Paul Krugman blogs:
Martin Wolf Is Not A Serious Person : And neither am I. Wolf writes:
I have now lost faith in the view that giving the markets what we think they may want in future – even though they show little sign of insisting on it now – should be the ruling idea in policy.
Amen. Yet most of the men in the room where I’m now sitting believe the contrary. With a few exceptions, everyone is calling for fiscal austerity everywhere, right now.
As Ricardo Caballero says, the big problem right now is that the world economy has too little safe high-quality financial assets, and thus excess demand for them is, by Walras's Law, producing excess supply of goods and services:
It’s the general equilibrium, stupid: [T]he fundamental problem... is a shortage of safe “AAA” assets. The world seems to need more US Treasury-like instruments than are available.... The demand for these assets has expanded as a result of the fear triggered by the crisis.... But this time the private sector industry created to supply these safe assets – the securitisation and complex-assets production industry – is severely damaged. Much of what we see that confuses us today is the equilibrium consequence of living in an environment with this shortage. There is enormous asset price volatility, especially as assets transit out of the safe assets category... the recent difficulties in the Eurozone can be seen in this light, with Greece and others dropping from the potential safe-asset producers list. This shortage also leads to chronically low safe real interest rates.... These however, are the consequences, not the source. The US Congress and the Bank for International Settlements’ knee-jerk reactions are (mostly) bound to reallocate the malady, rather than cure it.... [A] more effective goal would be to focus on expanding the real supply of AAA assets... two basic ways of achieving this in the short run... governments in safe-asset-producing countries [could] produce a lot more of them [by running fiscal deficits]... the private sector create the AAA assets and for the governments (at a fair price) to absorb only that part of the risk the private sector cannot handle.... [F]unding fiscal deficits is very inexpensive these days... as long as one remains within the safe-asset-producer category...
In short, expansionary fiscal policy (credit-worthy governments print up a huge honking tranche of AAA assets, and then use the money to buy goods and services) or expansionary monetary policy (credit-worthy central banks take on duration and interest rate risk by buying securities for cash, and by increasing the money stock increase the supply of the most AAA of AAA assets) or expansionary banking policy (Treasuries and central banks turn leaden risky assets into golden safe ones by offering guarantees of one sort or another). The hope is that, by Walras's Law which tells us that excess demands across all markets must sum to zero, that relieving excess demand for AAA assets will produce as a consequence the relief of excess supply and full-employment balance in the markets for goods, services, and labor as well.
This is the line of policy that was recommended by John Stuart Mill in the aftermath of the very first industrial business cycle--the 1825 crash of Britain's canal bubble:
John Stuart Mill: It must, undoubtedly, be admitted that there cannot be an excess [supply] of all other commodities, and an excess [supply] of [AAA assets] at the same time. But those who have, at periods such as we have described, affirmed that there was an excess of all commodities, never pretended that [AAA assets] was one of these commodities; they held that there was not an excess, but a deficiency of [AAA assets]. What they called a general superabundance, was not a superabundance of commodities relatively to commodities, but a superabundance of all commodities relatively to [AAA assets]. What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess [AAA assets] than any other commodity. [AAA assets], consequently, was in request, and all other commodities were in comparative disrepute. In extreme cases, [AAA assets] is collected in masses, and hoarded; in the milder cases, people merely defer parting with their [AAA assets], or coming under any new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable...
And that had in fact been carried out by the Bank of England in 1825-1826. Let me turn the microphone over to Walter Bagehot:
The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way that the passage has become classical. 'We lent it,' said Mr. Harman... [one of the Directors] of the Bank of England:
by every possible means and in modes we had never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the Bank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we rendered every assistance in our power...
This is the line of policy that, broadly, the world has been following since the subprime crash started in mid-2007 and excess demand for AAA assets first became grossly apparent. And this is the line of policy that the Group of 30 now wishes to reverse--without putting anything in its place.
Now it is certainly the case that the government budget constraint holds in the long run--that governments cannot keep running deficits and raising their debt and taking on tail risk forever without cracking the AAA status of their own debt and so not relieving but instead aggravating the excess demand for AAA assets which is the Walras's Law balancing entry to excess supply in the markets for goods and services and high unemployment. As Ricardo writes:
[W]ere we to continue along this path, at some point it will make sense to decouple fiscal deficits from asset production--lest we find ourselves cast in an epic Greek tragedy. The US Treasury would have to start buying riskier private assets rather than running fiscal deficits as the counterpart for its supply of Treasuries.... [In the medium term] the second, private-public approach is probably... sounder.... The private sector is much more efficient than the government in producing micro-AAA assets, but the opposite is true for macro-AAA asset production. Issuing public debt leaves the government in charge of bundling and producing both the micro- and the macro-AAA assets. Instead, if the government only provides an explicit insurance against systemic events... we could have a significant expansion in the supply of safe assets without the corresponding expansion of public debt...
But we are extremely far from cracking the U.S. government's status as the supplier of AAA assets to the global economy right now. When we see signs that further issues of Treasury bonds or loan guarantees by the U.S. government are starting to erode the AAA status of U.S. government debt, then will be the time to back off of expansionary U.S. fiscal, monetary, and banking policy. Then--not now.