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


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.


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


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.

Summers, Lawrence. 2011. “A Conversation on New Economic Thinking.” LarrySummers.com, April 8. http://larrysummers.com/commentary/speeches/brenton-woods-speech.

Summers, Lawrence. 2014. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound.” Business Economics 49 (2): 65–73.


Must-Read: Paul Krugman: Nutcases and Knutcases

Must-Read: If you work really, really hard, you might be able to make something not completely unintelligible out of Andrew Sentance. You might agree with Paul Krugman that interest rates need to be even lower to provide people with an incentive to consume and invest at the economy’s sustainable non-inflationary potential. But you might go on to say that interest rates need to be higher to curb people’s desires to engage in overleverage, bubbles, and Ponzi schemes–that debts of extraordinarily long duration with extraordinarily low rates of amortization is asking for trouble.

But if you did that, you would be advocating not tight money but, rather, a higher inflation target. Amortization rates and durations of debt, you see, depend primarily on nominal interest rates. While the Wicksellian real rate to balance aggregate supply and aggregate demand and make Say’s Law true in practice is a real interest rate. And a higher inflation target is the way to make a bigger wedge between the two.

So even if you try really, really hard to make something not completely unintelligible out of Andrew Sentance, you conclude that he has no idea what he is talking about:

Paul Krugman: Nutcases and Knut Cases: “Monetary permahawkery takes two forms…

…One is obviously ridiculous… with a lot of influence on right-wing politicians… the likes of Ron Paul, Zero Hedge, and Paul Ryan. Hyperinflation is always just around the corner. And no matter how wrong the scare stories have been in the past, there’s always a willing audience.

But the clear and present danger comes from people like Andrew Sentance, who was until recently a member of the Bank of England’s Monetary Policy Committee… a remarkable piece… castigating the Fed for not hiking rates…. Sentanc[has] made up his own version of macroeconomics… unaware that he has done so. As I… [and] others, notably Ben Bernanke… point out… monetary wisdom… starts with Knut Wicksell’s concept of the natural interest rate. Try to keep rates too low, and inflation accelerates; try to keep them too high, and inflation decelerates and heads toward deflation. Now comes Sentance, claiming that monetary policy has been consistently too easy, not just in recent months, but for the past generation….

This should imply that policy has had an inflationary bias, right? Except that inflation has trended downward…. You might have expected at least some effort to explain why this isn’t a problem…. Sentance mocks the decision not to raise rates, suggesting that it has no real justification…. How about the fact that inflation is still below the Fed’s target, and shows no sign of rising? And that doesn’t even get into the argument, which Larry Summers, yours truly, and many others have made, that the risks of getting it wrong are highly asymmetric…. Maybe Sentance is right to toss almost everything economists have said about interest rate policy for the past 117 years out the window. But… it’s hard to escape the suspicion that he has no idea that this is what he’s doing. And he sat on the committee making British monetary policy!

Must-Read: Heidi Roizen: How to Build a Unicorn From Scratch–and Walk Away with Nothing

Live from Silicon Valley: Heidi Roizen: How to Build a Unicorn From Scratch–and Walk Away with Nothing: “Liquidation preferences, participation, ratchets…

…even the very term preferred shares (they are called ‘preferred’ for a reason) are things every entrepreneur needs to understand. Most terms are there because venture capitalists have created them, and they have created them because over time they have learned that terms are valuable ways to recover capital in downside outcomes and improve their share of the returns in moderate outcomes–which more than half the deals they do in normal markets will turn out to be. There is nothing inherently evil… standard procedure for high risk investing.  But for you the entrepreneur to be surprised after the fact about what the terms entitle the venture firm to is just bad business–on your part. For any private company with different classes of stock, the capitalization table is not-at-all the full picture of who gets what in an outcome…

Must-Read: Paul Krugman: Angus Deaton and the Dodd-Frank Election

Must-Read: Paul Krugman: Angus Deaton and the Dodd-Frank Election: “Angus Deaton has won the Nobel, which is wonderful…

…a fine writer with important things to say about political economy. Cardiff Garcia excerpts a passage in which he explains why we should care about the concentration of wealth at the top:

[T]here is a danger that the rapid growth of top incomes can become self-reinforcing through the political access that money can bring. Rules… set not in the public interest but in the interest of the rich, who use those rules to become yet richer…. To worry about these consequences of extreme inequality has nothing to do with being envious of the rich and everything to do with the fear that rapidly growing top incomes are a threat to the wellbeing of everyone else…

Confessore, Cohen, and Yourish documents… that campaign finance this election cycle is dominated by a tiny number of [the] extremely wealthy… overwhelmingly flowing to Republicans…. The biggest piece of the super-rich-super-donor story is money from the financial sector. And there has… been a huge swing of finance capital away from Democrats to Republicans that began… after the passage of financial reform…. the people who brought you the financial crisis trying to buy the chance to do it all over again.

Angus Deaton and the Dodd Frank Election The New York Times

Note that “finance” as a whole was split 50-50 in the money it gave in 2008, and split 75-25 Republican in the money it gave before 2008–Tom Ferguson of U.Mass is the Master of All Who Know on these issues. “Hedge funds” are (or were) people who were not terribly invested in the pre-2009 structure of Wall Street, were relatively young, and were much more Democratic than finance as a whole even before 2008. Their swing to the Republicans is very bad news. You would think that after Arthur Burns’s inflation, Ronald Reagan’s deficits, and Ben Bernanke’s financial crisis that they would be wary. Economic regulation is onerous. But macroeconomic mismanagement is disastrous.

But no…

Is There a Valid “Stop the Misallocation of Capital” Argument for Raising Interest Rates Right Now?

Kristi Culpepper: @munilass: “Best explanation of difference between people who believe Fed…

…should raise rates vs people who think Fed should hold tight…. People who think Fed should raise rates think Fed is only making things worse by encouraging misallocation of capital. People who think Fed should hold tight are obsessed with inflation measures, pressures from global economy. So Fed is caught between narratives of two groups that are essentially always going to be talking past each other.

That was the keen-eyed observer Kristi Culpepper tweeting a few days ago. It struck me as incisive and insightful both about those who do and about those who do not want the Federal Reserve to raise interest rates.

I think she is correct about what those who want the Federal Reserve to raise interest rates are thinking: they are thinking that the prices that are interest rates are somehow wrong, and are leading people who are responding them to do things that are stupid for society as a whole.

But how stupid?

The argument is that the incentives to create long duration assets generated by extremely low interest-rate’s are too high. Therefore we as a society are creating too many long duration assets. But are we? The standard long duration asset is a building. And residential construction is still deeply depressed, well below anything we might think of as its normal equilibrium level. From the standpoint of residential construction, low interest rates are only partially compensating for other market failures that are currently leading us to build too few houses, not too many.


When I make this argument to those who want the Federal Reserve to raise interest rates, they move on. They point to non-residential construction–which is indeed healthy. but they cannot point to anyother long-duration investments in physical objects or organizations. And, indeed, in a world where the chief complaint about business is its short-termism, a configuration of market prices that puts a thumb in the scale in favor of projects of long-duration would seem to be a thing we need, not a thing to avoid.

And so they move on further: The argument becomes a claim that the Federal Reserve has made debt too valuable, and So the Federal Reserve is inducing overleverage. But too cheap relative to what? Issuing debt is richly valued. But the proceeds are not being used to build long-duration physical or organizational assets in excessive amounts. The proceeds are being used to buyback equities, but equities are also richly valued. So where is the incentive to overleverage? I do not see it.


And so we come to the last argument: Commercial banks are being squeezed between the zero floor on deposits and the low rates they earn in their traditional relatively-safe loan habitats. Commercial banks should be focused on running their banking branch-and-ATM networks efficiently, and efficiently lending on a large scale to loan customers where they understand the risks. But, now, because low safe interest rates and the zero lower bound on what they can pay deposits, commercial banks have to become judges of risk–a task that they are not well qualified to do, which pits them against people who can and do adversely-select and moral-hazard this.

This is, I think, correct: Low interest-rate are bad for the commercial banking sector. But they are very good for labor and for capital. And, as long as they do not induce undue inflationary pressures, for the economy as a whole.

So are we supposed to sacrifice the health of the economy as a whole simply to make life easier for the commercial banking sector?

Now do not get me wrong. I wish that interest rates were higher. I think it expansionary fiscal policy to push up interest rates is clearly the first best policy.

But we are not going to get that–at least not until 2017 at the earliest.

And the scary thing is that the Federal Reserve does indeed seem to contain a great many people whose answer to that question is: Yes: we do want to sacrifice the health of the rest of the economy in order to make life easier for the commercial banking sector. Therefore we are going to raise interest rates now:

  • even though inflationary pressures are not yet visible on the horizon,
  • even though the Federal Reserve has ample ability to raise interest rates in order to catch up should inflationary pressures appear, and
  • even though the Federal Reserve has no ability to reverse course and offset the damage done should raising interest rates to be a mistake.

Carter Glass and Louis Brandeis are rolling in their graves…

Must-Read: Barbara Roper: It Isn’t the Money, It’s the Economics

Must-Read: Barbara Roper: It Isn’t the Money, It’s the Economics: “If people actually take time to read the study, which Litan coauthored with Hal Singer of the Progressive Policy Institute…

…what is most shocking… is just how poor the quality of the analysis is…. Litan and Singer’s argument hinges on… 1) that industry will follow through on its threats to stop serving smaller accounts if the rule is adopted and 2) that investors will lose access to important benefits… as a result of losing access to human advisors. The first… is based on a fundamental error…. In building their case, Litan and Singer rely heavily on a 2011 Oliver Wyman study, also funded by industry rule opponents…. That study assumed that commissions would be prohibited and concluded that small savers would lose access to advice if a ban on commissions were adopted. Litan and Singer chide the Department of Labor for its ‘too facile’ dismissal of the study ‘on the grounds that brokers can continue collecting commissions,’ noting that ‘only firms, but not individual brokers, would be able to receive commissions’ under the reproposed rule. It is difficult to say where they got this notion….. It is a verifiable fact that, under the rule, individual brokers as well as broker-dealer firms could be compensated through commissions if they abide by the terms of the best-interest contract exemption….

Litan and Singer claim, mistakenly, that “the entire evidentiary rationale for the rule … depends on individual brokers no longer receiving commissions.” On the contrary, the regulatory-impact analysis is premised on the notion that, if brokers serve their clients under a best-interest standard and place reasonable restrictions on practices that conflict with that standard, it will encourage recommendations of lower cost, higher-quality investment options. As a result, investors who turn to brokers should see higher returns. But that has nothing to do with moving brokers away from earning commissions, as Litan and Singer mistakenly assume. There are any number of other problems with the study, but these three go to the heart of its credibility, or lack thereof…

Lunchtime Must-Read: Paul Krugman: Now That’s Rich

Paul Krugman: Now That’s Rich: “These 25 men (yes, they’re all men) made a combined $21 billion in 2013…

…their good fortune refutes several popular myths…. First, modern inequality isn’t about graduates. It’s about oligarchs. Apologists for soaring inequality… try to disguise the gigantic incomes of the truly rich by hiding them in a crowd of the merely affluent…. The goal of this misdirection is to soften the picture, to make it seem as if we’re talking about ordinary white-collar professionals who get ahead through education and hard work. But many Americans are well-educated and work hard… schoolteachers… don’t get the big bucks… those 25 hedge fund managers made more than twice as much as all the kindergarten teachers in America combined. And, no, it wasn’t always thus….

Conservatives want you to believe that the big rewards in modern America go to innovators and entrepreneurs…. But that’s not what those hedge fund managers do for a living…. They’re actually in the business of convincing other people that they can anticipate average opinion about average opinion. Once upon a time, you might have been able to argue with a straight face that all this wheeling and dealing was productive…. But… the evidence suggests… they don’t deliver high enough returns… and they’re a major source of economic instability….

Finally, a close look at the rich list supports the thesis made famous by Thomas Piketty… that we’re on our way toward a society dominated by wealth, much of it inherited, rather than work…. At first sight, this may not be obvious. The members of the rich list are, after all, self-made men. But, by and large, they did their self-making a long time ago…

Could We Have Had a Severe Recession Without the 2008 Financial Crisis?

Over at Grasping Reality: Monday DeLong Smackdown: Scott Sumner: Could We Have Had a Severe Recession Without the 2008 Financial Crisis?: “I have trouble with DeLong’s implicit assumption is that the financial crisis caused the Great Recession….

The years leading up to 1990 saw Australian-level NGDP growth, if not more. So even if lending standards tightened sharply in the wake of the 1989-90 crisis, there was no possibility of hitting the zero bound…. With no zero bound in prospect, there’d be no reason for markets to expect an NGDP collapse…. Even if we had managed the 2007-08 subprime crisis very well from a regulatory/resolution perspective, there is no question that banks would have tightened lending standards sharply. That effectively reduces the demand for credit…. It’s quite plausible that the Wicksellian equilibrium natural rate would have fallen to zero in late 2008, even with a better resolution of the banks….

Continue reading “Could We Have Had a Severe Recession Without the 2008 Financial Crisis?”

Morning Must-Read: Barry Eichengreen: It’s Not a Savings Glut, It’s a Tolerance for Holding Risky Investment Shortfall

Barry Eichengreen: It’s Not a Savings Glut, It’s a Tolerance for Holding Risky Investment Shortfall: “The data show little evidence of a savings glut….

It is plausible that the wealthy consume smaller shares of their income…. But to affect global interest rates, these trends have to translate into increased global savings…. A second explanation for low interest rates is a dearth of attractive investment projects. But this does not appear to be the diagnosis of stock markets…. Capital expenditure has been insufficient to prevent rates from trending down for more than three decades…. If the disorder has multiple causes, then there should be multiple treatments… tax incentives for firms to hire the long-term unemployed; more public spending on infrastructure, education, and research to compensate for the shortfall in private capital spending; and still higher capital requirements for banks and strengthened regulation of nonbank financial institutions…. Finally, central banks should set a higher inflation target…