high employment part, even though under the law the two goals are symmetric. If the Fed tightens too much and prevents hundreds of thousands or even millions of workers from getting jobs, most of the top staff would not be terribly troubled and it is unlikely anyone would suffer in their careers. On the other hand, if they allowed the inflation rate to rise to 3.0 percent, it is likely that many top officials at the Fed would be very troubled.
There is very little basis in economic research for maintaining that a stable 3.0 inflation rate is more costly to the country than having 1 million people being needlessly unemployed, but the view coming from the Fed is that the former is much worse than the latter. The Fed cultists at the Washington Post and elsewhere want us to just accept that this is the way the world works. It’s not surprising that some folks don’t quite see it that way.
It’s always dangerous when followers of an insular cult gain positions of power. Unfortunately, that appears to be the case with the Washington Post editorial board and the Federal Reserve Board Cultists.
The Federal Reserve Board Cultists adhere to a bizarre belief that the 19 members (12 voting) of the Federal Reserve Board’s Open Market Committee (FOMC) live in a rarified space where the narrow economic concerns of specific interest groups don’t impinge on their thinking. According to the cultists, when the Fed sits down to decide on its interest rate policy they are acting solely for the good of the country.
Those of us who live in the reality-based community know that the Fed is hugely responsive to the interests of the financial sector. There are many reasons for this. First, the twelve Fed district banks are largely controlled by the banks within the district, which directly appoint one third of the bank’s directors. The presidents of these banks occupy 12 of the 19 seats (5 of the voting seats) on the FOMC.
The seven governors of the Fed are appointed by the president and approved by Congress, but even this group often has extensive ties to the financial industry. For example, Stanley Fischer, the current vice-chair, was formerly a vice-chair of Citigroup.
The third main reason why the Fed tends to be overly concerned with the interests of the financial sector is that its professional staffers are often looking to get jobs in the sector. While jobs at the Fed are well-paying, staffers can often earn salaries that are two or three times higher if they take their expertise to a bank or other financial firm. As economic theory predicts, this incentive structure pushes them toward viewpoints that often coincide with those of the industry.
The net effect of these biases is that the Fed tends to be far more concerned about the inflation part of its mandate rather than the high employment part, even though under the law the two goals are symmetric. If the Fed tightens too much and prevents hundreds of thousands or even millions of workers from getting jobs, most of the top staff would not be terribly troubled and it is unlikely anyone would suffer in their careers. On the other hand, if they allowed the inflation rate to rise to 3.0 percent, it is likely that many top officials at the Fed would be very troubled.
There is very little basis in economic research for maintaining that a stable 3.0 inflation rate is more costly to the country than having 1 million people being needlessly unemployed, but the view coming from the Fed is that the former is much worse than the latter. The Fed cultists at the Washington Post and elsewhere want us to just accept that this is the way the world works. It’s not surprising that some folks don’t quite see it that way.
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The NYT had a piece on the proposals that various candidates have proposed to rein in Wall Street. The piece reports that former Secretary of State Hillary Clinton has proposed applying the normal income tax rate of 39.6 percent to capital gains on assets held less than six years rather than the 20 percent tax rate. (In both cases, capital gains for high income taxpayers are also subject to a 3.8 percent surtax connected with with Affordable Care Act.) It would have been helpful to point out that the lower capital gains tax currently only applies on assets held at least one year, so very short-term gains already do not qualify for the lower tax rate. Also, Secretary Clinton’s proposal would phase down the tax rate to 36 percent for assets held between 2–3 years, 32 percent for 3–4 years, on down to 20 percent for assets held more than six years.
It also would have been worth more discussion of the proposals for financial transactions tax. According to an analysis by the Tax Policy Center of the Urban Institute and the Brookings Institution, a tax like the one proposed by Senator Bernie Sanders would reduce Wall Street’s income from trading by more than $75 billion a year. This dwarfs the impact of all the other measures discussed in this article, including the Dodd-Frank financial reform act.
Note: An earlier version of this post had said that Clinton’s proposal would have the 20 percent rate on assets held for more than two years. Thanks to Robert Salzberg for correcting this error.
The NYT had a piece on the proposals that various candidates have proposed to rein in Wall Street. The piece reports that former Secretary of State Hillary Clinton has proposed applying the normal income tax rate of 39.6 percent to capital gains on assets held less than six years rather than the 20 percent tax rate. (In both cases, capital gains for high income taxpayers are also subject to a 3.8 percent surtax connected with with Affordable Care Act.) It would have been helpful to point out that the lower capital gains tax currently only applies on assets held at least one year, so very short-term gains already do not qualify for the lower tax rate. Also, Secretary Clinton’s proposal would phase down the tax rate to 36 percent for assets held between 2–3 years, 32 percent for 3–4 years, on down to 20 percent for assets held more than six years.
It also would have been worth more discussion of the proposals for financial transactions tax. According to an analysis by the Tax Policy Center of the Urban Institute and the Brookings Institution, a tax like the one proposed by Senator Bernie Sanders would reduce Wall Street’s income from trading by more than $75 billion a year. This dwarfs the impact of all the other measures discussed in this article, including the Dodd-Frank financial reform act.
Note: An earlier version of this post had said that Clinton’s proposal would have the 20 percent rate on assets held for more than two years. Thanks to Robert Salzberg for correcting this error.
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The NYT had an interesting piece noting criticisms from the left and right directed at the Federal Reserve Board over its monetary policy decisions. It concludes with a comment from Princeton University professor and former Fed vice-chair Alan Blinder, saying that the Fed cannot do much to either reduce inequality or government indebtedness.
This is not accurate. From February of 1994 to March of 1995, the Fed made a decision to raise its short-term interest rate from 3.0 percent to 6.0 percent. This was done to slow the economy and the rate of job creation. This was due to the fact the unemployment rate was falling into or below the level that the Fed models showed were consistent with stable inflation. In these models, if the unemployment rate was allowed to fall much below 6.0 percent, the inflation rate would begin to accelerate, leading to a problem of spiraling inflation.
In the summer of 1995, after the economy had slowed, the Fed chair Alan Greenspan pushed the Fed to lower interest rates even though the unemployment was below most estimates of full employment. He insisted that the Fed allow the unemployment continue to fall over the next four years even as it crossed 5.0 percent and eventually 4.0 percent in 1999 and 2000. This period of low unemployment was the only time in the last 40 years in which workers at the middle and bottom of the wage distribution saw sustained growth in real wages.
This is how Fed policy can affect inequality. If the Fed had not been pushed by Greenspan, who is not an orthodox economist, it likely would have raised interest rates during this period and prevented the low unemployment and real wage growth of this period.
It is also worth noting that the Fed’s policy was also the basis for the budget surpluses at the end of the decade. In 1996, after all the Clinton-Gingrich tax increases and spending had been passed into law, the Congressional Budget Office (CBO) projected a deficit for 2000 of close to $250 billion (2.5 percent of GDP). The fact that we had a surplus of roughly the same amount was not due to changes in budget policy, but rather the fact that we had an unemployment rate of 4.0 percent rather than the 6.0 percent projected by CBO. (The tax from capital gains created by the stock bubble also helped.)
The NYT had an interesting piece noting criticisms from the left and right directed at the Federal Reserve Board over its monetary policy decisions. It concludes with a comment from Princeton University professor and former Fed vice-chair Alan Blinder, saying that the Fed cannot do much to either reduce inequality or government indebtedness.
This is not accurate. From February of 1994 to March of 1995, the Fed made a decision to raise its short-term interest rate from 3.0 percent to 6.0 percent. This was done to slow the economy and the rate of job creation. This was due to the fact the unemployment rate was falling into or below the level that the Fed models showed were consistent with stable inflation. In these models, if the unemployment rate was allowed to fall much below 6.0 percent, the inflation rate would begin to accelerate, leading to a problem of spiraling inflation.
In the summer of 1995, after the economy had slowed, the Fed chair Alan Greenspan pushed the Fed to lower interest rates even though the unemployment was below most estimates of full employment. He insisted that the Fed allow the unemployment continue to fall over the next four years even as it crossed 5.0 percent and eventually 4.0 percent in 1999 and 2000. This period of low unemployment was the only time in the last 40 years in which workers at the middle and bottom of the wage distribution saw sustained growth in real wages.
This is how Fed policy can affect inequality. If the Fed had not been pushed by Greenspan, who is not an orthodox economist, it likely would have raised interest rates during this period and prevented the low unemployment and real wage growth of this period.
It is also worth noting that the Fed’s policy was also the basis for the budget surpluses at the end of the decade. In 1996, after all the Clinton-Gingrich tax increases and spending had been passed into law, the Congressional Budget Office (CBO) projected a deficit for 2000 of close to $250 billion (2.5 percent of GDP). The fact that we had a surplus of roughly the same amount was not due to changes in budget policy, but rather the fact that we had an unemployment rate of 4.0 percent rather than the 6.0 percent projected by CBO. (The tax from capital gains created by the stock bubble also helped.)
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Robert Samuelson has a column this morning on the impact of globalization on national economies. At one point the piece tells readers:
“Globalization has also punished the United States. From 2004 to 2006, the Federal Reserve raised short-term interest rates by 4.25 percentage points, believing that long-term rates on bonds and mortgages — which affect the economy more — would follow. They didn’t. If they had, would the 2008-2009 financial crisis have been avoided or softened? Then-Fed Chairman Ben Bernanke later argued that a ‘global savings glut’ of dollars — flooding into bonds — kept long-term rates down.”
This comment leaves out a very important part of the story. Foreign central banks, most importantly China’s, were buying up massive amounts of U.S. government bonds in this period. Their goal was to prop up the dollar against their currencies so that they could continue to run large trade surpluses and leaving the United States with large trade deficits. The trade deficit peaked at just under 6.0 percent of GDP ($1.1 trillion in today’s economy) in 2005.
Since the central banks were buying up long-term bonds it is not surprising that long-term interest rates stayed low in spite of the Fed’s decision to raise short-term rates. The impact of the foreign central banks policy on long-term interest rates is the same as the recent Fed policy of quantitative easing. Markets don’t care if bonds are purchased by the Central Bank of China or Japan or the Fed, it has the same impact on bond prices and interest rates.
Robert Samuelson has a column this morning on the impact of globalization on national economies. At one point the piece tells readers:
“Globalization has also punished the United States. From 2004 to 2006, the Federal Reserve raised short-term interest rates by 4.25 percentage points, believing that long-term rates on bonds and mortgages — which affect the economy more — would follow. They didn’t. If they had, would the 2008-2009 financial crisis have been avoided or softened? Then-Fed Chairman Ben Bernanke later argued that a ‘global savings glut’ of dollars — flooding into bonds — kept long-term rates down.”
This comment leaves out a very important part of the story. Foreign central banks, most importantly China’s, were buying up massive amounts of U.S. government bonds in this period. Their goal was to prop up the dollar against their currencies so that they could continue to run large trade surpluses and leaving the United States with large trade deficits. The trade deficit peaked at just under 6.0 percent of GDP ($1.1 trillion in today’s economy) in 2005.
Since the central banks were buying up long-term bonds it is not surprising that long-term interest rates stayed low in spite of the Fed’s decision to raise short-term rates. The impact of the foreign central banks policy on long-term interest rates is the same as the recent Fed policy of quantitative easing. Markets don’t care if bonds are purchased by the Central Bank of China or Japan or the Fed, it has the same impact on bond prices and interest rates.
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Robert Shiller rightly deserves his Nobel Prize as perhaps the world’s leading expert on asset bubbles. (I beat him by a year on the housing bubble in the United States.) But I think he gets the story badly wrong in making the case that there is currently a serious bubble in the U.S. stock market.
Shiller’s rationale is that the price-to-earnings ratio is well above its historic average. Furthermore, he points to the large stock plunges the last three times the price to earnings ratio approached current levels in 1929, 2000, and 2007.
There are two reasons I find the case less than compelling. First, it seems very plausible that people feel more comfortable investing in the stock market today than was the case thirty or forty years ago. This can be explained by the existence of index funds and the growth of defined contribution pensions. As a simple factual matter, a much larger percent of the population has stock holding today than was the case forty years ago, even if the distribution of holdings is still quite skewed.
The implication is that people if people view the market as less risky now than in the past, stock would command a lower risk premium than it had historically. This would justify a higher price-to-earnings ratio. This could mean that something like the ratio of 27 that Shiller calculates, compared to a long-term average of 17, could be reasonable. The ratio of 44 he calculated for 2000 clearly was not. (Note that the 2000 ratio is more than 60 percent higher than the current ratio.)
Btw, the tumble from 2007 peak was associated with a small detail: the collapse of the housing bubble and the ensuing financial crisis. I had warned of the market peak back then not because I thought stock prices were inherently too high, but that no one on Wall Street anticipated the devastation that would follow the collapse of the housing bubble.
The other reason why the current PEs in the stock market might be justified is that interest rates are well below their historic averages. With the nominal rate on 10-year Treasury bonds at just over 2.0 percent and the inflation rate around 1.6 percent, the real interest rate is roughly 0.5 percent. This compares to a long-period average in the range of 2.5-3.0 percent.
With the alternatives to holding stock offering returns that are far lower than they have in the past, it makes sense that people would be willing to accept a much lower return on their stock. The current PE should still allow a premium in the range of 4.0 percentage points relative to bonds, which is roughly the long period average. Of course if we had reason to expect that the real returns on bonds would rise sharply in the near future, then this argument would not carry much weight, but there does not appear to be any good story as to why real bond yields should be headed much higher in the near future.
In short, stocks do look high in the sense that people should expect lower returns in the future than the historic yield on stock, and they certainly should not expect to see anything like the run-up from 2009-2014. However, there is no reason to expect a sharp downturn barring a major downturn in the economy for reasons not currently in sight.
Robert Shiller rightly deserves his Nobel Prize as perhaps the world’s leading expert on asset bubbles. (I beat him by a year on the housing bubble in the United States.) But I think he gets the story badly wrong in making the case that there is currently a serious bubble in the U.S. stock market.
Shiller’s rationale is that the price-to-earnings ratio is well above its historic average. Furthermore, he points to the large stock plunges the last three times the price to earnings ratio approached current levels in 1929, 2000, and 2007.
There are two reasons I find the case less than compelling. First, it seems very plausible that people feel more comfortable investing in the stock market today than was the case thirty or forty years ago. This can be explained by the existence of index funds and the growth of defined contribution pensions. As a simple factual matter, a much larger percent of the population has stock holding today than was the case forty years ago, even if the distribution of holdings is still quite skewed.
The implication is that people if people view the market as less risky now than in the past, stock would command a lower risk premium than it had historically. This would justify a higher price-to-earnings ratio. This could mean that something like the ratio of 27 that Shiller calculates, compared to a long-term average of 17, could be reasonable. The ratio of 44 he calculated for 2000 clearly was not. (Note that the 2000 ratio is more than 60 percent higher than the current ratio.)
Btw, the tumble from 2007 peak was associated with a small detail: the collapse of the housing bubble and the ensuing financial crisis. I had warned of the market peak back then not because I thought stock prices were inherently too high, but that no one on Wall Street anticipated the devastation that would follow the collapse of the housing bubble.
The other reason why the current PEs in the stock market might be justified is that interest rates are well below their historic averages. With the nominal rate on 10-year Treasury bonds at just over 2.0 percent and the inflation rate around 1.6 percent, the real interest rate is roughly 0.5 percent. This compares to a long-period average in the range of 2.5-3.0 percent.
With the alternatives to holding stock offering returns that are far lower than they have in the past, it makes sense that people would be willing to accept a much lower return on their stock. The current PE should still allow a premium in the range of 4.0 percentage points relative to bonds, which is roughly the long period average. Of course if we had reason to expect that the real returns on bonds would rise sharply in the near future, then this argument would not carry much weight, but there does not appear to be any good story as to why real bond yields should be headed much higher in the near future.
In short, stocks do look high in the sense that people should expect lower returns in the future than the historic yield on stock, and they certainly should not expect to see anything like the run-up from 2009-2014. However, there is no reason to expect a sharp downturn barring a major downturn in the economy for reasons not currently in sight.
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Well, that may not be what they intended to point out, but it is in fact what they pointed out, according to the International Business Times. According to the paper:
“Critics point to the results in France and Italy, which have their own financial tax regimes. In Italy, average daily trading in Italian stocks dropped 29.7 percent in January and February 2014, compared to the average for the same period in 2013, Credit Suisse trading strategy analysts said last year.”
The tax rate on trades on exchanges was 0.1 percent on the transaction. If transactions costs averaged 0.3 percent before the tax, then this increased the cost per transaction by 33 percent to 0.4 percent. While the cost per trade will have risen by one third, the critics tell us that trading volume fell by 29.7 percent.
This means that Italian investors are actually spending 6.5 percent less on stock trades now than they did before the tax was put in place (0.703*1.33= 0.935). Since traders don’t on average make money on trading (some win and others lose), investors are actually saving money as a result of the tax. The full cost of the tax is therefore coming out of the pockets of the financial industry in the form of reduced trading volume. This would explain why they are critics of the tax.
Well, that may not be what they intended to point out, but it is in fact what they pointed out, according to the International Business Times. According to the paper:
“Critics point to the results in France and Italy, which have their own financial tax regimes. In Italy, average daily trading in Italian stocks dropped 29.7 percent in January and February 2014, compared to the average for the same period in 2013, Credit Suisse trading strategy analysts said last year.”
The tax rate on trades on exchanges was 0.1 percent on the transaction. If transactions costs averaged 0.3 percent before the tax, then this increased the cost per transaction by 33 percent to 0.4 percent. While the cost per trade will have risen by one third, the critics tell us that trading volume fell by 29.7 percent.
This means that Italian investors are actually spending 6.5 percent less on stock trades now than they did before the tax was put in place (0.703*1.33= 0.935). Since traders don’t on average make money on trading (some win and others lose), investors are actually saving money as a result of the tax. The full cost of the tax is therefore coming out of the pockets of the financial industry in the form of reduced trading volume. This would explain why they are critics of the tax.
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The NYT had an interesting map showing the extent to which countries trade with China as a way of illustrating its importance to the world economy. The main measure of the importance of trade with China is a circle showing the sum of imports and exports.
This is not really accurate, since the impact of a slowdown in China’s economy will be very different in its impact on imports and exports. If China’s economy’s slows sharply then the amount it imports from other countries will likely fall or at least grow considerably less rapidly than if its growth rate had been sustained.
On the other hand, there is no direct effect of slowing on China’s exports to its trading partners. There may be an indirect effect insofar as China’s slowing is associated with a lower value of its currency. In that case, its goods and services will become cheaper to its trading partners, which will likely lead to more rapid growth in Chinese imports by its trading partners. However this effect is likely to be considerably smaller than the impact on the exports of trading partners, which will fall due to both slower growth and changes in currency values.
It also would have been helpful if the numbers were expressed as shares of GDP. For example, Germany’s exports of $94 billion annually to China are far more important to its economy than the $153 billion exported by the United States, since the U.S. economy is more than four times as large as Germany’s.
The NYT had an interesting map showing the extent to which countries trade with China as a way of illustrating its importance to the world economy. The main measure of the importance of trade with China is a circle showing the sum of imports and exports.
This is not really accurate, since the impact of a slowdown in China’s economy will be very different in its impact on imports and exports. If China’s economy’s slows sharply then the amount it imports from other countries will likely fall or at least grow considerably less rapidly than if its growth rate had been sustained.
On the other hand, there is no direct effect of slowing on China’s exports to its trading partners. There may be an indirect effect insofar as China’s slowing is associated with a lower value of its currency. In that case, its goods and services will become cheaper to its trading partners, which will likely lead to more rapid growth in Chinese imports by its trading partners. However this effect is likely to be considerably smaller than the impact on the exports of trading partners, which will fall due to both slower growth and changes in currency values.
It also would have been helpful if the numbers were expressed as shares of GDP. For example, Germany’s exports of $94 billion annually to China are far more important to its economy than the $153 billion exported by the United States, since the U.S. economy is more than four times as large as Germany’s.
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The NYT told readers:
“The Federal Reserve has said that it expects to raise interest rates sometime soon, given evidence over the last year that economic growth is picking up.”
This undoubtedly had people wondering what the paper could have in mind. GDP growth has averaged less than 1.7 percent over the last three quarters. While employment growth has remained strong, the pace has slowed in recent months. Wages are barely keeping pace with inflation, with no sign of acceleration. Housing starts have picked up, but non-residential investment has been virtually flat.
In short, we are not looking at a story of the Fed raising rates in an economy that is picking up steam, rather the Fed seems to have lowered its expectations so that it is now prepared to raise rates and slow growth in an economy that is operating well below almost everyone’s estimates of potential GDP. What has changed is the Fed’s perceptions of an acceptable level of GDP and employment, not the economy.
The NYT told readers:
“The Federal Reserve has said that it expects to raise interest rates sometime soon, given evidence over the last year that economic growth is picking up.”
This undoubtedly had people wondering what the paper could have in mind. GDP growth has averaged less than 1.7 percent over the last three quarters. While employment growth has remained strong, the pace has slowed in recent months. Wages are barely keeping pace with inflation, with no sign of acceleration. Housing starts have picked up, but non-residential investment has been virtually flat.
In short, we are not looking at a story of the Fed raising rates in an economy that is picking up steam, rather the Fed seems to have lowered its expectations so that it is now prepared to raise rates and slow growth in an economy that is operating well below almost everyone’s estimates of potential GDP. What has changed is the Fed’s perceptions of an acceptable level of GDP and employment, not the economy.
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Andrew Ross Sorkin seems prepared to pronounce Ken Rogoff to be prescient once again with his prediction that China would run into a debt crisis. Rogoff’s past claims to prescience might be viewed as somewhat questionable. He, along with co-author Carmen Reinhardt, famously argued that countries face a severe slowdown in growth when their debt to GDP ratios exceed 90 percent. It turned out that this claim was driven by an error in an Excel spreadsheet, nonetheless it was used to justify austerity in the euro zone, the United States and elsewhere. This austerity did help to worsen the downturns caused by the collapse of asset bubbles, in effect contributing to the crisis that Sorkin credits Rogoff with predicting.
Anyhow, the jury is still out as to whether China will face a serious slump due to its market downturn, as Rogoff himself is quoted as saying in Sorkin’s piece. The prediction on which Rogoff and just about everyone else in the world has been proven correct is that China’s stock market bubble would burst. (It had risen by 150 percent between June of 2014 and June of 2015.) Rogoff does not seem prepared to say even now that this will lead to a more general collapse of China’s economy.
Andrew Ross Sorkin seems prepared to pronounce Ken Rogoff to be prescient once again with his prediction that China would run into a debt crisis. Rogoff’s past claims to prescience might be viewed as somewhat questionable. He, along with co-author Carmen Reinhardt, famously argued that countries face a severe slowdown in growth when their debt to GDP ratios exceed 90 percent. It turned out that this claim was driven by an error in an Excel spreadsheet, nonetheless it was used to justify austerity in the euro zone, the United States and elsewhere. This austerity did help to worsen the downturns caused by the collapse of asset bubbles, in effect contributing to the crisis that Sorkin credits Rogoff with predicting.
Anyhow, the jury is still out as to whether China will face a serious slump due to its market downturn, as Rogoff himself is quoted as saying in Sorkin’s piece. The prediction on which Rogoff and just about everyone else in the world has been proven correct is that China’s stock market bubble would burst. (It had risen by 150 percent between June of 2014 and June of 2015.) Rogoff does not seem prepared to say even now that this will lead to a more general collapse of China’s economy.
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