Paul Krugman:
Interest Rate Stories: [T]here are two different stories about why deficits might drive up interest rates... not at all the same.... The first story is good old crowding out: the government is borrowing, that competes with private borrowers, and that drives rates up.... [I]t’s a reasonable story when the economy is near full employment. But it’s all wrong when the economy is depressed, and especially if it’s in a liquidity trap....
The other story involves fears about a government’s solvency. The key point to understand here is that one year’s deficit, in practice, can’t matter very much in determining a government’s solvency, which depends on the present discounted value of revenues and obligations over many years. So the deficit matters in that case only to the extent that it represents a signal about government determination....
It’s worth noting that the current attack on Italy was not triggered by news about the deficit; it was triggered by worries about economic growth. And this makes one wonder whether austerity can really restore confidence...
Once again, I think Paul understates his case:
The Keynesian logic for expansion right now is reinforced by the fact that recessions and austerity programs cast shadows: raise unemployment now via austerity cuts in government spending, and some of that increased unemployment sticks around permanently as higher structural unemployment. Call the share of unemployment that does so s. Then an austerity program today worsens the long-run debt-and-deficit picture if:
mt > (r - g)/(r - g + s)
where m is the multiplier, t is the marginal tax rate, s is the share of the cyclical recession rise in unemployment that turns into a permanent rise in unemployment, r is the real interest rate on government debt, and g is the economy's real growth rate. Since right now mt is about 0.5, and r is less than 2% per year, this means that fiscal contraction is bad for the long-run debt-and-deficit right now as long as:
s + g > 2%
As long as the sum of the economy's long-term growth rate--which is now about 3%--and the share of a rise in unemployment that becomes structural is greater than 2%--which it definitely is--fiscal contraction is a bad, imprudent, and spendthrift thing.
Moreover, even if you have no Keynesian effects in the model at all, there is still an overwhelming case for borrow-and-spend right now. Why? Because the thirty-year Treasury inflation-indexed security rate at 1.86% 1.62% per year is lower than the expected long-run growth rate of the real economy right now of close to 3% per year. This is a basic topic sometimes taught in intermediate undergraduate macroeconomics: the neoclassical optimizing growth "Golden Rule." If the economy ever gets itself into a situation in which risk-adjusted long-run interest rates are lower than the risk-adjusted expected long-run growth rate of the economy, it is dynamically inefficient--and government should borrow and spend and keep borrowing and spending until at least it drives long-term interest rates up to and above the risk-adjusted expected long-run growth rate. (And the Keynesian multiplier and the shadows cast by recessions strengthen the case for spending.)
Yet I find none of the classical, semi-classical, new classical, or neoclassical economists who believe in optimizing growth models stepping forward and saying: "Because r < g right now, what we really need is more government spending and an expanded government debt."
It is very odd...
