There have been two annoying things about the past decade. The first is that I feel like I have been living in a Ken Macleod novel--and one of the more dystopic ones too, at least up until January 21, 2009 (I am glad he has stopped: Ken: please don't get cranky again). The second is that the best way to understand the world is through these two rules:
- Paul Krugman's analysis is correct.
- If you think that Paul Krugman's analysis is incorrect, see rule number 1.
Most recently, I thought that Paul Krugman must be being too harsh on Niall Ferguson. Ferguson could not really have forgotten so much economics as to believe that when interest rates are zero deficit spending is inherently contractionary, could he? But Paul said he did:
Liquidity preference, loanable funds, and Niall Ferguson (wonkish) - Paul Krugman Blog - NYTimes.com: Joe Nocera... fails to mention... the most depressing aspect... further confirmation that we’re living in a Dark Age of macroeconomics, in which hard-won knowledge has simply been forgotten. What’s the evidence? Niall Ferguson “explaining” that fiscal expansion will actually be contractionary, because it will drive up interest rates. At least that’s what I think he said....
[I]t might be useful to re-explain why [in] our current predicament... fiscal deficits won’t drive up interest rates unless they also expand the economy.... I imagine Niall Ferguson was thinking... of... the “loanable funds” model.... Keynes pointed out was that this picture is incomplete if... the economy is not at full employment.... [S]upply and demand for [loanable] funds... tells you what the interest rate would be conditional on the level of GDP... defines a relationship between the interest rate and GDP....
So what determines the level of GDP, and hence also ties down the interest rate?... [A]dd “liquidity preference”, the supply and demand for money. In the modern world... the central bank adjusts the money supply so as to [try to] achieve a target interest rate.... [But r]ight now the interest rate that the Fed chooses is essentially zero [and cannot go any lower], but that’s not enough to achieve full employment... the interest rate the Fed would like to have is negative... the Fed’s own economists estimate the desired Fed funds rate at -5 percent....
So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending... until the excess supply of savings has been sopped up... [and the interest rate consistent with full employment rises above zero].
Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. But the fact remains that our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.
And Krugman reiterated his judgment:
China and the liquidity trap - Paul Krugman Blog - NYTimes.com: By the way, I’ve had a chance to see the transcript of the PEN/ NY Review event, and I don’t think I was misrepresenting Niall Ferguson’s position...
Sure enough, now that I have taken a look at the transcript, I have to once again agree that Paul Krugman's analysis is correct. This is annoying. This is damned annoying. In fact, this is beyond annoying:
Niall Ferguson: Now we are in the therapy phase, and what therapy ar we using? Well, it is very interesting because we are using two quite contradictory courses of therapy. One is the prescription of Dr. Friedman, Milton Friedman, that is, that is being administered by the Federal Reserve: massive injections of liquidity to avert the kind of banking crisis that caused the Great Depression of the 1930s. I am fine with that. That is the right thing to do. But thre is qnother course of therapy that is simultaneously being administered, which is the therapy prescribed by Dr. Keynes, John Maynard Keynes, and that therapy involves the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year and the issuance therefore of vast quantities of freshly-minted bonds.
There is a clear contradiction between these two policies, and we are trying to have it both ways. You cannot be a Keynesian and a monetarist simultaneously, at least I cannot see how you can, because if the aim of the monetarist policy is to keep interest rates down to keep liquidity high, the effect of the Keynesian policy must be to drive interest rates up.... [T]here is going to be... a very painful tug-of-war between our monetary policy and our fiscal policy...
A real monetarist--like Milton Friedman's teacher Jacob Viner, say--would argue (in fact, did argue during the Great Depression) that when the interest rate is near zero monetary expansion and deficit spending do not offset but reinforce each other, for essentially the reasons set out by Krugman. As Paul said in rebuttal to Ferguson: "There is... no contradiction between the Federal Reserve's actions and... fiscal stimulus. It is very much necessary to do both..."
Normally the banking system buys bonds from corporations which then spend the money investing in plant and equipment. Right now that process has broken down, and until the banking system gets fixed the second-best is to have the government step into the role. As Krugman writes:
By buying a lot of private securities, the Federal Reserve is... playing the role the private banking system is no longer playing properly... debt-financed spending on infrastructure by the Obama administraiton is filling the hole left by the collapse in business investment....
Conclusion? Once again:
There is not an excess demand for savings that is going to drive up interest rates...
Niall Ferguson does indeed know a lot less than economists knew in the 1920s. Back then when R.G. Hawtrey was laying out the Treasury View he claimed that fiscal policy was ineffective--and was wrong. Niall Ferguson's belief that fiscal policy is destructive shows that he has not even got that far.
UPDATE: As a "friend" points out, Ferguson spent considerable time trying to bait Krugman into losing his cool:
- As d2 points out, the references to "Dr. Keynes" appear for some reason to work like a red flag to a bull on status-conscious Englishmen--for Keynes never got a Ph.D.--but it doesn't work on Dr. Krugman.
- "I rather fear that, at the risk of provoking the man sitting on the other side of me, that it says 1936 on the bottle of Dr. Keynes’ medicine..."
- "[I]if you listened carefully to what Paul Krumgan said, he actually agreed with me [laughter]..."
- "So, I hate to teach arithmetic to a Nobel laureate, it doesn’t quite add up..."
- Madrick: "Let’s let Paul speak..." Krugman: "Oh, Dear..." Ferguson: "Oh Dear indeed..." Krugman: "Let’s talk national income accounting offstage..." *