Must-Read: Jan Mohlmann and Wim Suyker: Blanchard and Leigh’s Fiscal Multipliers Revisited

Must-Read: Naughty, naughty!

Jan Mohlmann and Wim Suyker: Blanchard and Leigh’s Fiscal Multipliers Revisited: “[We] do not find convincing evidence for stronger-than-expected fiscal multipliers for EU countries…

…during the sovereign debt crisis (2012-2013) or during the tepid recovery thereafter…. As Blanchard and Leigh did, we find a negative and statistically significant coefficient for 2009-2010 and 2010-2011 but not for 2011-2012…. For 2012-2013 we find a larger estimate than Blanchard and Leigh, but due to the higher standard error the estimated coefficient is no longer significant at the 5% level…. In the two periods we added, our estimated coefficients are close to zero…. As Blanchard and Leigh did, we find a statistically significant negative coefficient in the panel forecast for 2009-2013. This result holds for the prolonged period 2009-2015. However, we do not find a statistically significant coefficient when we perform the panel analysis for the period 2011-2015.

Nowhere in their piece do Mohlmann and Suyker report their estimated coefficient and its standard error for the entire period 2009-2015.

Repeat: nowhere in their piece do they report estimates for their entire sample.

Trying to back out estimates from the information they do give, if they had reported it they would have reported a number like -0.60 with a standard error near 0.23. Compare that to the Blanchard-Leigh estimates for 2009-2013 of a number of -0.67 with a standard error of 0.16.

See that a good and true lead is not “[There is no] convincing evidence for stronger-than-expected fiscal multipliers… during… 2012-13 or thereafter…”

See that a good and true lead would be: “There is no statistical power at all over 2012-13, 2013-14, and 2014-15 to test whether excess fiscal multipliers in those years are different than the strong excess fiscal multipliers found by Blanchard and Leigh…”

Seizing the high ground of the null hypothesis for one’s favored position, and then running tests with no power, is undignified…

Blanchard leigh Google Search

Must-Read: Paul Krugman: Demand, Supply, and Macroeconomic Models

Paul Krugman talks to journalists during a news conference. (AP Photo/Francisco Seco)

Must-Read: A key factor Krugman omits in which standard Hicksian-inclined economists’ predictions have fallen down: the length of the short run. The length of the short run was supposed to be a small multiple of typical contract duration in the economy–perhaps six years in an economy characterized by three-year labor contracts, and perhaps three years in an economy in which workers and employers made decisions on an annual cycle. After that time, nominal prices and wages were supposed to have adjusted enough to nominal aggregates that the economy either would be at or would be well on the road to its long-run full-employment configuration. Moreover, the fact that price inertia was of limited duration combined with forward-looking financial markets and investment-profitability decisions to greatly damp short-run shortfalls of employment and production from full employment and sustainable potential.

It sounded good in theory. It has not proved true in reality since 2007:

Paul Krugman: Demand, Supply, and Macroeconomic Models: “If you came into the crisis with a broadly Hicksian view of aggregate demand…

…you did quite well… [arguing] that as long as we were at the zero lower bound massive increases in the monetary base wouldn’t be inflationary [and would have near-zero effects on broader aggregates]… budget deficits would not drive up interest rates… large multipliers from fiscal policy…. What hasn’t worked nearly as well is our understanding of aggregate supply… the absence of deflation… [of] the “clockwise spirals”… in inflation-unemployment space as evidence for… Friedman-Phelps…. The other big problem is the dramatic drop in… potential output… correlated with the depth of cyclical slumps….

[The] policy moral[?]… Central banks focused on stable inflation may think they’re doing a good job… when they are actually failing…. Fiscal contraction in a liquidity trap seems… absolutely terrible for the long-run as well as the short-run, and quite possibly counterproductive even in purely [debt burden] terms…. I don’t think even Hicksian-inclined economists have taken all of this sufficiently into account.

Must-Read: Simon Wren-Lewis: Politically Impossible

Must-Read: The writer, BTW, is Chris Giles. In light of this, does the almost-always excellent Financial Times have a significant quality-control problem here?

Simon Wren-Lewis: Politically Impossible: “An article in the Financial Times recently said of me…

…‘He has opposed deficit reduction when the economy was weak and when it was strong.’ Ah yes, this would be the same economist who has suggested the left aims to reduce the current deficit (all current spending less revenue) to zero, that pre-crisis fiscal policy in the Euro periphery should have been much more contractionary, and has championed fiscal councils as a way of eliminating deficit bias.

Should I have demanded a retraction? I didn’t: life is short, maybe it was a kind of joke, or even a misprint, and if not perhaps it said more about the writer than it did about me…. Equally it makes no sense obsessing about the need to reduce deficits in a recession and then turning a blind eye when surpluses are spent in a boom. Unfortunately just that kind of inconsistent thinking became hard-wired in the form of the Stability and Growth Pact (SGP), with its focus on a limit of 3% for deficits. Those who say that all that was wrong with the SGP is that it was not enforced have learnt nothing. This is why we need to move influence away from the Commission and towards independent national fiscal councils.

Painful lessons from the Great Recession: Hoisted from the archives from 5 years ago

What Have We Unlearned from Our Great Recession?

Jan 07, 2011 10:15 am, Sheraton, Governor’s Square 15 American Economic Association: What’s Wrong (and Right) with Economics? Implications of the Financial Crisis (A1) (Panel Discussion): Panel Moderator: JOHN QUIGGIN (University of Queensland, Australia)

  • BRAD DELONG (University of California-Berkeley) Lessons for Keynesians
  • TYLER COWEN (George Mason University) Lessons for Libertarians
  • SCOTT SUMNER (Bentley University) A defense of the Efficient Markets Hypothesis
  • JAMES K. GALBRAITH (University of Texas-Austin) Mainstream economics after the crisis:

My role here is the role of the person who starts the Alcoholics Anonymous meetings.

My name is Brad DeLong.

I am a Rubinite, a Greenspanist, a neoliberal, a neoclassical economist.

I stand here repentant.

I take my task to be a serious person and to set out all the things I believed in three or four years ago that now appear to be wrong. I find this distressing, for I had thought that I had known what my personal analytical nadir was and I thought that it was long ago behind me

I had thought my personal analytical nadir had come in the Treasury, when I wrote a few memos about how Rudi Dornbusch was wrong in thinking that the Mexican peso was overvalued. The coming of NAFTA would give Mexico guaranteed tariff free access to the largest consumer market in the world. That would produce a capital inflow boom in Mexico. And so, I argued, the peso was likely to appreciate rather than the depreciate in the aftermath of NAFTA.

What I missed back in 1994 was, of course, that while there were many US corporations that wanted to use Mexico’s access to the US market and so locate the unskilled labor parts of their value chains south, there were rather more rich people in Mexico who wanted to move their assets north. NAFTA not only gave Mexico guaranteed tariff free access to the largest consumer market in the world, it also gave US financial institutions guaranteed access to the savings of Mexicans. And it was this tidal wave of anticipatory capital flight–by people who feared the ballots might be honestly counted the next time Cuohtemac Cardenas ran for President–that overwhelmed the move south of capital seeking to build factories and pushed down the peso in the crisis of 1994-95.

I had thought that was my worst analytical moment.

I think the past three years have been even worse.

So here are five things that I thought I knew three or four years ago that turned out not to be true:

  1. I thought that the highly leveraged banks had control over their risks. With people like Stanley Fischer and Robert Rubin in the office of the president of Citigroup, with all of the industry’s experience at quantitative analysis, with all the knowledge of economic history that the large investment and commercial banks of the United States had, that their bosses understood the importance of walking the trading floor, of understanding what their underlings were doing, of managing risk institution by institution. I thought that they were pretty good at doing that.

  2. I thought that the Federal Reserve had the power and the will to stabilize the growth path of nominal GDP.

  3. I thought, as a result, automatic stabilizers aside, fiscal policy no longer had a legitimate countercyclical role to play. The Federal Reserve and other Central Banks were mighty and powerful. They could act within Congress’s decision loop. There was no no reason to confuse things by talking about discretionary fiscal policy–it just make Congress members confused about how to balance the short run off against the long run.

  4. I thought that no advanced country government with as frayed a safety net as America would tolerate 10% unemployment. In Germany and France with their lavish safety nets it was possible to run an economy for 10 years with 10% unemployment without political crisis. But I did not think that was possible in the United States.

  5. And I thought that economists had an effective consensus on macroeconomic policy. I thought everybody agreed that the important role of the government was to intervene strategically in asset markets to stabilize the growth path of nominal GDP. I thought that all of the disputes within economics were over what was the best way to accomplish this goal. I did not think that there were any economists who would look at a 10% shortfall of nominal GDP relative to its trend growth path and say that the government is being too stimulative.

With respect to the first of these–that the large highly leveraged banks had control over their risks: Indeed, American commercial banks had hit the wall in the early 1980s when the Volcker disinflation interacted with the petrodollar recycling that they had all been urged by the Treasury to undertake. American savings and loans had hit the wall when the Keating Five senators gave them the opportunity to gamble for resurrection while they were underwater. But in both of these the fact that the government was providing a backstop was key to their hitting the wall.

Otherwise, it seemed the large American high commercial and investment banks had taken every shock the economy could throw at them and had come through successfully. Oh, every once in a while an investment bank would flame out and vanish. Drexel would flame out and vanish. Goldman almost flamed out and vanished in 1970 with the Penn Central. We lost Long Term Capital Management. Generally we lost one investment bank every decade or generation. But that’s not a systemic threat. That’s an exciting five days reading the Financial Times. That’s some overpaid financiers getting their comeuppance, which causes schadenfreude for the rest of us. That’s not something of decisive macro significance.

The large banks came through the crash of 1987. They came through Saddam Hussein’s invasion of Kuwait. Everyone else came through the LTCM crisis. Everyone came through the Russian state bankruptcy when the IMF announced that nuclear-armed ex-superpowers are not too big to fail. They came through assorted emerging market crisis. They came through the collapse of the Dot Com Bubble.

It seemed that they understood risk management thing and that they had risk management thing right. In the mid 2000s when the Federal Reserve ran stress tests on the banks the stress was a sharp decline in the dollar if something like China’s dumping its dollar assets started to happen. Were the banks robust to a sharp sudden decline in the dollar, or had they been selling unhedged puts on the dollar? The answer appeared to be that they were robust. Back in 2005 policymakers could look forward with some confidence at the ability of the banks to deal with large shocks like a large sudden fall on the dollar.

Subprime mortgages? Well, those couldn’t possibly be big enough to matter. Everyone understood that the right business for a leveraged bank in subprime was the originate-and-distribute business. By God were they originating. But they were also distributing.

I thought about theses issues in combination with the large and persistent equity premium that has existed in the US stock market over the past century. You cannot blame this premium on some Mad Max scenario in which the US economy collapses because the equity premium is a premium return of stocks over US Treasury bonds, and if the US economy collapses then Treasury bonds’ real values collapse as well–the only things that hold their value are are bottled water, sewing machines and ammunition, and even gold is only something that can get you shot. You have to blame this equity risk premium on a market failure: excessive risk aversion by financial investors and a failure to mobilize the risk-bearing capacity of the economy. This there was a very strong argument that we needed more, not less leverage on a financial system as a whole. Thus every action of financial engineering–that finds people willing to bear residual equity risk and that turns other assets that have previously not been traded into tradable assets largely regarded as safe–helps to mobilize some of the collective risk bearing capacity of the economy, and is a good thing.

Or so I thought.

Now this turned out to be wrong.

The highly leveraged banks did not have control over their risks. Indeed if you read the documents from the SECs case against Citigroup with respect to its 2007 earnings call, it is clear that Citigroup did not even know what their subprime exposure was in spite of substantial effort by management trying to find out. Managers appeared to have genuinely thought that their underlings were following the originate-and-distribute models to figure out that their underlings were trying to engage in regulatory arbitrage by holding assets rated Triple A as part of their capital even though they knew fracking well that the assets were not really Triple A.

Back when Lehman Brothers was a partnership, every 30-something in Lehman Brothers was a risk manager. They all knew that their chance of becoming really rich depended on Lehman Brothers not blowing as they rose their way through the ranks of the partnership.

By the time everything is a corporation and the high-fliers’ bonuses are based on the mark-to-model performance of their positions over the past 12 months, you’ve lost that every-trader-a-risk manager culture. i thought the big banks knew this and had compensated for it.

I was wrong,

With respect to the second of these–that the Federal Reserve had the power and the will to stabilize nominal GDP: Three years ago I thought it could and would. I thought that he was not called “Helicopter Be”n for no reason. I thought he would stabilize nominal GDP. I thought that the cost to Federal Reserve political standing and self-perception would make the Federal Reserve stabilize nominal GDP. I thought that if nominal GDP began to undershoot its trend by any substantial amount, that then the Federal Reserve would do everything thinkable and some things that had not previously been thought of to get nominal GDP back on to its trend growth track.

This has also turned out not to be true.

That nominal GDP is 10% below its pre-2008 trend is not of extraordinarily great concern to those who speak in the FOMC meetings. And staffing-up the Federal Reserve has not been an extraordinarily great concern on the part of the White House: lots of empty seats on the Board of Governors for a long time.

With respect to the third of these–that discretionary fiscal policy had no legitimate role: Three years ago I thought that the Federal Reserve could do the job, and that discretionary countercyclical fiscal policy simply confused congress members, Remember Orwell’s Animal Farm? Every animal on the Animal Farm understands the basic principle of animalism: “four legs good, two legs bad” (with a footnote that, as Squealer the pig says, a wing is an organ of locomotion rather than manipulation and is properly thought of as leg rather than an arm–certainly not a hand).

“Four legs good, two legs bad,” was simple enough for all the animals to understand. “Short-term countercyclical budget deficit in recession good, long-run budget deficit that crowds out investment bad,” was too complicated for Congressmen and Congresswomen to understand. Given that, discretionary fiscal policy should be shunted off to the side as confusing. The Federal Reserve should do the countercycical stabiization job.

This also turned out not to be true, or not to be as true as we would like. When the Federal funds rate hits the zero lower bound making monetary policy effective becomes complicated. You can do it, or we think you can do it if you are bold enough, but it is no longer straightforward buying Treasury Bonds for cash. That is just a swap of one zero yield nominal Treasury liability for another. You have got to be doing something else to the economy at the same time to make monetary policy expansion effective at the zero nominal bound,

One thing you can do is boost government purchases. Government purchases are a form of spending that does not have to be backed up by money balances and so raise velocity. And additional government debt issue does have a role to play in keeping open market operations from offsetting themselves whenever money and debt are such close substitutes that people holding Treasury bonds as saving vehicles are just as happy to hold cash as savings vehicles. When standard open market operations have no effect on anything, standard open market operations plus Treasury bond issue will still move the economy.

With respect to the fourth of these–that no American government would tolerate 10% unemployment: I thought that American governments understood that high unemployment was social waste: that it was not in fact an efficient way of reallocating labor across sectors and response to structural change. When unemployment is high and demand is low, the problem of reallocation is complicated by the fact that no one is certain what demand is going to be when you return to full employment. Thus it is very hard to figure which industries you want to be moving resources into: you cannot look at profits but rather you have to look at what profits will be when the economy is back at full employment–and that is hard to do.

For example, it may well be the case that right now America is actually short of housing. There is a good chance that the only reason there is excess supply of housing right now is because people’s incomes and access to credit are so low that lots of families are doubling up in their five-bedroom suburban houses. Construction has been depressed below the trend of family formation for so long that it is hard to see how there could be any fundamental investment overhang any more.

It is always much better to have the reallocation process proceed by having rising industries pulling workers into employment because demand is high. It is bad to have the reallocation process proceed by having mass unemployment in the belief that the unemployed will sooner or later figure out something productive to do. I thought that American governments understood that.

I thought that American governments understood that high unemployment was very hazardous to incumbents. I thought that even the most cynical and self-interested Congressmen and Congresswomen and Presidents would strain every nerve to make sure that the period of high unemployment would be very short.

It turned out that that wasn’t true.

I really don’t know why. I have five theories:

  1. Perhaps the collapse of the union movement means that politicians nowadays tend not to see anybody who speaks for the people in the bottom half of the American income distribution.
  2. Perhaps Washington is simply too disconnected: my brother-in-law observes that the only place in America where it is hard to get a table at dinner time in a good restaurant right now is within two miles of Capitol Hill.
  3. Perhaps we are hobbled by general public scorn at the rescue of the bankers–our failure to communicate that, as Don Kohn said, it’s better to let a couple thousand feckless financiers off scot-free than to destroy the jobs of millions, our failure to make that convincing.
  4. I think about lack of trust in a split economics profession–where there are, I think, an extraordinarily large number of people engaging in open-mouth operations who have simply not done their homework. And at this point I think it important to call out Robert Lucas, Richard Posner, and Eugene Fama, and ask them in the future to please do at least some of their homework before they talk onsense.
  5. I think about ressentment of a sort epitomized by Barack Obama’s statements that the private sector has to tighten its belt and so it is only fair that the public sector should too. I had expected a president advised by Larry Summers and Christina Romer to say that when private sector spending sits down then public sector spending needs to stand up–that is is when the private sector stands up and begins spending again that the government sector should cut back its own spending and should sit down.

I have no idea which is true.

I do know that when I wander around Capitol Hill and the Central Security Zone in Washington, the general view I hear is: “we did a good job: we kept unemployment from reaching 15%–which Mark Zandi and Alan Blinder say it might well have reached if we had done nothing.” That declaration of semi-victory puzzles me.

Three years ago, I thought that whatever theories economists worked on they all agreed the most important thing to stabilize was nominal GDP. Stabilizing the money stock was a good thing to do only because money was a good advance indicator of nominal GDP. Worrying about the savings-investment balance was a good thing to worry about because if you got it right you stabilized nominal GDP. Job 1 was keeping nominal GDP on a stable growth path, so that price rigidity and other macroeconomic failures did not cause high unemployment. That, I thought, was something all economists agreed on. Yet I find today, instead, the economics profession is badly split on whether the 10% percent shortfall of nominal GDP from its pre-2008 trend is even a major problem.

So what are the takeaway lessons? I don’t know.

Last night I was sitting at my hotel room desk trying to come up with the “lessons” slide.

The best I could come up with is to suggest that perhaps our problem is that we have been teaching people macroeconomics.

Perhaps macroeconomics should be banned.

Perhaps it should only be taught through economic history and the history of economic thought courses–courses that start in 1800 back when all issues of what the business cycle was or what it might become were open, and that then trace the developing debates: Say versus Mathis, Say versus Mill, Bagehot versus Fisher, Fisher versus Wicksell, Hayek versus Keynes versus Friedman, and so forth on up to James Tobin. I really don’t know who we should teach after James Tobin: I haven’t been impressed with any analyses of our current situation that have not been firmly rooted in Tobin, Minsky, and those even further in the past.

Then economists would at least be aware of the range of options, and of what smart people have said and thought it the past. It would keep us from having Nobel Prize-caliber economists blathering that the NIPA identity guarantees that expansionary fiscal policy must immediately and obviously and always crowd-out private spending dollar-for-dollar because the government has to obtain the cash it spends from somebody else. Think about that a moment: there is nothing special about the government. If the argument is true for the government, it is true for all groups–no decision to increase spending by anyone can ever have any effect on nominal GDP because whoever spends has to get the cash from somewhere, and that applies to Apple Computer just as much as to the government.

And that has to be wrong.

So let me stop there and turn it over to Scott Sumner…

Must-Read: Michael Spence, Danny Leipziger, James Manyika, and Ravi Kanbur: Restarting the Global Economy

Must-Read: Michael Spence, Danny Leipziger, James Manyika, and Ravi Kanbur: Restarting the Global Economy: “The global economy is not working properly…

…aggregate demand must be expanded, the gap between excessively large pools of capital and huge unmet infrastructure needs must be bridged, and… the distributional downside of rapid technological advances and global integration must be addressed. Change will come only when a global vision is put forth, coupled with political will…. The challenges represented by these mismatches intersect and interact, and play out differently in the short, medium and long term. One normally thinks of aggregate demand deficiency as a short-term challenge of the business cycle, but the current mismatch at the global level has lasted more than seven years…. Deficient labour demand, as the result of weak aggregate demand overall, either lowers wages or causes unemployment if wages are rigid–worsening the distribution of income in either case. This trend towards greater inequality will only worsen as the consequence of long-run trends in labour-displacing technologies….

These three self-reinforcing mismatches are an indication not only of market failure, but also of the failure of governments to address the challenges they pose…. Three areas of concerted public action–boosting global demand (with an emphasis on investment and essential services), unblocking the flow of surplus funds towards unmet investment needs, and mitigating rising inequality–are mutually reinforcing. The analytical arguments behind them are strong. Public policy solutions are possible to deal with many economic challenges if political consensus can be achieved on tackling them, both nationally and globally. What is needed is global vision and political will that can make them a reality and thus restart the global economy so it can meet its potential on growth and on distribution.

Intellectual Broker: (Trying to) Make Sense of Current (Small) Analytical Disagreements Between Paul Krugman and Larry Summers: Where Is the Can Opener?

Larry Summers tweets:

David Wessel picks it up:

And I attempt to Twittersplain, with how much success I do not know:

Larry Summers: Where Paul Krugman and I differ on secular stagnation and demand: “Paul Krugman suggests that I have had some kind of change of heart on secular stagnation…

…and converged towards his point of view…. I certainly appreciate the gravity of the secular stagnation issue more than I did…. But I think Paul exaggerates the change in my views considerably. The topic… was: ‘North America faces a Japan-style era of high unemployment and low growth.’ Paul argued in favor. I opposed the motion–not on the grounds that the US economy was in good shape, but on the grounds that our demand deficiency problems should be easier to solve than Japan’s… [because] it is dimensionally much less than the problems that Japan faced in four respects. Japan’s problems were different in magnitude, different in the depth of their structural roots, different in the… perspective… relative to the rest of the world… different in the degree of resilience [of] their system…. Paul responded in part by saying:

The question is, are we going to be stuck in a state of depressed demand of the kind that Larry has talked about. Larry and I agree that that is what has been happening… I think Larry and I agree almost entirely on the economics, on what needs to be done….

I think we have both been focused on demand and the liquidity trap for a long time. There are, though, two areas where I have had somewhat different views from Paul. I believe that structural issues are often important for demand and growth…. Second, I have never related well to Paul’s celebrated liquidity trap analysis. It has always seemed to me be a classic example of economists’ tendency to ‘assume a can opener’. Paul studies an economy in liquidity trap that will, by deus ex machina, be lifted out at some point in the future. He makes the point that if you assume sufficiently inflationary policy after this point, you can drive ex ante real rates down enough to stimulate the economy even before the deus ex machina moment.

This is true and an important insight. But it seems to elide the main issue. Where is the deus ex machina? Where is the can opener? The essence of the secular stagnation and hysteresis ideas that I have been pushing is that there is no assurance that capitalist economies, when plunged into downturn, will over any interval revert to what had been normal. Understanding this phenomenon and responding to it seems the central challenge for macroeconomics in this era. Any analysis that assumes restoration of previous equilibrium is, from this perspective, missing the main issue. I was glad to see Paul recognize this point recently.  I suspect it will lead to more emphasis on fiscal rather than monetary actions in depressed economies.

Paul Krugman: Liquidity Traps, Temporary and Permanent: “Larry Summers reacts to an offhand post of mine, seeking to draw a distinction between our views…

…I actually don’t think our views differ significantly now, but he’s right that what he has been saying differs from the approach I took way back in 1998. And I’ve both acknowledged that and admitted that the approach I took then seems inadequate now…. Japan now looks like an economy in which a negative natural rate is a more or less permanent condition. So, increasingly, does Europe. And the US may be in the same boat, if only because persistent weakness abroad will lead to a strong dollar, and we will end up importing demand weakness. And if we are in a world of secular stagnation–of more or less permanent negative natural rates–policy becomes even harder.

And I commented on Paul’s webpage thus: But, as I was tweeting to David Wessel, you scorn the Confidence Fairy while having some hope for the Inflation-Expectations Imp, while he scorns the Inflation-Expectations Imp but has some hope for the Confidence Fairy, no? And he has more hope for pump-priming small fiscal expansion to trigger virtuous circles and give the economy escape velocity, no? Small differences relative to those of the two of you vis-a-vis Rogoff, Mankiw, Feldstein, Bernanke, and, I think, even Blanchard. But differences, no?…

Must-Read: Paul Krugman: I do not think that word…<

Must-Read: When did the default definition of “expansionary fiscal policy” become not (1) “the government hires people to build a bridge”, but rather (2) “the government borrows money from some people and writes checks to others, thus raising both current financial assets and expected future tax liabilities”? Or, rather, for what communities did it become (2) rather than (1), and why?

Or, perhaps, when did the deficit become the off-the-shelf measure of the fiscal-policy stance, rather than some other measure that incorporated some role for the balanced-budget multiplier?

This is something I really ought to know, but do not. It is bad that I do not know this:

Paul Krugman: I do not think that word…: “…means what Tyler Cowen and Megan McArdle think it means…

…The word in question is ‘spending.’ Tyler’s latest on temporary versus permanent government consumption clarifies… the confusion…. By ‘government spending’… I mean the government actually, you know, buying something–say, building a bridge. When Tyler says

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be ‘net wealth’ even when they are not,

the only way that makes sense is if he’s thinking of a rebate check. If the government builds a bridge, the boost to aggregate demand comes not because people are ‘tricked’ into feeling wealthier, but because the government is building a bridge. The question then is how much of that direct increase in government demand is offset by a fall in private consumption because people expect their future taxes to be higher; obviously that offset is smaller if they think the bridge is a one-time expense than if they think there will be a bridge built every year. That’s why temporary government spending has a bigger effect…. I guess there’s an alternative theory of what Tyler is talking about–maybe he doesn’t consider the wages of the bridge-builders count, that only what they do with those wages matters…

Or, rather, that all government expenditure is wasteful, and you might have well have simply handed out checks rather than forced people to engage in pointless useless make-work.

What Kind of New Economic Thinking Is Needed Now?: A Twitter Dialogue, with References

A Twitter Dialogue: IS-LM and the Neoclassical Synthesis in the Short-Run and the Medium-Run: Andy Harless asks a question, and I try to explain what I think Paul Krugman is thinking…


And let me put the relevant Paul Krugman pieces down here below the fold… or, rather, below the second fold:

Paul Krugman (October 30, 2015): An Unteachable Moment: “It is, as Antonio Fatas notes, almost seven years since the Fed cut rates to zero…

…The era of lowflation-plus-liquidity-trap now rivals in length the 70s era of stagflation, and has been associated with much worse real economic performance. So where, asks Fatas, is the rethinking of economic theory and policy? I asked the same question a couple of years ago…. Some of us anticipated much though not all of what has gone wrong. [But as] Fatas says…

even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers….

I did write a 1999 book titled The Return of Depression Economics, basically warning that Japan might be a harbinger…. [But even] I never expected policy to be so bad that Japan ends up looking like a role model…. We should have expected… as major a rethink as… in the 70s… [but] we’ve seen almost no rethinking. Economists who wrote that ‘inflation is looming’ in 2009 continued to warn about looming inflation five years later. And that’s the professional economists. As Josh Barro notes, conservatives who imagine themselves intellectuals have increasingly turned to Austrian economics, which explicitly denies that empirical data need to be taken into account….

Back to Fatas: how long will it take before the long stagnation has the kind of intellectual impact that stagflation did… before people stop holding up the 1970s as the ultimate cautionary tale, even… in the midst of a continuing disaster that makes the 70s look mild? I don’t know…. It’s clear that we have to understand this phenomenon in terms of politics and sociology, not logic.

Paul Krugman (October 20, 2015): Rethinking Japan: “The IMF held a small roundtable discussion on Japan yesterday…

…and in preparation for the event I thought it was a good idea to update my discussion of Japan…. I find it useful to approach this subject by asking how I would change what I said in my 1998 paper on the liquidity trap… one of my best papers; and it has held up pretty well…. But… there are two crucial differences between then and now. First, the immediate economic problem is no longer one of boosting a depressed economy, but instead one of weaning the economy off fiscal support. Second, the problem confronting monetary policy is harder than it seemed, because demand weakness looks like an essentially permanent condition.

Back in 1998 Japan was in the midst of its lost decade… good reason to believe that it was operating far below potential output. This is… no longer the case…. Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar (and Japan has done better than Europe)…. Japan [may be] closer to potential output than we are.

So if Japan isn’t deeply depressed at this point, why is low inflation/deflation a problem?The answer… is largely fiscal. Japan’s relatively healthy output and employment levels depend on continuing fiscal support… large budget deficits, which in a slow-growth economy means an ever-rising debt/GDP ratio. So far this hasn’t caused any problems…. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point. And here’s the thing: under current conditions, with policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion.

The big reason to raise inflation, then, is to make it possible to cut real interest rates… allowing monetary policy to take over from fiscal policy…. The fact that real interest rates are in effect being kept too high by insufficient inflation at the zero lower bound also means that debt dynamics for any given budget deficit are worse than they should be…. Raising inflation would both make it possible to do fiscal adjustment and reduce the size of the adjustment needed.

But what would it take to raise inflation? Back in 1998… I envisaged an economy in which the current level of the Wicksellian natural rate of interest was negative, but that rate would return to a normal, positive level…. It was easy to show that this proposition applied only if the money increase was perceived as permanent, so that the liquidity trap became an expectations problem. The approach also suggested that monetary policy would be effective if… the central bank could ‘credibly promise to be irresponsible’…. But what is this future period of Wicksellian normality of which we speak?…

Japan looks like a country in which a negative Wicksellian rate is a more or less permanent condition. If that’s the reality, even a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t. The only way to be at all sure of raising inflation is to accompany a changed monetary regime with a burst of fiscal stimulus…. While the goal of raising inflation is, in large part, to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion. This… is unconventional enough that one despairs of turning the argument into policy (a despair reinforced by yesterday’s meeting…)

How high should Japan set its inflation target?… High enough so that when it does engage in fiscal consolidation it can cut real interest rates far enough to maintain full utilization…. It’s really, really hard to believe that 2 percent inflation would be high enough…. Japan may face a version of the timidity trap. Suppose it convinces the public that it will really achieve 2 percent inflation… engages in fiscal consolidation, the economy slumps, and inflation falls well below 2 percent… the whole project unravels–and the damage to credibility makes it much harder to try again. What Japan needs (and the rest of us may well be following the same path) is really aggressive policy, using fiscal and monetary policy to boost inflation, and setting the target high enough that it’s sustainable. It needs to hit escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

Paul Krugman (March 21, 2014): Timid Analysis: IAn issue I’ve worried about for a long time…

…which I think I’ve been able to formulate a bit better. Here goes: If you look at the extensive theoretical literature on the zero lower bound since my 1998 paper, you find that just about all of it treats liquidity-trap conditions as the result of a temporary shock… [that] leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment. Eventually, however, the shock will end. So the way out is to convince the public that there has been a regime change, that the central bank will maintain expansionary monetary policy even after the economy recovers, so as to generate high demand and some inflation.

But if we’re talking about Japan, when exactly do we imagine that this period of high demand… is going to happen?… What does it take to credibly promise inflation? Well, it has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation. But a necessary (not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it isn’t, then the actual rate of inflation will fall short of the promise even if people believe in the promise–which means that they will stop believing after a while, and the whole effort will fail….

Suppose that the economy really needs a 4 percent inflation target, but the central bank says, ‘That seems kind of radical, so let’s be more cautious and only do 2 percent.’ This sounds prudent–but may actually guarantee failure.

Paul Krugman (March 20, 2014): The Timidity Trap: “In Europe… they’re crowing about Spain’s recovery…

…growth of 1 percent, versus 0.5 percent, in a deeply depressed economy with 55 percent youth unemployment. The fact that this can be considered good news just goes to show how accustomed we’ve grown to terrible economic conditions…. People seem increasingly to be accepting this miserable situation as the new normal…. How did this happen?… I’d argue that an important source of failure was what I’ve taken to calling the timidity trap–the consistent tendency of policy makers who have the right ideas in principle to go for half-measures in practice, and the way this timidity ends up backfiring, politically and even economically….

There are some important differences between the U.S. and European pain caucuses, but both now have truly impressive track records of being always wrong, never in doubt…. In America… a faction both on Wall Street and in Congress… has spent five years and more issuing lurid warnings about runaway inflation and soaring interest rates. You might think that the failure of any of these dire predictions to come true would inspire some second thoughts, but, after all these years, the same people are still being invited to testify, and are still saying the same things…. In Europe, four years have passed since the Continent turned to harsh austerity programs. The architects of these programs told us not to worry about adverse impacts on jobs and growth–the economic effects would be positive, because austerity would inspire confidence. Needless to say, the confidence fairy never appeared….

So what has been the response of the good guys?… The Obama administration’s heart–or, at any rate, its economic model–is in the right place. The Federal Reserve has pushed back against the springtime-for-Weimar, inflation-is-coming crowd. The International Monetary Fund has put out research debunking claims that austerity is painless. But these good guys never seem willing to go all-in…. The classic example is the Obama stimulus… obviously underpowered given the economy’s dire straits. That’s not 20/20 hindsight….

The Fed has, in its own way, done the same thing. From the start, monetary officials ruled out the kinds of monetary policies most likely to work–in particular, anything that might signal a willingness to tolerate somewhat higher inflation, at least temporarily. As a result, the policies they have followed have fallen short of hopes, and ended up leaving the impression that nothing much can be done.

And the same may be true even in Japan… finally adopting the kind of aggressive monetary stimulus Western economists have been urging for 15 years and more. Yet there’s still a diffidence… a tendency to set things like inflation targets lower than the situation really demands… [that] increases the risk that Japan will fail to achieve ‘liftoff’–that the boost it gets from the new policies won’t be enough to really break free from deflation.

You might ask why the good guys have been so timid, the bad guys so self-confident. I suspect that the answer has a lot to do with class interests. But that will have to be a subject for another column.

On the proper size of the public sector, and the proper level of public debt, in the 21st century

Progress and Confusion cover2 pdf 1 page

Rethinking Macro Policy III

Jack Morton Auditorium, George Washington University :: April 15-16, 2015

It has now been seven years since the onset of the global financial crisis. A central question is how the crisis has changed our view on macroeconomic policy. The IMF originally tackled this issue at a 2011 conference and again at a 2013 conference. Both conferences proved very successful, spawning books titled In the Wake of the Crisis and What Have We Learned? published by the MIT Press.

The time seemed right for another assessment. Research has continued, policies have been tried, and the debate has been intense. How much progress has been made? Are we closer to a new framework? To address these questions the IMF organized a follow up conference on “Rethinking Macro Policy III: Progress or Confusion?”, which took place at the Jack Morton Auditorium in George Washington University, Washington DC, on April 15–16, 2015.

The conference was co-organized by IMF Economic Counselor Olivier Blanchard, RBI Governor Raghu Rajan, and Harvard Professors Ken Rogoff and Larry Summers. It brought together leading academics and policymakers from around the globe, as well as representatives from civil society, the private sector, and the media. Attendance was by invitation only.

Wrap Up Video:


J. Bradford DeLong

On the Proper Size of the Public Sector, and the Proper Level of Public Debt, in the Twenty-First Century

Introduction

Olivier Blanchard, when he parachuted me into the panel, asked me to “be provocative.”

So let me provoke:

My assigned focus on “fiscal policy in the medium term” has implications. It requires me to assume that things are or will be true that are not now or may not be true in the future, at least not for the rest of this decade and into the next. It makes sense to distinguish the medium from the short term only if the North Atlantic economies will relatively soon enter a regime in which the economy is not at the zero lower bound on safe nominal interest rates. The medium term is at a horizon at which monetary policy can adequately handle all of the demand-stabilization role.

The focus on a medium run thus assumes that answers have been found and policies implemented for three of the most important macroeconomic questions facing us right now, here in the short run, today. Those three are:

  • What role does fiscal policy have to play as a cyclical stabilization policy?
  • What is the proper level of the inflation target so that open-market operation-driven normal monetary policy has sufficient purchase?
  • Should truly extraordinary measures that could be classified as “social credit” policies—mixed monetary and fiscal expansion via direct assignment of seigniorage to households, money-financed government purchases, central bank–undertaken large-scale public lending programs, and other such—be on the table?

Those three are still the most urgent questions facing us today. But I will drop them, and leave them to others. I will presume that satisfactory answers have been found to them, and that they have thus been answered.

As I see it, there are three major medium-run questions that then remain, even further confining my scope to the North Atlantic alone, and to the major sovereigns of the North Atlantic. (Extending the focus to emerging markets, to the links between the North Atlantic and the rest of the world, and to Japan would raise additional important questions, which I would also drop on the floor.) These three remaining medium-run questions are:

  • What is the proper size of the twenty-first-century public sector?
  • What is the proper level of the twenty-first-century public debt for growth and prosperity?
  • What are the systemic risks caused by government debt, and what adjustment to the proper level of twenty-first-century public debt is advisable because of systemic risk considerations?

To me, at least, the answer to the first question—what is the proper size of the twenty-first-century public sector?—appears very clear:

The optimal size of the twenty-first-century public sector will be significantly larger than the optimal size of the twentieth-century public sector. Changes in technology and social organization are moving us away from a “Smithian” economy, one in which the presumption is that the free market or the Pigovian-adjusted market does well, to one that requires more economic activity to be regulated by differently tuned social and economic arrangements (see DeLong and Froomkin 2000). One such is the government. Thus, there should be more public sector and less private sector in the twenty-first century than there was in the twentieth.

Similarly, the answer to the second question appears clear, to me at least:

The proper level of the twenty-first-century public debt should be significantly higher than typical debt levels we have seen in the twentieth century. Looking back at economic history reveals that it has been generations since the intertemporal budget constraint tightly bound peacetime or victorious reserve-currency-issuing sovereigns possessing exorbitant privilege (see DeLong 2014; Kogan et al. 2015).

Thus, at the margin, additional government debt has not required a greater primary surplus but rather has allowed a greater primary deficit—a consideration that strongly militates for higher debt levels unless interest rates in the twenty-first century reverse the pattern we have seen in the twentieth century, and mount to levels greater than economic growth rates.

This consideration is strengthened by observing that the North Atlantic economies have now moved into a regime in which the opposite has taken place. Real interest rates on government debt are not higher but even lower relative to growth rates than they were in the past century. Financial market participants now appear to expect this now ultra-low interest rate regime to continue indefinitely (see Summers 2014).

The answer to the third question—what are the systemic risks caused by government debt?—is much more murky:

To be clear: the point is not that additional government debt imposes an undue burden in the form of distortionary taxation and inequitable income distribution on the future. When current and projected interest rates are low, they do not do so. The point is not that additional government debt crowds out productive investment and slows growth. When interest rates are unresponsive or minimally responsive to deficits, they do not do so. Were either of those to fail to hold, we would have exited the current regime of ultra-low interest rates, and the answer to the second question immediately above would become different.

The question, instead, is this: in a world of low current and projected future interest rates—and thus also one in which interest rates are not responsive to deficits—without much expected crowding out or expected burdens on the future, what happens in the lower tail, and how should that lower tail move policies away from those optimal on certainty equivalence? And that question has four subquestions: How much more likely does higher debt make it that interest rates will spike in the absence of fundamental reasons? How much would they spike? What would government policy be in response to such a spike? And what would be the effect on the economy?

The answer thus hinges on:

  • the risk of a large sudden upward shift in the willingness to hold government debt, even absent substantial fundamental news, and
  • the ability of governments to deal with such a risk that threatens to push economies far enough up the Laffer curve to turn a sustainable into an unsustainable debt.

I believe the risk in such a panicked flight from an otherwise sustainable debt is small. I hold, along with Reinhart and Rogoff (2013), that the government’s legal tools to finance its debt through financial repression are very powerful. Thus I think this consideration has little weight. I believe that little adjustment to one’s view of the proper level of twenty-first-century public debt of reserve-currency-issuing sovereigns with exorbitant privilege is called for because of systemic risk considerations.
But my belief here is fragile. And my comprehension of the issues is inadequate.

Let me expand on these three answers:

The Proper Size of Twenty-First-Century Government

Suppose commodities produced and distributed are properly rival and excludible:

  • Access to them needs to be cheaply and easily controlled.
  • They need to be scarce.
    *They need to be produced under roughly constant-returns-to-scale conditions.

Suppose, further, that information about what is being bought and sold is equally present on both sides of the marketplace—that is, limited adverse selection and moral hazard.

Suppose, last, that the distribution of wealth is such as to accord fairly with utility and desert.

If all these hold, then the competitive Smithian market has its standard powerful advantages. And so the role of the public sector should then be confined to:

  1. antitrust policy, to reduce market power and microeconomic price and contract stickinesses,
  2. demand-stabilization policy, to offset the macroeconomic damage caused by macroeconomic price and contract stickinesses,
  3. financial regulation, to try to neutralize the effect on asset prices of the correlation of current wealth with biases toward optimism or pessimism, along with
  4. largely fruitless public-sector attempts to deal with other behavioral economics-psychological market failures—envy, spite, myopia, salience, etc.

The problem, however, is that as we move into the twenty-first century, the commodities we will be producing are becoming:

  • less rival,
  • less excludible,
  • more subject to adverse selection and moral hazard, and
  • more subject to myopia and other behavioral-psychological market failures.

The twenty-first century sees more knowledge to be learned, and thus a greater role for education. If there is a single sector in which behavioral economics and adverse selection have major roles to play, it is education. Deciding to fund education through very long-term loan financing, and thus to leave the cost-benefit investment calculations to be undertaken by adolescents, shows every sign of having been a disaster when it has been tried (see Goldin and Katz 2009).

The twenty-first century will see longer life expectancy, and thus a greater role for pensions. Yet here in the United States the privatization of pensions via 401(k)s has been, in my assessment, an equally great disaster (Munnell 2015).

The twenty-first century will see health care spending as a share of total income cross 25 percent if not 33 percent, or even higher. The skewed distribution across potential patients of health care expenditures, the vulnerability of health insurance markets to adverse selection and moral hazard, and simple arithmetic mandate either that social insurance will have to cover a greater share of health care costs or that enormous utilitarian benefits from health care will be left on the sidewalk.

Moreover, the twenty-first century will see information goods a much larger part of the total pie than in the twentieth. And if we know one thing, it is that it is not efficient to try to provide information goods by means of a competitive market for they are neither rival nor excludible. It makes no microeconomic sense at all for services like those provided by Google to be funded and incentivized by how much money can be raised not fromthe value of the services but fromthe fumes rising from Google’s ability to sell the eyeballs of the users to advertisers as an intermediate good.

And then there are the standard public goods, like infrastructure and basic research.

Enough said.

The only major category of potential government spending that both should not—and to an important degree cannot—be provided by a competitive price-taking market, and that might be a smaller share of total income in the twenty-first century than it was in the twentieth? Defense.

We thus face a pronounced secular shift away from commodities that have the characteristics—rivalry, excludability, and enough repetition in purchasing and value of reputation to limit myopia—needed for the Smithian market to function well as a societal coordinating mechanism. This raises enormous problems: We know that as bad as market failures can be, government failures can often be little if any less immense.

We will badly need to develop new effective institutional forms for the twenty-first century.

But, meanwhile, it is clear that the increasing salience of these market failures has powerful implications for the relative sizes of the private market and the public administrative spheres in the twenty-first century. The decreasing salience of “Smithian” commodities in the twenty-first century means that rational governance would expect the private-market sphere to shrink relative to the public. This is very elementary micro- and behavioral economics. And we need to think hard about what its implications for public finance are.

The Proper Size of the Twenty-First-Century Public Debt

Back in the Clinton administration—back when the US government’s debt really did look like it was on an unsustainable course—we noted that the correlation between shocks to US interest rates and the value of the dollar appeared to be shifting from positive to zero, and we were scared that the United States was alarmingly close to its debt capacity and needed major, radical policy changes to reduce the deficit (see Blinder and Yellen 2000).

Whether we were starting at shadows then, or whether we were right then and the world has changed since, or whether the current world is in an unstable configuration and we will return to normal within a decade is unclear to me.

But right now, financial markets are telling us very strange things about the debt capacity of reserve-currency-issuing sovereigns.

Since 2005, the interest rate on US ten-year Treasury bonds has fallen from roughly the growth rate of nominal GDP—5 percent/year—to 250 basis points below the growth rate of nominal GDP. Because the duration of the debt is short, the average interest rate on Treasury securities has gone from 100 basis points below the economy’s trend growth rate to nearly 350 basis points below. Maybe you can convince yourself that the market expects the ten-year rate over the next generation to average 50 basis points higher than it is now. Maybe.

Taking a longer run view, Richard Kogan and co-workers (2015) of the Center on Budget and Policy Priorities have been cleaning the data from the Office of Management and Budget. Over the past two hundred years, for the United States, the government’s borrowing rate has averaged 100 basis points lower than the economy’s growth rate. Over the past one hundred years, 170 basis points lower. Over the past fifty years, 30 basis points lower. Over the past twenty years, the Treasury’s borrowing rate has been on average greater than g by 20 basis points. And over the past ten years, it has been 70 basis points lower.

When we examine the public finance history of major North Atlantic industrial powers, we find that the last time that the average over any decade of government debt service as a percentage of outstanding principal was higher than the average growth rate of its economy was during the Great Depression. And before that, in 1890.

Since then, over any extended time period for the major North Atlantic reserve-currency-issuing economies, g > r, for government debt.

Only those who see a very large and I believe exaggerated chance of global thermonuclear war or environmental collapse see the North Atlantic economies as dynamically inefficient from the standpoint of our past investments in private physical, knowledge, and organizational capital: r > g by a very comfortable margin for investments made in private capital. Investments in wealth in the form of private capital are, comfortably, a cash flow source for savers.

But the fact that g > r with respect to the investments we have made in our governments raises deep and troubling questions.

Since 1890, a North Atlantic government that borrows more at the margin benefits its current citizens, increases economic growth, and increases the well-being of its bondholders (for they do buy the paper voluntarily): it is win-win-win. That fact strongly suggests that North Atlantic economies throughout the entire twentieth century suffered from excessive accumulation of societal wealth in the form of net government capital—in other words, government debt has been too low.

The North Atlantic economies of major sovereigns throughout the entire twentieth century have thus suffered from a peculiar and particular form of dynamic inefficiency. Over the past one hundred years, in the United States, at the margin, each extra stock 10 percent of annual GDP’s worth of debt has provided a flow of 0.1 percent of GDP of services to taxpayers, either in increased primary expenditures, reduced taxes, or both.

What is the elementary macroeconomics of dynamic inefficiency? If a class of investment—in this case, investment by taxpayers in the form of wealth held by the government through amortizing the debt—is dynamically inefficient, do less of it. Do less of it until you get to the Golden Rule, and do even less if you are impatient. How do taxpayers move away from dynamic inefficiency toward the Golden Rule? By not amortizing the debt, but rather by borrowing more.

Now we resist this logic. I resist this logic.

Debt secured by government-held social wealth ought to be a close substitute in investors’ portfolios with debt secured by private capital formation. So it is difficult to understand how economies can be dynamically efficient with respect to private capital and yet “dynamically inefficient” with respect to government-held societal wealth. But it appears to be the case that it is so. But there is this outsized risk premium, outsized equity and low-quality debt premium, outsized wedge. And that means that while investments in wealth in the form of private capital are a dynamically efficient cash flow source for savers, investments by taxpayers in the form of paying down debt are a cash flow sink.
I tend to say that we have a huge underlying market failure here that we see in the form of the equity return premium—a failure of financial markets to mobilize society’s risk-bearing capacity—and that pushes down the value of risky investments and pushes up the value of assets perceived as safe, in this case the debt of sovereigns possessing exorbitant privilege. But how do we fix this risk-bearing capacity mobilization market failure? And isn’t the point of the market economy to make things that are valuable? And isn’t the debt of reserve-currency-issuing sovereigns an extraordinarily valuable thing that is very cheap to make? So shouldn’t we be making more of it? Looking out the yield curve, such government debt looks to be incredibly valuable for the next half century, at least.

These considerations militate strongly for higher public debts in the twenty-first century then we saw in the twentieth century. Investors want to hold more government debt: the extraordinary prices at which it has sold since 1890 tell us that. Market economies are supposed to be in the business of producing things that households want whenever that can be done cheaply. Government debt fits the bill, especially now. And looking out the yield curve, government debt looks to fit the bill for the next half century at least.

Systemic Risks and Public Debt Accumulation

One very important question remains very live: Would levels of government debt issue large enough to drive r > g for government bonds create significant systemic risks? Yes, the prices of the government debt of major North Atlantic industrial economies are very high now. But what if there is a sudden downward shock to the willingness of investors to hold this debt? What if the next generation born and coming to the market is much more impatient? Governments might then have to roll over their debt on terms that require high debt-amortization taxes, and if the debt is high enough, those taxes could push economies far enough up a debt Laffer curve. That might render the debt unsustainable in the aftermath of such a preference shift.

Two considerations make me think that this is a relatively small danger:

  1. When I look back in history, I cannot see any such strong fundamental news-free negative preference shock to the willingness to hold the government debt of the North Atlantic’s major industrial powers since the advent of parliamentary government. The fiscal crises we see—of the Weimar Republic, Louis XIV Bourbon, Charles II Stuart, Felipe IV Habsburg, and so forth—were all driven by fundamental news.

  2. As [Reinhart and Rogoff (2013)(http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf) have pointed out at substantial length, twentieth- and nineteenth-century North Atlantic governments proved able to tax their financial sectors through financial repression with great ease. The amount of real wealth for debt amortization raised by financial repression scales roughly with the value of outstanding government debt. And such taxes are painful for those taxed. But only when even semi-major industrial countries have allowed large-scale borrowing in potentially harder currencies than their own—and thus have written unhedged puts on their currencies in large volume—is there any substantial likelihood of major additional difficulty or disruption.

Now, Kenneth Rogoff (2015) disagrees with drawing this lesson from Reinhart and Rogoff (2013). And one always disagrees analytically with Kenneth Rogoff at one’s great intellectual peril. He sees the profoundly depressed level of interest rates on the debt of major North Atlantic sovereigns as a temporary and disequilibrium phenomenon that will soon be rectified. He believes that excessive debt issue and overleverage are at the roots of our problems—call it secular stagnation, the global savings glut, the safe asset shortage, the balance sheet recession, whatever.

In Rogoff’s view:

Unlike secular stagnation, a debt supercycle is not forever.… Modern macroeconomics has been slow to get to grips with the analytics of how to incorporate debt supercycles.… There has been far too much focus on orthodox policy responses and not enough on heterodox responses.… In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader “credit surface” the global economy faces.… The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role.

The key here is Rogoff’s assertion that the low borrowing rate faced by major North Atlantic sovereigns “do[es] not necessarily capture the broader ‘credit surface’”—that the proper shadow price of government debt issue is far in excess of the sovereign borrowing rate. Why? Apparently because future states of the world in which private bondholders would default are also those in which it would be very costly in social utility terms for the government to raise money through taxes.

I do not see this. A major North Atlantic sovereign’s potential tax base is immensely wide and deep. The instruments at its disposal to raise revenue are varied and powerful. The correlation between the government’s taxing capacity and the operating cash flow of private borrowers is not that high. A shock like that of 2008–2009 temporarily destroyed the American corporate sector’s ability to generate operating cash flows to repay debt at the same time that it greatly raised the cost of rolling over debt. But the US government’s financial opportunities became much more favorable during that episode.

Moreover, Rogoff also says:

When it comes to government spending that productively and efficiently enhances future growth, the differences are not first order. With low real interest rates, and large numbers of unemployed (or underemployed) construction workers, good infrastructure projects should offer a much higher rate of return than usual.

and thus, with sensible financing and recapture of the economic benefits of government spending, have little or no impact on debt-to-income ratios.

Conclusion

Looking forward, I draw the following conclusions:

  1. North Atlantic public sectors for major sovereigns ought, technocratically, to be larger than they have been in the past century.

  2. North Atlantic relative public debt levels for major sovereigns ought, technocratically, to be higher than they have been in the past century.

  3. With prudent regulation—that is, the effective limitation of the banking sector’s ability to write unhedged puts on the currency—the power major sovereigns possess to tax the financial sector through financial repression provides sufficient insurance against an adverse preference shock to the desire for government debt.

The first two of these conclusions appear to me to be close to rock-solid. The third is, I think, considerably less secure.

Nevertheless, in my view, if the argument against a larger public sector and more public debt in the twenty-first century than in the twentieth for major North Atlantic sovereigns is going to be made successfully, it seems to me that it needs to be made on a political-economy government-failure basis.

The argument needs to be not that larger government spending and a higher government debt issued by a functional government would diminish utility but rather that government itself will be highly dysfunctional. Government needs to be viewed not as one of several instrumentalities we possess and can deploy to manage and coordinate our societal division of labor, but rather as the equivalent of a loss-making industry under really existing socialism. Government spending must be viewed as worse than useless. Therefore relaxing any constraints that limit the size of the government needs to be viewed as an evil.

Now the public choice school has gone there. As Lawrence Summers (2011) said, they have taken the insights on government failure and “driven it relentlessly towards nihilism in a way that isn’t actually helpful for those charged with designing regulatory institutions,” or, indeed, making public policy in general. In my opinion, if this argument is to be made, it needs a helpful public choice foundation before it can be properly built.

Figure 20.1: Ten-year Constant Maturity U.S. Treasury Nominal Rate:

10 Yr U S Treasury Nominal Interest Rate Source FRED png

Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.


Figure 20.2: Economic Growth and Interest Rates Have Become More Closely Aligned:

Nominal Interest Rate & Smoothed Forward Nominal GDP Growth Rate:

Nom Int Rate Smoothed GDP Growth Rate png

Source: Richard Kogan and colleagues of the Center on Budget and Policy Priorities http://CBPP.org


References

Blinder, Alan, and Janet Yellen. 2000. The Fabulous Decade: Macroeconomic Lessons from the 1990s. New York: Century Foundation.

DeLong, J. Bradford. 2014. “Notes on Fiscal Policy in a Depressed Interest-Rate Environment.” Faculty blog, Department of Economics, University of California, Berkeley, March 16. http://delong.typepad.com/delonglongform/2014/03/talk-preliminary-notes-on-fiscal-policy-in-a-depressed-interest-rate-environment-the-honest-broker-for-the-week-of-february.html.

DeLong, J. Bradford, and A. Michael Froomkin. 2000. “Speculative Microeconomics for Tomorrow’s Economy.” First Monday 5 (2), February 7. http://firstmonday.org/ojs/index.php/fm/article/view/726.

Goldin, Claudia, and Lawrence Katz. 2009. The Race between Education and Technology. Cambridge, MA: Harvard University Press.

Kogan, Richard, Chad Stone, Bryann Dasilva, and Jan Rezeski. 2015. “Difference between Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Budget Outlook.” Washington, DC: Center on Budget and Policy Priorities, February 27. http://www.cbpp.org/research/federal-budget/difference-between-economic-growth-rates-and-treasury-interest-rates.

Munnell, Alicia. 2015. “Falling Short: The Coming Retirement Crisis and What to Do About It.” Brief 15-7. Center for Retirement and Research, Boston College,April. http://crr.bc.edu/briefs/falling-short-the-coming-retirement-crisis-and-what-to-do-about-it-2.

Reinhart, Carmen M., and Kenneth S. Rogoff. 2013. “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten.” Working Paper 266. Washington, DC: IMF, December 24. https://www.imf.org/external/pubs/cat/longres.aspx?sk=41173.0.

Rogoff, Kenneth. 2015. “Debt Supercycle, Not Secular Stagnation.” VoxEU. Centre for Economic Policy and Research, April 22. http://www.voxeu.org/article/debt-supercycle-not-secular-stagnation.

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https://fold.cm/read/delong/2015-04-15-on-the-proper-size-of-the-public-sector-and-the-proper-level-of-public-debt-in-the-twenty-first-century-s4wY9ii7