On the horizon, I see the eurozone breakup vigilantes approaching the form of Ken Rogoff's latest: Three Wrongs Do Not Make a Right. But first, focus on his conclusion:
High return infrastructure projects pay for themselves in the long run, and are a reasonable risk for the short run… [as are] effective expenditures aimed at making education more effective…. Monetary policy should have been even more aggressive after the crisis…. Debt overhang is a huge problem…. I have long clearly favoured sharply writing down debts… at the ultimate expense of taxpayers in the core of Europe…
Hold tight to that: Ken Rogoff believes, along with the rest of us, that since 2010 European governments (including Britain's) should have spent more, that central banks should have eased more, and that banking policy should have written-off more.
Now I wish Ken would go farther: I wish he would do the arithmetic of fiscal policy in more depth, because I think that if he did he would agree with Larry Summers and me that at current interest rates--and at the interest rates that bond markets expect to prevail for at least the next generation--it is not just government investments in infrastructure and education that pay for themselves in the sense of reducing the future debt burden, but any government expenditures at all that do so.
But right now I will take what I can get: And what I get is that Ken Rogoff agrees with us that on the far side of the Atlantic fiscal, monetary, and banking policies have all there been inappropriately austere since 2010. The only questions we have to debate are: how much and how far should governments have gone in additional stimulative fiscal, monetary, and banking policies.
Now, with that established, let me circle back around through the piece and engage in an activity that has always paid high dividends for me: the diligent study of Ken Rogoff Thought.
Perhaps I should first lay out how I think of fiscal policy in a context in which the effectiveness of monetary policy is constrained and cannot carry out its full stabilization-policy mission. As I see it, when monetary policy is unconstrained there is then no case for the government's spending more than "classical" principles would indicate--the effective multiplier μ on government spending is then zero, and there is no point. But when monetary police is constrained, and μ is positive, the DeLong-Summers analytics are thus:
- Boost government spending this year by £1.
- Boost output this year by £μ.
- Boost government debt as of the end of this year by £(1 - τμ), where τ is the marginal tax-and-transfer share.
- Boost future debt amortization expenditures required by £(r-g)(1 - τμ), where r is the real interest rate on government debt and g is the growth rate of the economy.
- Boost future tax collections by £τμη, where η is the hysteresis shadow cast on long-run potential output by a short-run depression.
Therefore:
- If (r-g)(1 - τμ)<τμη, you know that fiscal policy is too austere--that more government spending now does not worsen but improves the long-run fiscal balance. (r-g)(1 - τμ)>τμη is necessary for fiscal policy not to be too tight.
- That means that you should certainly be less austere as long as r < g + [τμ/(1 - τμ)]η
- In Britain right now, g=1.5%/year, τ=40%, μ=1.5. That gives us the conclusion that policies are certainly too austere as long as r < 0.015 + 1.5η
Given that the real 10-year gilt is currently yielding less than 0.5%/year, fiscal policy is definitely too austere. And if we are willing to say that η=0.05--that a £1 depression reduces future potential output by 1s--we can say that fiscal policy is too austere until (a) exit from the liquidity trap makes monetary policy unconstrained and so drops μ, or (b) r rises to be above 9%/year in real terms.
In this framework, any claim that the UK government should not have spent-more-and-borrowed-more (or cut-taxes-more-and-borrowed-more) in 2010 and today is a claim that the effective real interest rate, the effective cost of government borrowing, is higher than the interest rate the market charges the UK to buy its gilts--and is higher by an amount on the order of 10%/year: that £1 of additional bonds outstanding imposes costs on the economy that, when properly valued, amount to the full face-value of the bond when added up over ten years.
What could those costs possibly be?
They are not the costs of the interaction of a possible euro collapse with higher debt to be found in an IS-LM model:
Ken Rogoff:Three Wrongs Do Not Make a Right:
Prof Krugman's comment, using a… canonical modern IS-LM macroeconomic model, shows that even if a euro collapse would have led to a run on sterling, the result would be… a rise in demand… even if this built-in automatic stabilizer were not enough to prevent a “squeeze” on long-term bonds, the Bank of England could just print money and buy them up en masse thanks to the liquidity trap…. Thus there was in fact no need to reconcile his debt management advice with his euro red alert…. Krugman’s analysis… is completely internally consistent within its own universe.
Rogoff's quarrel is with IS-LM as an adequate model of the situation:
I think the model is missing some absolutely essential elements….
First, a collapse in demand in the UK’s major trading partner would lead to a downward shift in demand for British goods, tending to shift the IS curve inwards… the euro might well fall even more than the pound, further aggravating this effect…. UK banks would get hammered if a disorderly euro-breakup led to a wave of defaults… another reason why the IS curve would shift inwards…. There would almost certainly be a giant negative wealth effect on demand as the stock market crashed, with housing prices likely to follow…
But these are all effects of a collapse in the euro on the British economy--these are not, or at least not yet, effects of the interaction of a euro collapse with debt--of how the British economy would be dragged down further in the event of a euro collapse by a higher debt.
And so Rogoff moves on:
This is just a sketch, and like Prof Krugman, I welcome further concrete analytical contributions in this area…. It is likely that the answers will be quite sensitive to the underlying risk, and that long-term debt sustainability will sometimes come into play. And what about long-term debt sustainability? Well, the aftermath of a euro breakup is exactly a situation where credibility would be everything.
In arguing that the UK can always just print money, Profs Krugman and Simon-Wren Lewis take for granted the credibility of long-term fiscal sustainability and the Bank of England’s commitment to maintain low inflation. But… the UK’s macro policy credibility is far from bullet proof…. Even in a liquidity trap, the capacity to print money is not an infinitely deep well. In a real attack, it is not just government liabilities but bank liabilities that would come under attack.
The UK has short-term external debt over 250 per cent of GDP. A calamity of the proportions we are talking about here would make it very hard to sustain credibility, and the UK government would have had to call on every ounce of its credibility reserve…. There is a completely legitimate question of how a country can best enhance credibility when faced with the high risk of an impending external shock….
I would put my money on the time-honoured advice that countries with very large budget and current account deficits have more trouble maintaining credibility than countries that don’t…. As one can see from the highly debatable assumptions implicit in Krugman’s analytical framework, and from the apparent inconsistencies between his UK debt management advice and eurozone breakup call, they are not simple at all.
Going back to my calculation that the costs of carrying extra debt must be priced at 10%/year or more above the interest rate on gilts for austerity to be a good idea, and figuring the chances of a euro breakup in a way that is a catastrophe for the British economy at 5%/year, that tells me that the costs to the British economy of that external-demand-and-confidence shock would have to be higher by £2 for every £1 of extra debt in order for general austerity to be a good idea.
May I say that as long as the UK is issuing sterling debt--and as long as regulators are on the job and keeping British banks from turning around and bundling that sterling debt with sterling puts when they sell it to foreigners--that Rogoff's "my money [is] the time-honoured advice that countries with very large budget and current account deficits have more trouble maintaining credibility" does not get me to the conclusion of £2 in higher costs to the British economy in a catastrophic euro breakup for every £1 of extra debt that Rogoff needs in order for his argument to cross the finish line?
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