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In 2005-2013, the Long-Run Came First, and the Short-Run Came Later

The Current State of the Macro Policy Debate: Musings on Paul Krugman vs. The Three Tweeters of Bruxelles

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The original argument against expansionary fiscal policy in the current conjuncture was that it was not worth undertaking because of crowding-out. Fiscal expansion would push up long-term real interest rates and that would diminish private investment. The net effect on demand, employment, and spending would be zero--or even less than zero: the "expansionary austerity" meme.

The Keynesian counter-argument was that accommodative monetary policy would prevent any crowding out. That counter-argument was dismissed with the claim that while central banks controlled short-term interest rates, long-term rates had a mind of their own, and that bond markets would require sacrifices to make it clear that debt would never explode in order to maintain or restore their confidence.

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Years passed, It became clear that unprecedented volumes of bond issues issues were not in fact putting upward pressure on long-term interest rates--save in eurozone countries that had a hard exchange rate peg and no ability to control their own monetary policy.

The argument against expansionary fiscal policy was counterproductive shifted.

The argument against became, instead, a declaration that uncertainty about how and when taxes would be levied on businesses or others to amortize government debt was sharply diminishing business' desires to invest. Government debt issues were, the argument implicitly went, reducing the pool of savings. But uncertainty was causing an equal reduction in business demand for funds to finance capacity expansion. Thus fiscal expansion was ineffective, and austerity would be expansionary, even though the prediction that rising debt would quickly generate spikes in long-term interest rates had been false.

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The Keynesian response to this epicycle was as follows: If uncertainty reduced business demand for funds to spend on investment projects it would do so by lowering the value of expected future profits from such capital projects. Such a reduction in value would apply as well to the existing capital traded on the stock market as well. Hence the uncertainty argument implicitly predicted that fiscal expansion would cause stock market values to collapse. That was the implicit consequence of the explanation of the failure of interest rates to rise. And that equity-value collapse had not happened. Equity values had--in both the U.S. and Europe--recovered nicely from their March 2009 panic lows. High unemployment was keeping a lid on wage costs, and low interest rates were diminishing business interest expenses, and so there was more for equity holders.


Now asset markets are telling senior policymakers in the U.S. and Europe as loudly as they possibly can that, on the current expected debt trajectory for the credit-worthy sovereigns of the U.S., Japan, the U.K., and Germany, they possess ample debt capacity. The hurdle rate for ten-year borrow-and-spend projects is -0.6%/year. Even projects that do not add to potential GDP in the future are worth undertaking on a ten-year financing basis as long as the multiplier is greater than 0.94, and with the IMF now saying that the open-economy constant-monetary-and-financial-conditions multiplier for a typical European economy on its own is 1.5, that means a multiplier for the North Atlantic as a whole somewhere north of 2.5.

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So now the intellectual argument against further fiscal expansion to boost demand, spending, production, and employment has gone underground.

In the U.S., what I hear appears to be a chorus of: "la-la-la-la-I-can't-hear-you-let's-talk-about-the-sequester-and-the-importance-of-cutting-spending-and-the-grand-bargain-Bowles-Simpson!-Bowles-Simpson!!-Bowles-Simpson!!!".

And, in Europe, we have the Three Tweeters of Brussels--along with Commissioner Olli Rehn's statements that the intellectual debate is not constructive.

(And, in the U.S. at least, the urgency of the question is boosted by the emergence of Obama appointee Jeremy Stein as the leader of the Federal Reserve wing arguing that monetary policy cannot bear the burden of being this loose for much longer.)

If we were to try to construct the intellectual argument against Keynesian expansionary fiscal policy right now, how would it go? I think it would go more-or-less like this:

  1. Ignore the forecasts of future interest rates in the term structure. They are what Paul Krugman calls "Pangloss" prices--based on the marginal investor's hope that all will go well and belief that they are smarter than the average bear and will be able to liquidate their position before price fall. Accept that interest rates are going to normalize, and normalize quickly: within five years or so.

  2. An economy with a high debt burden has a Reinhart-Rogoff slow-growth possible equilibrium out there: one in which fear of high debt causes real Treasury interest rates to be higher than their 3%/year average by two percentage points and in which growth lags normal potential by 1.5%/year--in the U.S., a long-run growth rate of 1%/year.

  3. In order to eliminate the possibility of such a stagnation equilibrium, the debt has to be sustainable and financeable even if long-run growth is that low and interest rates are that high: debt sustainability calculations have to be capable of delivering a good outcome with a four percentage-point gap between the government's financing cost and the economy's growth rate.

  4. In the U.S., at least, primary federal spending looks to be at or above some 23% of GDP for the rest of the decade.

  5. At a debt-to-annual GDP ratio of 100%, sustainability in the slow-growth Reinhart-Rogoff scenario would require federal taxes to be 27% of GDP: 23% to cover primary spending, plus 4% to hold the debt-to-annual GDP ratio constant at a growth rate of 1%/year and a Treasury real rate of 5%/year.

  6. There is no way that the U.S. political system can tax 27% of GDP. If we tip over to the Reinhart-Rogoff scenario, the U.S. goes to an unsustainable debt path immediately.

  7. Each year that the debt-to-annual GDP ratio stays high we run the unknown risk of tipping into that equilibrium. The debt-to-annual GDP ratio needs to get on a downward trajectory as fast as possible.

To this, the Keynesian counter is: (a) that is a very implausible scenario that you are spinning, (b) in the meanwhile employment in America is something like 6% lower than it would be if the economy were functioning properly, (c ) each year of subnormal output casts in all likelihood a huge and destructive hysteresis shadow over the future, (d) we know how to restore production to potential and employment to its natural rate--print money and buy stuff--and (e) even if we start to tip over into an unsustainable debt-path scenario, we can handle it, because that is why God made financial repression.

Let me spell (e) out a little bit. If investors start to fear that the U.S. debt trajectory is truly unstable, the immediate consequence is a fall in the dollar and an export boom, with somewhat higher domestic inflation. Because the U.S. government regulates the financial system, it can set reserve requirements where it likes--it can thus use its reserve requirements to force banks to hold Treasuries, and if it doesn't like the interest rate at which banks are holding Treasuries, it can up reserve requirements some more.

No, financial repression is not ideal. But it is not a disaster like a collapse of confidence in the debt and the currency. And when you weigh a small chance of being forced into financial repression should interest rates super-normalize against the near-certainty if nothing is done of what is now looking like Lost Decades--decades, plural--it is hard to see how the benefit-cost analysis comes out in favor of doubling-down on the failed policies of austerity.Screenshot 3 6 13 7 34 AM

Paul Krugman:

Of Cockroaches and Commissioners: Kevin O’Rourke points me to… FT’s Brussels… various officials at the European Commission are issuing outraged tweets against yours truly… [for being] mean to Olli Rehn…. What you would never grasp from those outraged tweets is that all my criticisms have been substantive. I never asserted that Mr. Rehn’s mother was a hamster and his father smelt of elderberries; I pointed out that he has been promising good results from austerity for years, without changing his rhetoric a bit despite ever-rising unemployment, and that his response to studies suggesting larger adverse effects from austerity than he and his colleagues had allowed for was to complain that such studies undermine confidence.

It’s telling that what the Brussels blog calls a “particularly nasty attack” was in fact a summary of Paul DeGrauwe’s work indicating that European austerity has been deeply wrong-headed, in the course of which I quoted Mr. Rehn asserting, once again, that old-time austerian faith.

Kevin O’Rourke refers to the “cocooned elites in Brussels”, which gets to the heart…. The dignity of office can be a terrible thing for intellectual clarity… never have anyone point out how utterly wrong you have been at every stage…. Those of us on the outside need to do whatever we can to break through that cocoon…. There’s an especially telling tweet in there about how “unimpressive” I was when visiting the Commission in 2009. No doubt; I’m not an imposing guy…. [Y]ou can see what these people consider important: never mind whether you have actually proved right or wrong….

The European economy is in disastrous shape; so, increasingly, is the European political project. You might think that eurocrats would worry mainly about that reality; instead, they’re focused on defending their dignity from sharp-tongued economists.

Kevin O'Rourke:

The Irish Economy » Blog Archive » Methinks they do protest too much: It isn’t Paul Krugman’s fault that the European Commission has been busily defending a macroeconomic policy mix that is doing tremendous damage to the European periphery: the EC only has itself to blame on this one. And so the latest outraged tweets emerging from the Brussels bubble are a little hard to take.

One of the tragedies of the interwar period is that the good guys — liberal internationalists — tended to support a macroeconomic policy mix that was destructive, as a result of their support for the gold standard. In so doing they helped undermine the case for liberal internationalism. It would be helpful if the cocooned elites in Brussels remembered that they are, de facto, the public face of the European project...

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The Three Tweeters of the European Commission:

@NYTimeskrugman #Rehn did not make that claim. But as you mention it: 1940s UK could rely on US largesse. 2013 eurozone needs market access. @ECspokesSimon Simon O'Connor

@EconCharlemagne What’s next? Spitting? @ECspokesKoen Koen Doens

Paul Krugman is pretty critical of EU Commission - surprising given how unimpressive he was in Mar 09 when here to give actual crisis ideas @RyanHeathEU Ryan Heath

Here is @NeelieKroesEU speech debating @NYTimesKrugman in March09 @traynorbrussels @BrunoBrussels @aoifewhite101 @RyanHeathEU Ryan Heath

If @NYTimesKrugman is worried abt "cockroach" ideas he needs 2 remember Single Market & #EU itself r the biggest cockroaches: not going away @NeelieKroesEU Neelie Kroes

We need critics not cynics. Hope, action & realism the essential balance now for Europe. @NYTimesKrugman too cynical, we r not the Tea Party @NeelieKroesEU Neelie Kroes

The #EU is a complex, fragile miracle of cultures as well as economy. @NYTimeskrugman Paul very cynical - easy to be so from a distance @NeelieKroesEU Neelie Kroes