How Is It That We Have Lost the Argument?

Martin Wolf:

Why it is right for central banks to keep printing: Confronted with huge fiscal deficits, many have concluded that they should hurry fiscal tightening on as fast as possible, in the hope that it will prove expansionary. What are the chances that they will be right? Small, I believe.... [A]las, many “sound” people prefer orthodox recessions to unorthodox recoveries.

Why might a sharp structural fiscal tightening promote recovery?... [S]maller prospective deficits may improve confidence among consumers and investors, thereby raising consumption and lowering risk-premia in interest rates.... Is it persuasive? In a word: no. The authors group together data for members of the Organisation for Economic Co-operation and Development between 1970 and 2007. But the impact of fiscal tightening is going to depend on circumstances.

A reduction in the fiscal deficit must be offset by shifts in the private and foreign balances. If fiscal contraction is to be expansionary, net exports must increase and private spending must rise, or private savings [must] fall. Thus, experience of fiscal contraction is going to be very different when it occurs in a few small countries... when the financial sector is in good health... when the private sector is unindebted... when interest rates are high... when external demand is buoyant... and when real exchange rates depreciate sharply....

Yet another approach is to find a situation that is indeed quite like today’s. The closest parallel is the 1930s... [when] fiscal stimulus was effective when tried.... In current circumstances, the belief that a concerted fiscal tightening across the developed world would prove expansionary is, to put it mildly, optimistic. At this stage, I will inevitably be asked: what is the alternative?....

[T]he deleveraging cycle is generating huge private sector financial surpluses.... [T]hese surpluses must now to be invested in government liabilities. This helps explain why yields on the bonds of safer governments remain so low.... [I]f governments need to run deficits, to support demand at a time of private sector weakness, they can always borrow from central banks. Yes, this is “printing money”. It is also an insanely radical policy recommended by no less insane a radical than Milton Friedman, back in 1948.... [O]ne does not have to decide whether fiscal policy or monetary policy is doing the heavy lifting: they are two sides of one coin. The argument for aggressive monetary expansion remains strong... since the growth of broad money and nominal GDP is weak. So Friedman’s policy of “quantitative easing”, as it is called, still makes good sense. Am I recommending the economics of Robert Mugabe? No. As in everything else, it is the context that matters. At present, we have “too little money chasing too many goods”. In this environment, monetary policy must be aggressive....

The conventional wisdom is that a strong and co-ordinated structural fiscal contraction, focused on spending, will promote the growth of a thousand private blooms. I hope this will prove true. But I doubt it...

That fiscal contraction is expansionary when it is part of a package including substantial real exchange rate depreciation and substantail interest rate reductions by the central banks is something I have believed ever since I first started thinking about these issues. I was printing up color graphs to support that argument back in December 1992 so that Summers, Reich, Blinder, and Altman could make that argument to President-Elect Clinton.

But the world's exchange rate cannot depreciate against itself right now. North Atlantic ce ntral banks (Britain's aside) have no room to reduce the interest rates they control. The only argument left is that fiscal contraction will shrink risk premia and boost private-sector confidence--but no fiscal contraction now will solve the long-term financing problems of the North Atlantic social insurance states. If the alternative to stimulative fiscal policy accompanied by Friedmanite quantitative easing now were a policy that moved the North Atlantic governments into Auerbach-Kotlikoff intergenerational balance, I would say that they might have an argument.

But it isn't.

A Keynesian economist would say that demand is way low--and that the government needs to boost it. A monetarist economist would say that spending is way low--and so the government can either boost velocity by boosting the opportunity cost of holding money (which is most easily done by printing more government bonds--running bigger deficits) or boost the money stock by printing money. A market-oriented economist would say that U.S. Treasury (and German government, and Japanese government bonds) right now are extraordinarily valuable assets--and thus that the way to maximize economic value is to print more of them, i.e. run bigger government deficits.

The only response I hear is that the market lacks confidence. But the market doesn't lack confidence in the government. THe market lacks confidence in the private sector--it lacks confidence that unemployment will be low and capacity utilization high enough for private businesses to make the operating profits needed to service their debt, and that the financial system is well-enough capitalized that those operating profits will flow through to newly-issued financial instruments rather than being diverted to cover unrecognized but very real past losses. I could understand: "we need to shrink risk premia by having the government guarantee new bond issues." I cannot understand: "we need to shrink risk premia by raising taxes and cutting spending for the fiscal year that starts in July."

I could understand losing the argument if consumer price inflation was rising, if expectations of inflation in the Treasury-TIPS spreads were rising, if real interest rates on long U.S. Treasury bonds were rising, if there were any signs at all that we were moving from the green zone to the yellow zone as far as the U.S. Treasury bond's status as safe asset in the world economy were concerned. But we are not doing that. As Alan Greenspan just wrote:

An urgency to rein in budget deficits seems to be gaining some traction among American lawmakers. If so, it is none too soon. Perceptions of a large U.S. borrowing capacity are misleading. Despite the surge in federal debt to the public during the past 18 months—to $8.6 trillion from $5.5 trillion—inflation and long-term interest rates, the typical symptoms of fiscal excess, have remained remarkably subdued. This is regrettable...

That the U.S.--in spite of the Reagan deficits, in spite of the Bush 41 deficits, in spite of the Bush 43 deficits--still has room to borrow to deal with national emergencies likes wars and depressions is not regrettable. It is gratifying.

The hope is that this is all just Dingbut Kabuki: that the U.S. government will continue the ARRA rather than letting it die off and expire, and will find some way to compensate for the next round of state and local fiscal contraction, and that the Europeans will talk a lot but do nothing to send their economies deeper into recession. But I fear that it is not.

Somehow we seem to have lost the argument--within the ECB, within the French and the European governments, within the British Liberal Party, within the Bank of England, within the Federal Reserve, with U.S. Senator number 60, and even within the White House.

And I do not understand how, or why we have lost the argument.