Must-Read: Paul Krugman (2013): Phantom Crises
Must-Read: Paul Krugman (2013): Phantom Crises: “Simon Wren-Lewis is puzzled by a Ken Rogoff column that sorta-kinda defends Cameron’s austerity policies…
…I want to focus on… Rogoff’s assertion that Britain could have faced a southern Europe-style crisis, with a loss of investor confidence driving up interest rates and plunging the economy into a deep slump…. I just don’t see how this is supposed to happen in a country with its own currency that doesn’t have a lot of foreign currency debt–especially if the country is currently in a liquidity trap…. You would think, given how many warnings have been issued about this possibility, that someone would have written down a simple model of the mechanics, but I have yet to see anything of the sort….
Suppose that investors turn on your country for some reason… a decline in capital inflows at any given interest rate… the currency depreciates. If you have a lot of foreign-currency-denominated debt, this could actually shift IS left through balance-sheet effects, as we learned in the Asian crisis. But… for Britain… IS shifts right…. The interest rate will rise… only because the loss of investor confidence is actually, through depreciation, having an expansionary effect…. If the central bank is worried about the inflationary effect of depreciation… we could… have a contractionary effect… run[ning] through the inflation fears of the central bank, which doesn’t seem to be at all what Rogoff or others are talking about….
What sounds like a straightforward claim–that loss of foreign confidence causes a contractionary rise in interest rates–just doesn’t come out of anything like a standard model…. Show me the model!… I know that many people find this line of argument, in which a loss of investor confidence is if anything expansionary, deeply counterintuitive. But macro, and especially liquidity trap macro, tends to be like that. So don’t give me your gut feelings; give me a coherent story about who does what, i.e. a model. I eagerly await a response.