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How worried should we be about the deficit?
There have been many posts on this topic lately, start with Paul Krugman and Brad DeLong if you need to catch up. Today I have a few simple points:
1. Even if "it is fine to borrow more" is the most likely scenario, it is not the only scenario. Let's take a page from Marty Weitzman on climate change. The worst-case scenarios matter too, because they can be very, very bad. We need to think probabilistically about this issue.
2. Are there current intelligent discussions of the implied interest rate volatility embedded in current options prices? If we are looking for market tests, why not start there? Focusing on the point estimate of the market interest rate(s) discourages you from thinking probabilistically.
3. I know less about Belgium but I am not reassured by Krugman's point that "Italy can do it." I and many other observers consider Italy's economy to be a basket case which will only get worse. Nor is Japan in a satisfactory place, economically speaking.
4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is politically weak because it’s Italy. If these countries can run up debts of more than 100 percent of GDP without being destroyed by bond vigilantes, so can we."
I would interpret this evidence differently. A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms. It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy. I believe that the not-always-swift American voter in fact understands high deficits -- correctly -- in this light. They don't hold theories about "crowding out," rather they sense something in the house must be rotten. And so they rail against deficits, as do some of their elected representatives. It's a more justified reaction than the pure economics alone can illuminate.
When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm.
Posted by Tyler Cowen on November 24, 2009 at 07:32 AM in Economics, Political Science | Permalink
Comments
I've followed politics for quite a few decades now, and I've learned deficits matter during Democrat administrations and don't matter during Republican administrations.
Posted by: Tom at Nov 24, 2009 7:44:41 AM
A few points, in no particular order:
1. Isn't it more important to focus on bringing unemployment down and making sure the economy is set for strong growth? Easier said than done, of course, but if growth is anemic, the deficit becomes a bigger problem right from the beginning.
2. I'm more concerned about the political forces holding back any sort of reasonable response. I don't mean to sound like a partisan Democrat here, but if the Republicans are simply unwilling to consider tax increases of any kind, it doesn't look like there's much room for negotiation. I can understand their reluctance, in some senses at least, but there's only so to cut from the budget. Hell, even there, they seem to be unable to work with the Democrats.
3. Back right around the time Obama was sworn in and the economic problems seemed to be at their peak, when the stimulus was being debated, some supporters of it said that if the deficits were a big concern, the Bush tax cuts on upper income people should be reversed. I believe Jeffrey Sachs and Robert Frank are included in this group. As I said before, it's easier to talk about doing this than to actually do it, but assuming it was possible, why wasn't it done? If they felt that would be the wrong way to go about bringing in extra revenue, why not, as Dean Baker and others have suggested, implement a financial transaction tax?
Even if that isn't the right idea now, why not propose it to go into effect two or three years down the line? Assuming that it brings in what the upper estimates suggest, which is $150 billion, it would give us a lot of needed revenue. This might be politically easier to pass, since it could be pitched as a way to sock it to Wall Street. And while it wouldn't close the gap by itself, $150 billion in new revenue with $50 billion in spending cuts would be a big step in the right direction. I assume, of course, that something relatively small like $50 billion is possible since they cut $17 billion right around the time the stimulus was being debated.
4. I sometimes wonder if it's more important right now for the administration to show that it's concerned about the deficit than to actually do anything about it. In a few years, this wouldn't be the case, but right now, it might be. That's why I suspect all of the concern about the mounting debt and the administration's bizarre reaction to it--again, over the short term--is more posturing than anything else, and not in a bad way.
Posted by: Brian J at Nov 24, 2009 8:16:54 AM
It would be fine to apply a purely mechanical/technical/"hydraulic" analysis to the deficit if it were being used as a stimulus in the sense that Keynes intended, i.e. temporary spending that uses the multiplier to avoid government planning as a solution to the consequences of the business cycle trough. The problem is that this deficit is a consequence of bad policies and decision-making systems, rather than a decision to shift exogenous economic activity away from a future peak and towards the trough. Particularly the Bush wars and the Obama health bureaucracy.
Much the same is true of my country (Ireland), in which we actually ran deficits in some years during the large economic expansion at the beginning of the decade, due to an incomes policy dictated by the largest businesses and trade unions that depended on a house price bubble and easy money. So this isn't anti-American or anything (or anti-Belgian or anti-Italian). It's a common theme in polities with problems.
Posted by: Millian at Nov 24, 2009 8:17:38 AM
I think the water overflow is a great analogy. Right now the US economy is on fire. Do you really want to call in the plumber to cut off the water?
Posted by: Morten at Nov 24, 2009 8:20:41 AM
You missed Krugman's point.
Posted by: Colin at Nov 24, 2009 8:26:56 AM
Krugman's point is weak because Italy and Belgium face little risk of a currency crisis.
Posted by: NC at Nov 24, 2009 8:30:55 AM
"4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is politically weak because it’s Italy. If these countries can run up debts of more than 100 percent of GDP without being destroyed by bond vigilantes, so can we."
I would interpret this evidence differently. A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms. It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy. "
Exactly. This is precisely why California has such a ridiculous deficit and debt.
Posted by: Adam Jackson at Nov 24, 2009 8:41:31 AM
"Krugman's point is weak because Italy and Belgium face little risk of a currency crisis."
And you believe that the United States does?
Posted by: Colin at Nov 24, 2009 8:47:59 AM
"I've followed politics for quite a few decades now, and I've learned deficits matter during Democrat administrations and don't matter during Republican administrations."
It must be strange to see the world solely through the lens of political teams.
You have never seen libertarian criticism of deficit spending by Republican politicians? Let me give you a hint. People can oppose deficit finance without favoring tax increases. People can oppose an expansion in the size of government while considering deficit finance a compounding problem.
There are plenty of critics of "big government" Republicans.
Just because Republican politicians and the pundits who repeat their talking points ignore such views and instead make a partisan case doesn't mean that such views don't exist.
Take off your blinders! There is more to the world than the rhetoric of politicians and their lackeys in the media.
Posted by: Bill Woolsey at Nov 24, 2009 8:49:38 AM
Another thing to keep in mind about Italy and Belgium: Neither is the lone hyperpower whose banks constitute the hub of the international financial system. Also, both are protected from currency runs by their use of the Euro. Comparatively, if California were a sovereign nation with its own currency, they'd probably have done some hyperinflating long ago.
Krugman and Delong can quibble about the timing of the exact date when the world loses confidence in $US-denominated assets, and they are certainly more qualified to do so than I. But it would be unarguably obvious to anyone in any historical era other than our own - what we are not witnessing is not the behaviour of a well-governed, long-for-this-world state.
Cheers,
Zdeno
Posted by: Zdeno at Nov 24, 2009 9:02:41 AM
How can it be that deficits don't matter because we are in a recession and yet it is critical to focus on medical spending reform because it is a long-term budget problem and the bill is fiscally responsible?
Posted by: Andrew at Nov 24, 2009 9:15:00 AM
As a resident of Italy... I take issue with 'basket case'. Things certainly are bad right now, and not getting better, but *long term*, I think Italy has a lot of good "fundamentals" - geography, climate, history, art, and most importantly, a great deal of smart, creative , and yes, hard working people. Unfortunately, 'long term' may be 10, 20, 50, 100 years or more, as the set of the aforementioned people does not really interact with the set of people in charge.
Posted by: David N. Welton at Nov 24, 2009 9:16:45 AM
Being an Italian living in Belgium, I drew the attention of Krugman to the inappropriate, to say the least, comparison he made. I posted comments in his blog. He is now making jokes about the issue without explaining a) his concept of sustainability of deficits and debts and solvency b) the correlation, if any, between increasing deficits and debts and creating jobs c) what if, in the worst scenario, US bond vigilantes (chines) decide to dump dollars and treasuries which ends up in situations of “self-fulfilling solvency traps”.
Posted by: M.G. in Progress - The Unbearable Lightness of Being an economist at Nov 24, 2009 9:17:28 AM
There are plenty of critics of "big government" Republicans.
Who are largely ignored by the 'man on the street' and 'those who ask questions' - critics of "big spending" democrats are much more likely to invoke the Socialist bogeyman.
Posted by: Chris E at Nov 24, 2009 9:17:43 AM
It's cliche by now, but where were these guys years ago when Bush killed the surplus?...Ok I know that was somewhat to dealing with an economic crisis, but the huge tax cuts and all that after, those were just political gifts. The "American voter" is not what interpets this. The "American carrer-minded Senator" is. I read here earlier a post talking about the Congress's lack of will in making similar budget cuts to the one's in the healthcare bill. But as I see it about 49 senators are willing to bother to put these "unpopular" cuts in the bill in the first place. I believe it is the other 38 Republicans who have decided that its really not in America's intrest to do anything about the largest fiscal crisis ever predicted to be probable. Then there is the 12 senators who could careless because they are in the senate to secure for themselves more power and care little for the "American voters" they serve. I would dont mind your style guide, but I would prefer to redefine SG2 to: Republicans don't care, and carrer-minded senators from the "middle" made the bill bad, not us" since I think if I followed it all correctly this is what happened. If Republicans actually cared about this issue, or if any of the "centrist" were less carrer-minded and more country-minded then our congress could function to blance out it's revenue with its expenses, and what is weird about all this talk of socialism is that they would probably do this in a way that maintains much more of the "freedom" or markets enjoy, as opposed to the future the others are trying to ensure....(I rarely hear praise of the markets of police states)
Posted by: Travis at Nov 24, 2009 9:32:08 AM
Take off your blinders! There is more to the world than the rhetoric of politicians and their lackeys in the media.
I can't tell you how many times I have tried to explain to friends who live outside the Beltway and repeat the talking points of both major parties how ridiculous it is and how naive they appear.
What is produced in DC is theatre. Yes, the end result of that theatre has real world impacts, but the primary result I see amongst way too many people "who follow politics" is that they are merely repeating well worn BS of one of the major parties. My experience is that most people "who follow politics" are not very thoughtful, instead trying to shove everything into a D or R good / bad dichotomy.
It's not the apathetic who are the biggest threat to our liberty, it is, as C.S. Lewis stated, the "omnipotent moral busybodies" (especially those "who follow politics") who can be found in great abundance in both major parties.
Posted by: anon at Nov 24, 2009 9:40:06 AM
Back in the 80s, when I was in my 20s, I used to lie in bed at night worrying about the national debt and ongoing deficits and how we were mortgaging the future and there wouldn't be any social security left when I hit 65, etc. It was the most pressing issue of the time, in my mind. In the 90s Newt Gingrich and Bill Clinton wrestled deficits to the ground and actually had a surplus one or two years. I was so relieved; I thought now we can get on to other things. National health care, infrastructure investments, stuff that will allow us to prosper in the future.
Then Bush and the Delay Republicans took over and cut taxes for the rich in the early 2000s. We were back to deficits in order to make rich people richer. It was the most irresponsible thing and I felt betrayed as a deficit hawk. These people had no intention of getting the country on a solid financial basis; they just wanted to cut taxes. That betrayal turned me. No more worrying about deficits. No more responsibility. If we solve deficits, politicians just come in and cut taxes for the wealthy. Now I'm pro-debt. I'm sick of being responsible so others can take advantage. Expand government spending left and right. When the Republicans come back into power, they will limit spending growth, but they will also be forced to raise taxes to deal with the debt. That's the way to go now. You can't trust politicians of any party with a balanced budget.
Posted by: Dirk at Nov 24, 2009 9:41:07 AM
"Most pundits, professional and amateur, consider a genius as someone who can articulate one's platform more effectively than themself. An idiot is someone who effectively articulates the other side."
Eric Falkenstein, in "My Politicals Enemies are Idiots!"
Posted by: anon at Nov 24, 2009 9:48:44 AM
As for your point about American voters worrying about deficits, Krugman wrote a brilliant reply already - voters say they're worried about deficits, but even during the biggest deficit reduction in modern history, they thought deficit increased. So it's sort of like worrying about "crime", "corruption" and so on - it's a concern completely disconnected from reality. Null hypothesis says voters will worry the same amount about deficits/crime/corruption regardless of changes in their levels.
Posted by: Tomasz Wegrzanowski at Nov 24, 2009 9:52:52 AM
Well, the deficit certainly has its uses to the extent it serves as a barrier to ObamaCare being enacted. Absent a deficit this thing probably gets enacted rather easily. Starve the beast anyone?
Posted by: Colin at Nov 24, 2009 9:55:15 AM
Republicans seek to stave the beast of a growing government.
Democrats seek to starve the beast of free enterprise.
Republicans argue that borrowing from one group of Americans (and paying them interest) while taxing other Americans to fund needed spending can on net have a benefit.
Democrats are arguing that who gets the interest payments doesn't matter as long as you reward political supporters.
Posted by: DanC at Nov 24, 2009 10:04:32 AM
This anti-deficit talk is pretty contrarian. Smart nobel prize winning experts agree. We need more deficit spending now! Even Dick Cheney agrees that "deficits don't matter" and he was vice president of the most powerful nation in the world! Tyler may have some smarts, but it is difficult to find reliable signal that contrarian Tyler really has any clue what he is talking about, so we should all jsut rely on the conventional experts and borrow way more money...at least up to 100% of GDP like Italy...or else we could have a great depression.
Posted by: R Hanson at Nov 24, 2009 10:15:09 AM
Good point about Weitzman, Tyler. And for those who (correctly) accuse Republican pundits of only caring about deficits when Dems are in power, let's recall this Krugman column from 2003. Yes, there wasn't a "liquidity trap" back then, but he was freaking out about a 10-year projected deficit of $1.8 trillion. He even said he refinanced his house, so confident was he that "skyrocketing" deficits (in the range of 3 - 4% of GDP) would push up interest rates.
Posted by: Bob Murphy at Nov 24, 2009 10:18:39 AM
There is only a left and a right. All opinions on economics can be classified as left or right. It is binary, you are unscientific if you disagree with me on that! Anyone who talks bad about deficits is obviously a George Bush supporting Republican hippocrite that is in favor of big deficits when republicans are in power.
Since we know all anti-deficit folks are hippocrites like George Bush then the only sensible position is to just honestly back big government spending AND taxes, like Obama or Krugman or Brad delong(that guy is really smart). Those are the only two ways that serious people can think. Of course the conspiracy theorist will disagree, but they are insane.
Posted by: Brainwashed Serious Person at Nov 24, 2009 10:21:06 AM
At least part of Tyler's argument seems to be based on the political reality that it will be hard to deal with the deficit down the road. When you support large tax cuts, even when it is unlikely politically that there will be large corresponding cuts in defense or entitlements, then you cannot say the deficit is an important priority.
Posted by: jim at Nov 24, 2009 10:45:11 AM
1945/2010 US Federal Revenue/Expense Numbers from usgovernmentrevenue.com. In $ billions. )I hope it stays lined up.)
Income taxes 34.4 1,230
Soc Sec. 1.9 938
Other taxes 16.8 164
Total Revenue 53.1 2,333
Expenditures (106.8) (3,591)
Deficit 1945 (53.7) (1,258)
National Debt 258.7 14,456
GDP 223.1 14,729
Population 141MM 309MM
A more telling comparison might be the US to Iceland and Puerto Rico.
The Federal deficits were/are purpose-driven both in the 1940’s and today.
The Roosevelt and Truman administrations were fighting a two-ocean, world war against two massively powerful military/industrial nations. The deficit was reversed after the war was won.
The Obama regime is waging a war of mass fiscal destruction against the racist, unjust private sector. The 2000's deficit narrative will conclude when the private sector has been obliterated.
PS: Krugman is an Obama-worshipping imbecile and a useless tool.
PPS: Good for you, Gabe!
Posted by: T. Shaw at Nov 24, 2009 11:14:00 AM
"When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm."
The debt question misses the deeper point. Yes, we should do something to fix the toilet from overflowing but when and how? If the house is on fire, the leaky toilet is sort of a secondary concern. Heck, maybe it'll help douse the flames. Then, how do we fix the toilet once the fire's out? do we bring in a new toilet and pipes, or do we fix it around the existing parts, or do we also have to fix the exterior main pipes leading into the house?
So, do we fix the deficit before or after the recession? Do we cut spending or raise taxes? If we cut spending, where? If we raise taxes, on whom? By how much? And oh, by the way, try doing either without honking off a salient block of voters.
Posted by: Jim B. at Nov 24, 2009 11:20:16 AM
Aren't expectations key here? If the debt-to-GDP ratio is expected to stabilize, running it up to 100% or even 200% shouldn't be a problem. But if it's expected to continue to rise indefinitely, then we'll run into trouble at much lower debt levels. I think this holds true in any model with a transversality condition.
Posted by: Steven at Nov 24, 2009 11:24:17 AM
All that really needs to be said about this topic and this thread is that the very first comment was blatantly, hypocritically and ignorantly hyper-partisan, and that was just the tip of the iceberg. I see no way out of America's financial problems PRECISELY because this thread is representative of virtually ALL discourse on the topic. Garbage in, garbage out.
Posted by: BKarn at Nov 24, 2009 12:26:49 PM
Colin,
Since this is about default, then we shouldn't ignore currency risk. A straightforward comparison of debt-to-GDP ratios is rather faulty because it ignores it.
Posted by: NC at Nov 24, 2009 12:38:52 PM
It's also about ROI, which means what the money is spent on.
Voters can be upset about what the money is spent on.
When it suits his purposes Krugman talks about the "popularity" of this or that transfer program. When spending is unpopular, he calls the voters egg-no-ra-mooses
Posted by: Andrew at Nov 24, 2009 12:40:07 PM
Discussing the fiscal condition of the government without reference to the demographics of the country is intellectually dishonest or empty. Take your pick. Either way, Krugman ends up looking like a charlatan.
Posted by: Yancey Ward at Nov 24, 2009 1:11:26 PM
I was going to make exactly Morten's point. Your house is on fire--why are you worrying about the leaking sistern.
If CW is so reliable then why was it so happy to run up personal and private debt in the good times? This is nonsense, surely. Government should be saving in the good times and spending in depression. CW seems to have it quite backwards (though the deficit does need a long-term solution).
I don't sense any comprehension of the corrosiveness of unemployment here--what a catastrophe it is and how it blights and retards generations, especially the young. The current situation is downright scary.
Posted by: Chris Dornan at Nov 24, 2009 1:41:24 PM
To Tyler's metaphor of the backed-up toilet, I don't think anyone argues that the toilet shouldn't be fixed - just the timing of the repair. Krugman is arguing that with unemployment over 10%, the house the toilet is in is on fire. Since an overflowing toilet helps to fight the fire, perhaps the repair can wait until after the fire is extinguished.
Posted by: Chris at Nov 24, 2009 1:47:27 PM
You might want to think about this a different way: think about the runup in household debt in the last ten years: household debt to GDP increased from 68% to 102% of GDP. http://www.comstockfunds.com/files/NLPP00000/425.pdf At the same time, financial institutions increased leverage dramatically. Consumers are deleveraging, saving and reducing borrowing. Financial institutions are deleveraging, and are acquiring US debt as part of their restored capital base. In the process of deleveraging, there is a demand for US debt for bank balance sheets (as opposed to flaky mortgages). So, current debt may not be a big problem, although, if we runup consumer debt and releverage, it could be. In the longer term, starting now, we should be thinking about countercyclical tax policies--one's that kick in to reduce debt when we get back to full employmenet, rather than producing policies that runup or expand deficits through tax cuts when we get to full employment.
Posted by: Bill at Nov 24, 2009 2:00:02 PM
MOVE index which is an index of implied treasury volatilities is at 87 basis points which is slightly below average over the last 20 years and is pretty low
Posted by: Michael Kogan at Nov 24, 2009 2:05:12 PM
Point #1 (Weitzman) is just plain stupid. Worst-case scenarios have incomparable magnitudes, and there is nothing irreversible about fiscal policy. I've heard this argument before (Andy Biggs made it comparing Social Security and global warming) and I attacked it as completely wrong. It would probably work well for you as a sound bite on TV, but it doesn't stand even the slightest rational scrutiny.
Posted by: bullfighter at Nov 24, 2009 2:41:29 PM
@ NC: "Krugman's point is weak because Italy and Belgium face little risk of a currency crisis."
That, I believe, is part of Krugmans point: if even Belgium could have debt at 130% of GDP and deficits around 6%, without the Belgian franc plummeting, then he reckons the US could handle it too.
I was going to reply that Belgium has run surpluses on the trade balance for a long time - which probably helps preventing a currency catastrophe. Also, Belgium had a very high savings rate. Unfortunately, I can't find data for, say, the 1980s on my country's statistical websites.
It's weird to see my country being debated in American politics. On the other hand, we're delivering the first president of the EU, so perhaps it's about time America starts studying us.
@ Tyler: Jacques Brel? Chocolates? Hergé? Jean-Claude Van Damme? Georges Simenon?
Posted by: Koen at Nov 24, 2009 2:50:51 PM
Yawn.
More idiots lost in the "left vs. right" mindset.
Get a clue.
Posted by: samantha at Nov 24, 2009 2:56:32 PM
Former Enron advisor Paul Krugman has degraded himself so spectacularly in recent years, it is impossible to take him as anything more than a partisan hack at this point. Staggering deficits are OK when Democrats get to spend the money... yeah, right.
You are correct that these deficits are a symptom of underlying decay. But it not out of ineptitude; these deficits are intentional, with the goal of enormous tax increases in the near future. VAT, cap-and-tax, whatever it takes. Then, massive cash inflow to the public sector... they pay down the debt a bit... and then keep the taxes in place.
It's rather like wanting a new porch, but your wife disagrees. So every day, you take a chisel, and bit by bit, erode the support beams. Eventually it collapses, and voila -- you get to have a new porch!
Posted by: Jim at Nov 24, 2009 3:23:05 PM
Perhaps Italy carries an implied bailout in their debt in the same way that Fannie/Freddie did. Suppose Italy fell apart. Would not the U.S. and Europe prop it back up, at least to some degree, even if in an altered structure?
The U.S. is the world economic backstop. A reasonable assessment of economic stability of debt pricing should reflect that. And generally does.
Posted by: infopractical at Nov 24, 2009 4:00:02 PM
Don't know the answer, but do the Italian and Belgium governments also ignore tens of trillions in "off-balance-sheet liabilities?
Posted by: Gabe at Nov 24, 2009 4:29:13 PM
It does indeed seem to be commonsense that, beyond some reasonable level of time and size, high deficits are bad are bad. In the lead-up to the 2008 crisis there were concerted efforts in politics, big-business markets, and economics profession to countermand that intuitive logic. Despite their differences, Italy and Japan have both been like countries on debt-drip life-support awaiting arrival of doctor to correct underlying institutional sickness. Meanwhile the hospital beds are filling up fast – UK, et. al. We need you USA --- get yourself off the drip. I found Russ Roberts discussion this week with Carmen Reinhart on EconTalk useful in getting across the basic point: the *overarching* factor in all big economic crises of emerging and advanced economies is current account deficit, which correlates with availability of credit. Risk associated with moral hazard, implicit guarantees, too-big-to-fail, etc. are all after the fact of debt. They are secondary and merely aggravating to factors that create capacity to over-borrow. After the crisis private sector debt tends to get passed on to public sector. I’ve been reading Buchanan and Wagner’s ‘Democracy in Deficit’ (1977). They did not hold out much hope that politics would ever put a stop to the free lunch. They were non-partisan on that point. I wonder if Krugman has read it. It’s rather prescient to put it mildly... Future hope lies in a marriage of brave-intelligent-visionary leadership with good ol’ voter commonsense. Debts are (probably) bad.
Posted by: Michael G. Heller at Nov 24, 2009 4:58:22 PM
Why would anyone try to destroy Italy, on the euro, with an implicit Anglo-German backstop? It's like trying to kill Lehman in 2004.
Posted by: 8 at Nov 24, 2009 5:01:17 PM
Italy and Belgium free ride on European Central Bank. There is hope that in worst case scenario Germany will bailot weaker eurozone countries.
Posted by: 123 at Nov 24, 2009 5:24:31 PM
@Bob Murphy
That Krugman column from 2003 is unbelievable. I've always felt that Krugman makes arguments he himself knows are insincere because he believes they are effective, but I'd not yet found the smoking gun.
It suggests that Krugman, for all his knowledge of economics, is simply not an honest man.
Posted by: Jay at Nov 24, 2009 5:41:52 PM
Even in the context of believing the market efficient, it's an error to look solely at the interest-rate market to conclude that one can run a larger deficit.
Suppose the market is efficient, and the current deficit is x, and an alternative scenario is a much larger deficit of y. Because the market is efficient, it will have internalized the probability that it thinks x will happen and the probability that y will happen, and this probability will be reflected in the price (the interest-rate). So it's quite possible that the market has simply decided that the probability of y is very low. That is, the interest-rate market may not be saying that y is not a problem; it may be saying simply that y will not happen. Maybe not, of course, but this kind of information (the probability that y will happen) cannot, even under the best scenario, be gleaned simply by looking at the interest-rate market. There are too many factors, and those who are justifying their positions by looking at the interest-rate market, even spot or option, are wrong.
Posted by: The real a at Nov 25, 2009 1:19:42 AM
Just to try to make my point clearer: suppose there are two scenarios of deficits, x (prudent budget) and y (even more stimulus). The market rate would be the same in the following two cases (ok abide by the simplifying assumptions):
1/ if x happens, interest rate is 2%; if y happens, interest rate is 10%; probability of x is 75%; probability of y is 25%: (2%)(75%) + (10%)(25%) = 4%
2/ if x happens, interest rate is 4%; if y happens, interest rate is 4%; probability of x is 100%; probability of y is 0%. (4%)(100%) + (4%)(0%) = 4%
- a
So the argument that the interest-rate market is telling us that it's ok to have deficits y is incorrect; it may be that the interest-rate market is telling us that it doesn't believe that there will be deficits y (because, for instance, the political will is just not there to pass such a budget). Going to the option market doesn't help either; one can't differentiate between the interest rate that y will cause, and the probability that y will happen.
Posted by: The real a at Nov 25, 2009 3:31:15 AM
We need vigorous economic growth to stimulate the economy and reduce unemployment. That is the only way that real estate will recover.
admin
http://invetrics.com
Posted by: Michael at Nov 25, 2009 3:53:53 AM
Hi, I'm italian. sorry for my poor english.
I think Krugman doesn't know much about Italy. Italy and US are very different countries. We have high level of private savings really different from american one. The sum of private and public debt for US in now more or les 350% of GDP! for us is more or less the half.Second we pay low interests for the debt (thank's Euro).Most important due to the high public debt (ok, not only) we practically don't grow since mid ninties!
Posted by: marco at Nov 25, 2009 8:36:21 AM
