## If You Are Looking for a Monument to John Hicks, Look Around You!

Pro Growth Liberal accuses me of burying the lead:

EconoSpeak: Why Deficits Have Not Increased Interest Rates: Brad DeLong Makes Me Go Huh?: Brad DeLong makes an interesting observation:

it is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by $2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp... If Brad wanted to mock the standard new classical belief that we are always near full employment so any significant fiscal stimulus would drive up interest rates, this observation would be a nice rebuttal along the lines of the old fashion Keynesian notions that we are both below full employment and are in a liquidity trap... Well, yes, that is what I do want to mock (and make a couple of other points alongside). So let me be more explicit: Last fall I had a large number of conversations with bond market observers who said things like: "Interest rates are low now, but look at how much the Treasury is going to borrow over the next eighteen months. When those borrowings hit the market, Treasury bond prices are going to fall bigtime and interest rates rise. At the moment bond prices are high and interest rates are low, but that's only because finance firms' top management aren't letting traders off their leash to short Treasuries. The traders all expect Treasury prices to fall and interest rates to rise. Mark my words: when the Treasury tries to sell all those bonds next year, it won't find buyers at anything near current prices. Where will all the extra savings to buy those bonds come from?..." As I wrote: [S]upply-and-demand are supposed to rule--and a sharp increase in Treasury borrowings is supposed to carry a sharp increase in interest rates along with it to crowd out other forms of interest sensitive spending. Yet: Hasn't happened. Hasn't happened at all: It is astonishing. Between last summer and the end of this year the U.S. Treasury will expand its marketable debt liabilities by$2.5 trillion--an amount equal to more than 20% of all equities in America, an amount equal to 8% of all traded dollar-denominated securities. And yet the market has swallowed it all without a burp...

And the interesting thing is that I knew that this was going to be what would happen--or, rather, I strongly believed that this was going to be what would happen--and all because I had read John Hicks (1937).

Let me give you the Hicksian argument about what happens in a financial crisis--a sudden flight to safety that greatly raises interest rate spreads, and as a result diminishes firms' desires to sell bonds to raise capital for expansion and at the same time leads individuals to wish to save more and spend less on consumer goods as they, too, try to hunker down.

In Hicks's model, the immediate consequence is an excess demand for (safe) bonds in the hands of investment banks: bond prices rise, and interest rates falls. As interest rates fall, (a) firms see that they can get capital on more attractive terms adn so seek to issue more bonds, and (b) households see the interest rate they can get on their savings fall, and so lose some of their desire to save. The market heads toward equilibrium. But as the market heads toward equilibrium, something else happens as well: the fall in interest rates and the rise in savings is accompanied by a greater desire on the part of households and businesses to hold more of their wealth safely--in pure cash. And so the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending falls, and workers are fired, and as workers are fired and lose their incomes their saving goes from positive to negative.

Thus the process of return to equilibrium takes two forms:

• interest rates fall, boosting investment and curbing savings.
• spending and thus employment and production fall, further curbing savings.

In normal times, the correct policy response is for the Federal Reserve to inject more money into the economy: through open-market operations it should buy bonds for cash, thus increasing the amount of cash so that even at the lower velocity we still have the same volume of spending, and thus transform the adjustment process from a fall in interest rates, spending, employment, and production to a fall in interest rates alone.

A little thought, however, will lead us to the conclusion that such open-market operations may fail. In them, the Federal Reserve is buying bonds, shrinking the supply of bonds out there--and thus pushing up their price and pushing down interest rates. For each amount that the Federal Reserve expands the money stock, therefore, it puts downward pressure on interest rates and thus on monetary velocity. In the limit where interest rates are so low that people don't really see a difference between cash and short-term government bonds like Treasury bills, open-market operations have no effect because they simply swap one zero-yielding government asset for another.

It is in this situation that a government deficit can be useful. A government deficit means that the government is printing and issuing a lot of bonds at exactly the same moment that private investors are looking for a safe asset to hold. As these bonds hit the market, people who otherwise would have socked their money away in cash--thus diminishing monetary velocity and slowing spending--buy the bonds instead. A large and timely government deficit thus short-circuits the adjustment mechanism, and avoids the collapse in monetary velocity that was the source of all the trouble.

Thus a Hicksian analysis last fall would have said--did say--"don't worry: a large flood of government bond issues won't push up interest rates; it will stem a collapse in monetary velocity instead as people who want to hold their wealth in safe form and would otherwise be holding money find themselves happy holding government bonds instead."

And it has all come true.

Lector, si requiris monumentum Hickium, circumspice!