Over at Grasping Reality: Ben Adler: “Rick Perry stole my urbanist talking points. Too bad he doesn’t actually understand them…

Must-Read: Three percent of the prime-age population who really ought to be at work right now in a full-employment economy are not at work. Whatever your estimate of potential output growth is, the economy is surely not growing markedly faster than it. Inflation is below your target. And yet the Federal Reserve believes that it is time to tighten policy?

It is very hard to understand…

Tim Duy: More Mediocrity: “Federal Reserve Chair Janet Yellen will be playing a game of mixed messages with Congress tomorrow…

…as she explains why she believes a rate hike approaches in spite of lackluster data. Today’s data didn’t help… core spending growth is decelerating on a year-over-year basis to 2013 rates…. I think [the Fed] are concluding 2014 was sufficient to largely close the output gap, as evidenced by falling unemployment and other measures of labor underutilization. San Francisco Federal Reserve President John Williams even believes that optimally, US growth needs to DECELERATE in 2016…. Hence, Boston Federal Reserve President Eric Rosengren can say things to Reuters like:

If we do continue to get improvement in labor markets, if we do become reasonably confident that we’re moving back to 2-percent inflation, it may be appropriate as early as September,’ he said of raising rates from near zero. ‘I don’t think we have seen that evidence yet but we still have a couple months of data to see whether it’s more strongly confirmed.

Rosengren has long advocated for more monetary accommodation than most of his colleagues at the central bank…. One senses greater impatience on the more hawkish side of the FOMC. They will argue like Mester that the general consistency of underlying growth, steady improvement in labor utilization, and proximity to mandates signals it is time to leave behind the policies of the financial crisis…

New Preface to Charles Kindleberger, “The World in Depression 1929-1939”:

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J Bradford DeLong and Barry J. Eichengreen: New preface to Charles Kindleberger,* The World in Depression 1929-1939*:

The parallels between Europe in the 1930s and Europe today are stark, striking, and increasingly frightening. We see unemployment, youth unemployment especially, soaring to unprecedented heights. Financial instability and distress are widespread. There is growing political support for extremist parties of the far left and right.

Both the existence of these parallels and their tragic nature would not have escaped Charles Kindleberger, whose World in Depression, 1929-1939 was published exactly 40 years ago, in 1973.[1]  Where Kindleberger’s canvas was the world, his focus was Europe. While much of the earlier literature, often authored by Americans, focused on the Great Depression in the US, Kindleberger emphasised that the Depression had a prominent international and, in particular, European dimension. It was in Europe where many of the Depression’s worst effects, political as well as economic, played out. And it was in Europe where the absence of a public policy authority at the level of the continent and the inability of any individual national government or central bank to exercise adequate leadership had the most calamitous economic and financial effects.[2]

These were ideas that Kindleberger impressed upon generations of students as well on his reading public. Indeed, anyone fortunate enough to live in New England in the early 1980s and possessed of even a limited interest in international financial and monetary history felt compelled to walk, drive or take the T (as metropolitan Boston’s subway is known to locals) down to MIT’s Sloan Building in order to listen to Kindleberger’s lectures on the subject (including both the authors of this preface). We understood about half of what he said and recognised about a quarter of the historical references and allusions. The experience was intimidating: Paul Krugman, who was a member of this same group and went on to be awarded the Nobel Prize for his work in international economics, has written how Kindleberger’s course nearly scared him away from international macroeconomics. Kindleberger’s lectures were surely “full of wisdom”, Krugman notes. But then, “who feels wise in their twenties?” (Krugman 2002).

There was indeed much wisdom in Kindleberger’s lectures, about how markets work, about how they are managed, and especially about how they can go wrong. It is no accident that when Martin Wolf, dean of the British financial journalists, challenged then former-US Treasury Secretary Lawrence Summers in 2011 to deny that economists had proven themselves useless in the 2008-9 financial crisis, Summers’s response was that, to the contrary, there was a useful economics. But what was useful for understanding financial crises was to be found not in the academic mainstream of mathematical models festooned with Greek symbols and complex abstract relationships but in the work of the pioneering 19th century financial journalist Walter Bagehot, the 20th-century bubble theorist Hyman Minsky, and “perhaps more still in Kindleberger” (Wolf and Summers 2011).

Summers was right. We speak from personal experience: for a generation the two of us have been living – very well, thank you – off the rich dividends thrown off by the intellectual capital that we acquired from Charles Kindleberger, earning our pay cheques by teaching our students some small fraction of what Charlie taught us. Three lessons stand out, the first having to do with panic in financial markets, the second with the power of contagion, the third with the importance of hegemony.

First, panic. Kindleberger argued that panic, defined as sudden overwhelming fear giving rise to extreme behaviour on the part of the affected, is intrinsic in the operation of financial markets. In The World in Depression he gave the best ever “explain-and-illustrate-with-examples” answer to the question of how and why panic occurs and financial markets fall apart. Kindleberger was an early apostate from the efficient-markets school of thought that markets not just get it right but also that they are intrinsically stable. His rival in attempting to explain the Great Depression, Milton Friedman, had famously argued that speculation in financial markets can’t be destabilising because if destabilising speculators drive asset values away from justified, or equilibrium, levels, such speculators will lose money and eventually be driven out of the market.[3]

Kindleberger pushed back by observing that markets can continue to get it wrong for a very, very long time. He girded his position by elaborating and applying the work of Minsky, who had argued that markets pass through cycles characterised first by self-reinforcing boom, next by crash, then by panic, and finally by revulsion and depression. Kindleberger documented the ability of what is now sometimes referred to as the Minsky-Kindleberger framework to explain the behaviour of markets in the late 1920s and early 1930s – behaviour about which economists otherwise might have arguably had little of relevance or value to say. The Minsky paradigm emphasising the possibility of self-reinforcing booms and busts is the organising framework of The World in Depression. It then comes to the fore in all its explicit glory in Kindleberger’s subsequent book and summary statement of the approach, Mania, Panics and Crashes.[4]

Kindleberger’s second key lesson, closely related, is the power of contagion. At the centre of The World in Depression is the 1931 financial crisis, arguably the event that turned an already serious recession into the most severe downturn and economic catastrophe of the 20th century. The 1931 crisis began, as Kindleberger observes, in a relatively minor European financial centre, Vienna, but when left untreated leapfrogged first to Berlin and then, with even graver consequences, to London and New York. This is the 20th century’s most dramatic reminder of quickly how financial crises can metastasise almost instantaneously. In 1931 they spread through a number of different channels. German banks held deposits in Vienna. Merchant banks in London had extended credits to German banks and firms to help finance the country’s foreign trade. In addition to financial links, there were psychological links: as soon as a big bank went down in Vienna, investors, having no way to know for sure, began to fear that similar problems might be lurking in the banking systems of other European countries and the US.

In the same way that problems in a small country, Greece, could threaten the entire European System in 2012, problems in a small country, Austria, could constitute a lethal threat to the entire global financial system in 1931 in the absence of effective action to prevent them from spreading.

This brings us to Kindleberger’s third lesson, which has to do with the importance of hegemony, defined as a preponderance of influence and power over others, in this case over other nation states. Kindleberger argued that at the root of Europe’s and the world’s problems in the 1920s and 1930s was the absence of a benevolent hegemon: a dominant economic power able and willing to take the interests of smaller powers and the operation of the larger international system into account by stabilising the flow of spending through the global or at least the North Atlantic economy, and doing so by acting as a lender and consumer of last resort. Great Britain, now but a middle power in relative economic decline, no longer possessed the resources commensurate with the job. The rising power, the US, did not yet realise that the maintenance of economic stability required it to assume this role. In contrast to the period before 1914, when Britain acted as hegemon, or after 1945, when the US did so, there was no one to stabilise the unstable economy. Europe, the world economy’s chokepoint, was rendered rudderless, unstable, and crisis- and depression-prone.

That is Kindleberger’s World in Depression in a nutshell. As he put it in 1973:

The 1929 depression was so wide, so deep and so long because the international economic system was rendered unstable by British inability and United States unwillingness to assume responsibility for stabilising it in three particulars: (a) maintaining a relatively open market for distress goods; (b) providing counter-cyclical long-term lending; and (c) discounting in crisis…. The world economic system was unstable unless some country stabilised it, as Britain had done in the nineteenth century and up to 1913. In 1929, the British couldn’t and the United States wouldn’t. When every country turned to protect its national private interest, the world public interest went down the drain, and with it the private interests of all…

Subsequently these insights stimulated a considerable body of scholarship in economics, particularly models of international economic policy coordination with and without a dominant economic power, and in political science, where Kindleberger’s “theory of hegemonic stability” is perhaps the leading approach used by political scientists to understand how order can be maintained in an otherwise anarchic international system.[5]

It might be hoped that something would have been learned from this considerable body of scholarship. Yet today, to our surprise, alarm and dismay, we find ourselves watching a rerun of Europe in 1931. Once more, panic and financial distress are widespread. And, once more, Europe lacks a hegemon – a dominant economic power capable of taking the interests of smaller powers and the operation of the larger international system into account by stabilising flows of finance and spending through the European economy.

The ECB does not believe it has the authority: its mandate, the argument goes, requires it to mechanically pursue an inflation target – which it defines in practice as an inflation ceiling. It is not empowered, it argues, to act as a lender of the last resort to distressed financial markets, the indispensability of a lender of last resort in times of crisis being another powerful message of The World in Depression. The EU, a diverse collection of more than two dozen states, has found it difficult to reach a consensus on how to react. And even on those rare occasions where it does achieve something approaching a consensus, the wheels turn slowly, too slowly compared to the crisis, which turns very fast.

The German federal government, the political incarnation of the single most consequential economic power in Europe, is one potential hegemon. It has room for countercyclical fiscal policy. It could encourage the European Central Bank to make more active use of monetary policy. It could fund a Marshall Plan for Greece and signal a willingness to assume joint responsibility, along with its EU partners, for some fraction of their collective debt. But Germany still thinks of itself as the steward is a small open economy. It repeats at every turn that it is beyond its capacity to stabilise the European system: “German taxpayers can only bear so much after all”. Unilaterally taking action to stabilise the European economy is not, in any case, its responsibility, as the matter is perceived. The EU is not a union where big countries lead and smaller countries follow docilely but, at least ostensibly, a collection of equals. Germany’s own difficult history in any case makes it difficult for the country to assert its influence and authority and equally difficult for its EU partners, even those who most desperately require it, to accept such an assertion.[6] Europe, everyone agrees, needs to strengthen its collective will and ability to take collective action. But in the absence of a hegemon at the European level, this is easier said than done.

The International Monetary Fund, meanwhile, is not sufficiently well capitalised to do the job even were its non-European members to permit it to do so, which remains doubtful. Viewed from Asia or, for that matter, from Capitol Hill, Europe’s problems are properly solved in Europe. More concretely, the view is that the money needed to resolve Europe’s economic and financial crisis should come from Europe. The US government and Federal Reserve System, for their part, have no choice but to view Europe’s problems from the sidelines. A cash-strapped US government lacks the resources to intervene big-time in Europe’s affairs in 1948; there will be no 21st century analogue of the Marshall Plan, when the US through the Economic Recovery Programme, of which the young Charles Kindleberger was a major architect, extended a generous package of foreign aid to help stabilise an unstable continent. Today, in contrast, the Congress is not about to permit Greece, Ireland, Portugal, Italy, and Spain to incorporate in Delaware as bank holding companies and join the Federal Reserve System.[7]

In a sense, Kindleberger predicted all this in 1973. He saw the power and willingness of the US to bear the responsibility and burden of sacrifice required of benevolent hegemony as likely to falter in subsequent generations. He saw three positive and three negative branches on the then-future’s probability tree. The positive outcomes were: “[i] revived United States leadership… [ii] an assertion of leadership and assumption of responsibility… by Europe…” [sitting here, in 2013, one might be tempted to add emerging markets like China as potentially stepping into the leadership breach, although in practice the Chinese authorities have been reluctant to go there, and] [iii] cession of economic sovereignty to international institutions….” Here, in a sense, Kindleberger had both global and regional – meaning European – institutions in mind. “The last”, meaning a global solution, “is the most attractive”, he concluded,” but perhaps, because difficult, the least likely…” The negative outcomes were: “(a) the United States and the [EU] vying for leadership… (b) one unable to lead and the other unwilling, as in 1929 to 1933… (c) each retaining a veto… without seeking to secure positive programmes…”

As we write, the North Atlantic world appears to have fallen foul to his bad outcome (c), with extraordinary political dysfunction in the US preventing its government from acting as a benevolent hegemon, and the ruling mandarins of Europe, in Germany in particular, unwilling to step up and convince their voters that they must assume the task.

It was fear of this future that led Kindleberger to end The World in Depression with the observation: “In these circumstances, the third positive alternative of international institutions with real authority and sovereignty is pressing.”

Indeed it is, more so now than ever.

References

Eichengreen, Barry (1987), “Hegemonic Stability Theories of the International Monetary System”, in Richard Cooper, Barry Eichengreen, Gerald Holtham, Robert Putnam and Randall Henning (eds.), Can Nations Agree? Issues in International Economic Cooperation, The Brookings Institution, 255-298.

Friedman, Milton (1953), “The Case for Flexible Exchange Rates”, in Essays in Positive Economics, University of Chicago Press.

Friedman, Milton and Anna J Schwartz (1963), A Monetary History of the United States, 1857-1960, Princeton University Press.

Gilpin, Robert (1987), The Political Economy of International Relations, Princeton University Press.

Keohane, Robert (1984), After Hegemony, Princeton University Press.

Kindleberger, Charles (1978), Manias, Panics and Crashes, Norton.

Krugman, Paul (2003), “Remembering Rudi Dornbusch”, unpublished manuscript, http://www.pkarchive.org, 28 July.

Lake, David (1993), “Leadership, Hegemony and the International Economy: Naked Emperor or Tattered Monarch with Potential?”, International Studies Quarterly, 37: 459-489.

Wolf, Martin and Lawrence Summers (2011), “Larry Summers and Martin Wolf: Keynote at INET’s Bretton Woods Conference 2011”, http://www.youtube.com, 9 April.

Notes

[1] Kindleberger passed away in 2003. A second modestly revised and expanded edition of The World in Depression was published, also by the University of California Press, in 1986. The second edition differed mainly by responding to the author’s critics and commenting to some subsequent literature. We have chosen to reproduce the ‘unvarnished’ 1973 Kindleberger, where the key points are made in unadorned fashion.

[2] The book was commissioned originally for a series on the economic history of Europe, with each author writing on a different decade. This points to the question of why the title was not, instead, “Europe in Depression.” The answer, presumably, is that the author – and his publisher wished to acknowledge that the Depression was not exclusively a European phenomenon and that the linkages between Europe and the US were also critically important.

[3] Friedman’s great work on the Depression, coauthored with Anna Jacobson Schwartz (1963), was in Kindleberger’s view too monocausal, focusing on the role of monetary policy, and too U.S. centric. See also Friedman (1953)

[4] Kindleberger (1978). Kindleberger amply acknowledged his intellectual debt to Minsky. But we are not alone if we suggest that Kindleberger’s admirably clear presentation of the framework, and the success with which he documented its power by applying it to historical experience, rendered it more impactful in the academy and generally.

[5] A sampling of work in economics on international policy coordination inspired by Kindleberger includes Eichengreen (1987) and Hughes Hallet, Mooslechner and Scheurz (2001). Three important statements of the relevant work in international relations are Keohane (1984), Gilpin (1987) and Lake (1993).

[6] The European Union was created, in a sense, precisely in order to prevent the reassertion of German hegemony.

[7] The point being that the US, in contrast, does possess a central bank willing, under certain circumstances, to acknowledge its responsibility for acting as a lender of last resort. Nothing in fact prevents the Federal Reserve, under current institutional arrangements from, say, purchasing the bonds of distressed Southern European sovereigns. But this would be viewed as peculiar and inappropriate in many quarters. The Fed has a full plate of other problems. And intervening in European bond markets, the argument would go, is properly the responsibility of the leading European monetary authority.

Must-Read: Barry Eichengreen: Saving Greece, Saving Europe: “The Greek people deserve better than what they are being offered…

…Germany wants Greece to choose between economic collapse and leaving the eurozone. Both options would mean economic disaster; the first, if not both, would be politically disastrous as well. When I wrote in 2007 that no member state would voluntarily leave the eurozone, I emphasized the high economic costs of such a decision. The Greek government has shown that it understands this…. But when I concluded that no country would leave the eurozone, I failed to imagine that Germany would force another member out….

Economically, the new program is perverse, because it will plunge Greece deeper into depression. It envisages raising additional taxes, cutting pensions further, and implementing automatic spending cuts if fiscal targets are missed. But it provides no basis for recovery or growth. The Greek economy is already in free-fall, and structural reforms alone will not reverse the downward spiral. The agreement… will worsen Greece’s slump…. As the depression deepens, the deficit targets will be missed, triggering further spending cuts and accelerating the economy’s contraction. Eventually, the agreement will trigger Grexit, either because the creditors withdraw their support after fiscal targets are missed, or because the Greek people rebel…. Finally, the privatization fund at the center of the new program will do nothing to encourage structural reform. Yes, Greece needs to privatize inefficient public enterprises. But… privatization at fire-sale prices, with most of the proceeds used to pay down debt, will not put Greek parliamentarians or the public in a mood to press ahead enthusiastically with structural reform.

Greece deserves better… a program that respects its sovereignty and allows the government to establish its credibility… a program capable of stabilizing its economy rather than bleeding it to death. And it deserves support from the ECB…. Europe deserves better, too. Other European countries should not in good conscience accede to this politically destructive, economically perverse program…. Last but not least, the German public deserve better. Germans deserve a leader who stands firm in the face of extremism, rather than encouraging it…

Must-Read: Paul Krugman: The Laziness Dogma: “The real source of [J.E.B. Bush’s] remark was the ‘nation of takers’ dogma that has taken over conservative circles…

…the insistence that a large number of Americans, white as well as black, are choosing not to work, because they can live lives of leisure thanks to government programs. You see this laziness dogma everywhere on the right… the hidden background to Mitt Romney’s infamous 47 percent… the furious attacks on unemployment benefits at a time of mass unemployment and on food stamps… claims that many, if not most, workers receiving disability payments are malingerers… a vision of the world in which the biggest problem facing America is that we’re too nice to fellow citizens facing hardship….

Over the past few decades working-class white families have been changing in much the same way that African-American families changed in the 1950s and 1960s, with declining rates of marriage and labor force participation. Some of us look at these changes and see them as consequences of an economy that no longer offers good jobs to ordinary workers. This happened to African-Americans first, as blue-collar jobs disappeared from inner cities, but has now become a much wider phenomenon thanks to soaring income inequality. Mr. Murray, however, sees the changes as the consequence of a mysterious decline in traditional values, enabled by government programs which mean that men no longer ‘need to work to survive.’ And Mr. Bush presumably shares that view…. Mr. Bush’s clumsy call for longer work hours wasn’t a mere verbal stumble. It was, instead, an indication that he stands firmly on the right side of the great divide over what working American families need…. While Jeb Bush may sometimes sound like a moderate, he’s very much in line with the party consensus… [of] the laziness dogma…

Must-Read: Daniel Davies: Groptimism: “Well, a deal is done…. And any deal was better than no deal….

…It seems more likely than not that we’ll see a sharp rebound in [Greek] economic growth in Q4…. A lot of the debt service money goes to the ECB and IMF, it’s true, but enough of the outstanding GGBs are owned by Greek residents to make it likely that the fiscal stance right now is stimulative…. The Greek banking system is not broken. Although the branches are closed, the ATMs are limited and capital controls are in place, these are the results of a government crisis that spread to the banks, not a banking crisis that spread to the government…. Flight capital moves both ways…. There is potentially a lot of pent up investment demand…. Greece has spent the last six months living under the shadow of a currency crisis. Of course that affects investment…. Moving Greece away from the edge of the precipice is very likely to have a positive effect on investment spending.

So, if we believe in the national income accounting identity… it very much makes sense to look for a bounce back…. Now… optimism for the near term do[es]n’t all stretch out into the medium term. In particular, the primary surpluses are scheduled to rise, and the new agreement has (stupidly) incorporated a debt-brake sort of idea–a kind of “automatic destabiliser” to cut spending if the surplus targets are missed. So for 2016 and onward, the I and X components might have to take on more of the work, if the Eurogroup turns out to be determined to go through with a bad idea on G…. But, with a bit of good will and good sense, things look a lot better than they did a week ago. The outlook isn’t all bad, by any means.

Must-Read: Matthew Yglesias: The Retirement Age: “Raising the retirement age is a strange prescription for countries suffering from mass youth unemployment…

…If you have a country — Greece, say, or France — where youth unemployment is very high, it’s strange to decide that raising the retirement age is the cure for your economic woes…. A jobless person in their twenties living on social assistance is a sad case. A jobless person in their sixties living on social assistance is retired, which is a perfectly respectable thing to be in life. Retired people are happy and unemployed people are sad…. Somebody has to work and pay the taxes so that others can not work.

Young people, generally, would rather have a job than a social assistance check whereas older people would rather have a social assistance check than a job. This is what makes it so odd to look at a country with high youth unemployment and decide that what’s needed is a higher retirement age…. The larger point is that raising the retirement age is an idée fixe of the global elite. I recently read an IMF report about Finland… a great country with a world-class education system, the #3 least-corrupt government… other strong fundamentals. But they’ve run into a very non-mysterious economic problem — Nokia has gone to shit. Somehow the IMF’s solution to this is that Finland should raise its retirement age…

**Introduction**

Olivier Blanchard, when he parachuted me into this 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 and into the next decade. It makes sense to distinguish the medium from the short term only if the North Atlantic economies will relatively soon enter a régime 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 focus to emerging markets, to the links between the North Atlantic and the res of the world, and to Japan would raise additional important questions, which I will also drop on the floor.) These three remaining medium-run questions are:

* What is the proper size of the 21st-century public sector?

* What is the proper level of the 21st-century public debt for growth and prosperity?

* What are the systemic risks caused by government debt, and what adjustment to the proper level of 21st-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 21st-century public sector?–appears very clear.

The optimal size of the 21st-century public sector will be significantly larger than the optimal size of the 20th-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 21st-century than there was in the 20th.

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

The proper level of the 21st century public debt should be significantly higher than typical debt levels we have seen in the 20th 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 allowed a greater primary deficit–a consideration that strongly militates for higher debt levels *unless interest rates in the 21st century reverse the pattern we have seen in the 20th 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 régime 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 have been in the past century. Financial market participants now appear to expect this now ultra-low interest-rate régime 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.

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 un- or minimally-responsive to deficits, they do not do so. Were either of those to fail to hold, we would have exited the current régime of ultra-low interest rates, and the answer to the second question immediately above would become different.

The question, instead, is: 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 sub-questions: 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.

* 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 Rinehart and Rogoff (2013), that the government’s legal tools to finance its debt via 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 21st-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 21st 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—i.e., 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 21st 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 via very long-term loan-finance, 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 401k(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% if not 33%, 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 the twentieth. And if we know one thing, it is that it is not efficient to try to provide information goods via 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 off of the value of the services but off of the 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.

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

Back in the Clinton administration–back when the U.S. government’s debt really did look like it was an an unsustainable course–we noted that the correlation between shocks to U.S. interest rates and the value of the dollar appeared to be shifting from positive to zero, and we were scared that the U.S. was alarmingly close to its debt capacity and needed major, radical policy changes to reduce the deficit (see Alan Blinder and Janet 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 U.S. ten-year Treasury bonds has fallen from roughly the growth rate of nominal GDP–5%/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 et al. (2015) of the CBPP has been cleaning the data from OMB. Over the past 200 years, for the U.S., the government’s borrowing rate has averaged 100 basis points lower than the economy’s growth rate. Over the past 100 years, 170 basis points lower. Over the past 50 years, 30 basis points lower. Over the past twenty years Treasury’s borrowing rate has been on average greater than g by 20 basis points. And over the past ten years, 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… the Great Depression. And before that… 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. 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 20th 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 20th Century have thus suffered from a peculiar and particular form of dynamic inefficiency. Over the past 100 years, in the United States, at the margin, each extra stock 10% of annual GDP’s worth of debt has provided a flow of 0.1% of GDP of services in taxpayers in increased primary expenditures or reduced taxpayers.

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 via 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 21st-century then we saw in the 20th-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.

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**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.

First, 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—are all driven by fundamental news.

Second, as Reinhart and Rogoff (2013) have pointed out at substantial length, 20th and 19th Century North Atlantic governments have proven able to tax their financial sectors via 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, cough, cough 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 son 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 via 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 2008-9 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 U.S. 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.

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**Conclusion:**

I conclude that, looking forward:

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—i.e., 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 via 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 21st century than in the 20th 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.

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**References**

Alan Blinder and Janet Yellen (2000), _The Fabulous Decade: Macroeconomic Lessons from the 1990s_ (New York: Century Foundation)

J. Bradford DeLong (2014), “Notes on Fiscal Policy in a Depressed Interest-Rate Environment” (Berkeley: UC Berkeley):

J. Bradford DeLong and A. Michael Froomkin (2000), “Speculative Microeconomics for Tomorrow’s Economy”, _First Monday_ 5:2 (February 7):

Claudia Goldin and Lawrence Katz (2009), _The Race Between Education and Technology_ (Cambridge: Harvard University Press) http://amzn.to/1M6Glbg

Richard Kogan et al. (2015), “Difference Between Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Budget Outlook” (Washington: CBPP):

Alicia Munnell (2015), “Falling Short: The Coming Retirement Crisis and What to Do About It” (Boston College: CRR)

Carmen M. Reinhart and Kenneth S. Rogoff (2013), “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten” (Washington, DC: IMF)

Kenneth Rogoff (2015), “Debt Supercycle, Not ecular Stagnation” (VoxEU)

Lawrence Summers (2011), “A Conversation on New Economic Thinking”

Lawrence Summers (2014), “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound”, _Business Economics_ 49:2 (June)

Noah Smith: We’re All Smart. And Dumb. Sometimes: “The good criticism of behavioral econ is that it’s very hard to go from the lab to the real world…

…The bad one [is] people are way, way too afraid of the soft paternalism of nudges…. William Easterly… expressed this fear when he tweeted: ‘Behavioral econ [Thaler] says we are too dumb to fix our own mistakes but smart enough to fix everyone else’s[.]’ Easterly… mischaracterized behavioral economics. Behavioral econ isn’t about smart people knowing what’s best for dumb people. It’s about all people being smart some of the time and dumb at other times. Or strong-willed some of the time and weak-willed at other times…. Critics of soft paternalism should realize that people are already being nudged all the time, and not by government. The true masters of behavioral economics are marketers in the private sector… and have never had any compunction about using it to take your money.

Ever wonder why prices in stores are $9.99 instead of $10? Behavioral economics. How about sales and discounts? Just raise the base price and treat the real price as a discount, and behavioral economics will make people more eager to buy. That yogurt that advertises itself as fat-free? Check out how many grams of sugar it has. And so on. Marketing is by far the biggest application of behavioral economics, it’s perfectly legal and it’s already everywhere. You are being nudged 24/7. If you stop to think about it, it’s ludicrous that behavioral econ skeptics are up in arms about government nudges, but blithely unconcerned about corporate nudges. But stopping to think about things is something we rarely do. And that’s why behavioral economics is important.