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Krugman has it right

Posted by WARREN MOSLER on May 21st, 2010

Lost Decade Looming?

By Paul Krugman

May 20 (NYT) —Despite a chorus of voices claiming otherwise, we aren’t Greece. We are, however, looking more and more like Japan.

For the past few months, much commentary on the economy — some of it posing as reporting — has had one central theme: policy makers are doing too much. Governments need to stop spending, we’re told. Greece is held up as a cautionary tale, and every uptick in the interest rate on U.S. government bonds is treated as an indication that markets are turning on America over its deficits. Meanwhile, there are continual warnings that inflation is just around the corner, and that the Fed needs to pull back from its efforts to support the economy and get started on its “exit strategy,” tightening credit by selling off assets and raising interest rates.

And what about near-record unemployment, with long-term unemployment worse than at any time since the 1930s? What about the fact that the employment gains of the past few months, although welcome, have, so far, brought back fewer than 500,000 of the more than 8 million jobs lost in the wake of the financial crisis? Hey, worrying about the unemployed is just so 2009.

But the truth is that policy makers aren’t doing too much; they’re doing too little. Recent data don’t suggest that America is heading for a Greece-style collapse of investor confidence. Instead, they suggest that we may be heading for a Japan-style lost decade, trapped in a prolonged era of high unemployment and slow growth.

As we discussed, could not agree more!

Let’s talk first about those interest rates. On several occasions over the past year, we’ve been told, after some modest rise in rates, that the bond vigilantes had arrived, that America had better slash its deficit right away or else. Each time, rates soon slid back down. Most recently, in March, there was much ado about the interest rate on U.S. 10-year bonds, which had risen from 3.6 percent to almost 4 percent. “Debt fears send rates up” was the headline at The Wall Street Journal, although there wasn’t actually any evidence that debt fears were responsible.

Correct, it was fears that growth would cause the fed to hike rates to something more ‘normal’

Since then, however, rates have retraced that rise and then some. As of Thursday, the 10-year rate was below 3.3 percent. I wish I could say that falling interest rates reflect a surge of optimism about U.S. federal finances. What they actually reflect, however, is a surge of pessimism about the prospects for economic recovery, pessimism that has sent investors fleeing out of anything that looks risky — hence, the plunge in the stock market — into the perceived safety of U.S. government debt.

Yes, though I would say pessimism that slow growth and negative CPI cause markets to discount ‘low for a lot longer’ rates from the Fed. It’s all about the Fed’s reaction function. Long rates are the sum of short rates, plus or minus a few ‘supply technicals.’

What’s behind this new pessimism? It partly reflects the troubles in Europe, which have less to do with government debt than you’ve heard; the real problem is that by creating the euro, Europe’s leaders imposed a single currency on economies that weren’t ready for such a move.

The euro govt debt is highly problematic as they are all set up like US States and will bounce checks if they don’t have sufficient funds in their accounts. Unlike the US, Japan, UK, etc. the credit risk in the euro zone is real, just like the US States. And that forces them to act pro cyclically, cutting back and tightening up in slowdowns, again like the US States.

But there are also warning signs at home, most recently Wednesday’s report on consumer prices, which showed a key measure of inflation falling below 1 percent, bringing it to a 44-year low.

This isn’t really surprising: you expect inflation to fall in the face of mass unemployment and excess capacity. But it is nonetheless really bad news. Low inflation, or worse yet deflation, tends to perpetuate an economic slump, because it encourages people to hoard cash rather than spend, which keeps the economy depressed, which leads to more deflation. That vicious circle isn’t hypothetical: just ask the Japanese, who entered a deflationary trap in the 1990s and, despite occasional episodes of growth, still can’t get out. And it could happen here.

Banks, too, are necessarily pro cyclical, making matters worse in down turns. Only the Federal government can be counter cyclical, however, unfortunately, our Federal government thinks it’s ‘run out of money’ and ‘dependent on foreign borrowing that our children will have to pay back.’ Complete nonsense, but they believe it, as does the mainstream media and academic community.

So what we should really be asking right now isn’t whether we’re about to turn into Greece. We should, instead, be asking what we’re doing to avoid turning Japanese. And the answer is, nothing.

Agreed!

It’s not that nobody understands the risk. I strongly suspect that some officials at the Fed see the Japan parallels all too clearly and wish they could do more to support the economy. But in practice it’s all they can do to contain the tightening impulses of their colleagues, who (like central bankers in the 1930s) remain desperately afraid of inflation despite the absence of any evidence of rising prices. I also suspect that Obama administration economists would very much like to see another stimulus plan. But they know that such a plan would have no chance of getting through a Congress that has been spooked by the deficit hawks.

Agreed, and because they don’t have a sufficient grasp of monetary operations to support the case for a fiscal adjustment large enough to close the output gap and get us back to full employment.

In short, fear of imaginary threats has prevented any effective response to the real danger facing our economy.

Completely agree! See my ’7 Deadly Frauds of Economic Policy’

Will the worst happen? Not necessarily. Maybe the economic measures already taken will end up doing the trick, jump-starting a self-sustaining recovery. Certainly, that’s what we’re all hoping. But hope is not a plan.

They seem complacent with the forecast 5 year glide path to 5% unemployment.

54 Responses to “Krugman has it right”

  1. Tom Hickey Says:

    Richard Koo is also warning about Japanification due to ill-placed concern over deficits and not enough attention to stimulus.

    I still think that the scale is tipped more toward double-dip than a lost decade. Koo is concerned about this too, since it is looking like tightening is going to occur before private deleveraging has run its course. There are still shoes to fall.

    Reply

  2. Jason M Says:

    I just came to this site to tell people that Krugman has an article out today where he almost sounds like an MMT’er…fortunately Warren was already on to this article!
    cheers

    Reply

  3. Dan Weintraub Says:

    Respectfully, I think that you (and Paul) are wrong.

    YES…I understand the operational arguments. I understand the distinction between states and the federal government vis-a-vis debt. (Always feel like I have to provide this disclaimer, so as not to be pounced upon as somehow being one of the so-dubbed ill-informed masses)

    IMO, you are ignoring three critical issues:

    1. The events we see unfolding are as much about a herd mentality and about trust and confidence as they are about $$$. Could the FED and Treasury, operationally speaking, fund trillions MORE in stimulus without the bond market calling ‘bullsh*t’ and thus causing a modest rise in interest rates? Perhaps. But the instinct of the herd has kicked in. The herd senses danger. The herd has been defrauded and ripped off and trampled upon by Wall Street and government alike for decades, and they are skittish (to say the least). The herd does not want to work for $8/hour cleaning up BP’s oil spill, or for 8$/hour greeting shoppers at Walmart. They are angry. The people have lost confidence in the system. Decades of abuse have come home to roost. Further spending, regardless of operational principles, is thus seen as somehow part and parcel of more duplicity. The public are wising up to the ongoing charade and shananigans (The Senate Financial Reform Bill? HA! What a laugh!!), and the herd is on the move—moving away from government as a solution to a problem caused (at least in part) by government in the first place. (Can you say Gramm-Leach-Bliley?)

    2. DEBT is an issue—even public debt in a system of floating currency. It is an issue because DEBT implies an agreement between parties: lender and borrower. AND, borrowers expect to be repaid their monies (+ interest of course). You may make the ‘operational’ claim that public debt is simply a function of shifting funds in FED reserve accounts from interest-bearing to spending accounts; but these operations, were ALL nations empowered with the same abilities, would render public debt an absurdity. No one would lend, and no one would borrow, as EVERYONE would believe that no debts or liabilities would ever be serviced. The American government may, at this moment in time, still possess the capability to execute such operational issues with relative impunity—but not for long. It’s not that we are a Greece waiting to happen, it’s that we are something totally new. We are the father of the international economy, and dad, it is quickly being discovered, has liver disease from drinking too much Johnny Black (on margin, mind you) over the past decades.

    3. ALL economic growth created over the past several decades has been created via Ponzi dynamics. My gosh you guys! The 500+ TRILLION dollar notional derivatives temple of inter-twined obligations is a perfect example. Hundreds of claims, worth trillions of dollars, on the same virtual piece of wealth-pie. Debt-deflation and credit destruction are not only coming, they Are here…and the result WILL BE Deflation, regardless of the FED’s short term spending efforts.

    DW

    Reply

    Min Reply:

    Dan Weintraub: “The people have lost confidence in the system. Decades of abuse have come home to roost.”

    It isn’t just abuse. It is persistent anti-government rhetoric, coupled with planned incompetence by Bush II and lack of cohesion among Congressional Democrats.

    Dan Weintraub: “Further spending, regardless of operational principles, is thus seen as somehow part and parcel of more duplicity.”

    It isn’t “somehow”. Again, it is rhetoric. First the Republicans do their best to oppose and restrict economic stimulus, and then, when they have succeeded in reducing its effectiveness, claim that it is a failure. Note that they do not claim that no stimulus at all would have done more good. And the Democrats do not call them on that.

    Dan Weintraub: “2. DEBT is an issue—even public debt in a system of floating currency. It is an issue because DEBT implies an agreement between parties: lender and borrower. AND, borrowers expect to be repaid their monies (+ interest of course). You may make the ‘operational’ claim that public debt is simply a function of shifting funds in FED reserve accounts from interest-bearing to spending accounts; but these operations, were ALL nations empowered with the same abilities, would render public debt an absurdity. No one would lend, and no one would borrow, as EVERYONE would believe that no debts or liabilities would ever be serviced.”

    Why would they jump to that conclusion? The debts are indeed serviced, and would continue to be. The effect of government debt is distributional, filling the coffers of the creditors. Why would they stop lending? I can see why governments might stop borrowing, since borrowing means paying a lot more for things, but for some reason they keep doing so.

    Dan Weintraub: “The American government may, at this moment in time, still possess the capability to execute such operational issues with relative impunity—but not for long.”

    Why do you think that?

    Dan Weintraub: “3. ALL economic growth created over the past several decades has been created via Ponzi dynamics.”

    It’s not just the economic growth since 1971, it’s the growth since 1836. Since then the government’s public debt has been growing. There have been reductions, but each trough has been higher than the previous one. We are never going to pay it back unless we stop funding deficits by creating new debt. That may resemble Ponzi dynamics, because old debt is serviced by new debt, and it is never paid back, but it is not the same thing.

    Why not? Because we have decided to create our money by issuing debt. As the economy grows we need more money, and therefore, more debt. Even though the debt is not paid back, it is still useful to us. It is not in itself a burden.

    Reply

    Min Reply:

    OC, when I say that the debt is never paid back, I do not mean default. I mean that old debt is replaced by new debt. :)

    Reply

    Dan Weintraub Reply:

    @ Min,

    I don’t see the difference between rhetoric and belief. In America, the most skilled rhetoriticians create reality. I’m not saying that the herd is necessarily correct. I am saying that the herd—as manipulated by the rhetoric of the nation’s rhetorical kings—is in full flight.

    Min says: “…The debts are indeed serviced, and would continue to be. The effect of government debt is distributional, filling the coffers of the creditors. Why would they stop lending? I can see why governments might stop borrowing, since borrowing means paying a lot more for things, but for some reason they keep doing so…”

    Because the value of currencies must eventually be undermined by the weight of falling trust and confidence. We have lost sight of what money IS…at a most basic and fundamental level. In the fossil fuel age, money has become an end unto itself. Thus more and more people and institutions employ pyramid-scheme-like scams in order to chase money—not to produce goods necessary to the daily functioning of society. At some point down the road, lending and borrowing cease, because money ceases having real value for the citizens of the state.

    DW

    Reply

    Min Reply:

    Min says: “…The debts are indeed serviced, and would continue to be. The effect of government debt is distributional, filling the coffers of the creditors. Why would they stop lending? I can see why governments might stop borrowing, since borrowing means paying a lot more for things, but for some reason they keep doing so…”

    DW: “Because the value of currencies must eventually be undermined by the weight of falling trust and confidence.”

    What falling trust and confidence? If going off the Gold Standard were enough to erode trust and confidence significantly, people around the world would not, after almost 40 years, be running to the dollar as a safe haven. Yes, some people are afraid, but the U. S. has never defaulted, and never will, unless the crazies take over.

    Dan Weintraub Reply:

    @ Min,

    DW: “Because the value of currencies must eventually be undermined by the weight of falling trust and confidence.”

    MIN: “…What falling trust and confidence? If going off the Gold Standard were enough to erode trust and confidence significantly, people around the world would not, after almost 40 years, be running to the dollar as a safe haven. Yes, some people are afraid, but the U. S. has never defaulted, and never will, unless the crazies take over…”

    DAN HERE: I think that you and I may be looking at differing time frames viz this conversation. It strikes me that, looking at the past century (give or take), the extraordinary changes that we have witnessed in both the amount and distributions of wealth in the world is mind-boggling. Generally speaking, those who comprise the world’s ‘middle class’ are exposed to far more information than ever before with regard to how POOR they have become in relation to their wealthy fellow citizens.

    YEs, we can talk about the relative loss of spending-value of the dollar over the past 100 years, and YES we can talk about the operational ins-and-outs of life under a floating currency regime; but what I am witnessing—as both a student and teacher of history—are vastly shifting trends and attitudes toward the nation-state and toward wealth….and it is MY belief that these trends, over the next 10-20 years, will drive social upheaval and conflict of a caliber we have never before seen.

    Tom Hickey Reply:

    DW: “over the next 10-20 years, will drive social upheaval and conflict of a caliber we have never before seen.”

    This is what Marx foresaw and Keynes attempted to avoid when it was threatening during the Great Depression — and PK’er’s are continuing in that trend. Interestingly, some to oppose PK and MMT do so on the grounds that it delays the inevitable breakdown of capitalism.

  4. Floccina Says:

    The thing is, that Government does not even need to get bigger a FICA cut would do the trick but because of the “innocent” fraud of separate SS tax we cannot do what needs to be done.

    The median voter rules the Government and he does not understand money and maybe never will, makes one wonder if free banking is the only solution.

    Reply

    beowulf Reply:

    Exactly, the US GDP is $14.6 trillion, and its only functioning at 73% of utilization capacity. If economy was operating 100% utilization capacity, we’d have a $20 trillion GDP. To give an idea of how big a shortfall of aggregate demand that is, the Government begin a FICA tax holiday ($900 billion), revenue sharing with the states ($300 billion), Medicare for All ($1 trillion), a guaranteed job program ($500 billion) and all that would fill just half of the $5.4 trillion gap! There’d be little risk of inflation since as the economy started moving, there’d be fewer guaranteed jobs to fund and FICA rates could be automatically increase as unemployment rates move down.

    From just after Pearl Harbor till 1951, the Fed was locked into a maximum of .0375% short term and 2.5% long term rates with the Fed automatically buying any unsold Treasuries. Inflation was controlled by taxes and income policy, not interest rates and somehow we never “ran out of money”. Ancient history, I guess. As with Greek fire or sending a man to the moon, theres are some things civilization just forgets how to do.

    Reply

    Min Reply:

    Beowulf: “As with Greek fire or sending a man to the moon, theres are some things civilization just forgets how to do.”

    Greek fire! Oh, Archimedes!

    Reply

    RSJ Reply:

    Beowulf,

    Capacity Utilization is a measure applicable only to the goods producing sector, which accounts for less than 20% of output and even less employment — and these numbers are falling pretty rapidly.

    More importantly, these numbers don’t mean a whole lot when there is an integrated global supply chain. If increasing production requires picking up the phone and ordering twice as many units from China, then firms will have a lot of excess capacity.

    Reply

    beowulf Reply:

    Roger that, I should have kept it focused on unemployment. Just read last night (in a Bill Vickrey paper on unemployment) Okum’s formula that each point drop of unemployment = 2.5 increase in GDP… So considering our 10% current unemployment, we’d instead have a GDP 25% larger if we were at 0% unemployment.

  5. Floccina Says:

    Oh BTW isn’t part of the problem here that for every dollar that the Gov spends it sucks in a dollar by selling bonds? If people wanted to hold money but could not get bonds would they horde cash (just bearer bonds) or would they buy land.

    Reply

  6. anon Says:

    Don’t know why you picked this particular article to start agreeing with Krugman on something. He’s been saying the same thing about US fiscal policy response for two years – that it’s been inadequate. You’ve ridiculed him for his lack of understanding of monetary operations, yet his instincts about the appropriate size of the deficit, etc. are quite in line with MMT. And he doesn’t seem far off here:

    http://neweconomicperspectives.blogspot.com/2009/07/employing-krugmans-cross-farewell-mr.html

    Reply

    Tom Hickey Reply:

    Krugman has said plenty of things about the counter-cyclical need for deficits but a balance over a cycle, making him a deficit dove.

    Reply

    zanon Reply:

    Krugman only said these when democrat was in office.

    When republican in office, he complain about deficit spending.

    making him partisan hack

    Reply

    anon Reply:

    “but a balance over a cycle”

    That surprises me if he was that specific. Are you sure he said that? I doubt it. Any reference you can recall?

    Reply

    Tom Hickey Reply:

    Not in exactly those words, perhaps, but Krugman generally hedges himself about deficit spending, saying something like “it may eventually become a problem but it isn’t now,” giving credence to the notion that the US has a debt problem10.

    ESM Reply:

    I refer you to this column from 2003. Zanon is absolutely right. Krugman is a partisan hack. I would be surprised if he doesn’t actually understand all this stuff, but he is not interested in enlightening the unwashed masses. He is only interested in advancing his political agenda.

  7. Bx12 Says:

    I don’t see how the EZ/US states analogy can be entertained in the shadow of the conversation on this topic that has recently took place (Marshall’s latest) where I have seen no corroboration of that analogy, and, if anything, has shed light on diverging views.

    Reply

    anon Reply:

    agreed

    Reply

  8. zanon Says:

    Bx12: I read the Marshall conversation, and EU is closer to US States than to Fed now than it was before eurozone. Sure analogy is imperfect, but it sheds light on real operational differences.

    Anon: Obama fiscal response is to give money to his political cronies, bankers and unions. average family got what — $20? It is joke.

    Of course republicans oppose obama stimulus because the stimulus is just giving money to democrats. Wake me up when Obama decides to stimulate real economy by giving money to household.

    Reply

    Bx12 Reply:

    Zanon,

    I can only interpret your response as a panicky rush to override my call for caution. This sentence

    “Bx12: I read the Marshall conversation, and EU is closer to US States than to Fed now than it was before eurozone. Sure analogy is imperfect, but it sheds light on real operational differences.”

    does not even make sense. For one, you are confusing EU and EZ.

    Reply

    zanon Reply:

    sorry i was getting words backwards.

    i agree that the analogy between US states and EZ is not perfect or as close as some commenters here have claimed. Marshall thread was informative here and I am pleased with the learning.

    Reply

    Bx12 Reply:

    Zanon,

    The future belongs to those who foresee correctly. Steve Keen/Peter Schiff/Roubini are now reaping the rewards of their correct and substantiated predictions, and they have no shortage of people seeking their advice.

    The turmoils today are likely to engender significant changes tomorrow, of which new theories will emerge, those that, looking back, will be deemed relevant.

    That the US does not have a Greece problem is not falsifiable as so vaguely stated, and when you dig a bit, there’s hardly a coherent theory. Krugman’s reputation will not suffer from his casual thinking : that is what he is regularly serving us in his NYT column.

    Everyone else that does not have this privilege should adhere to a much higher standard in order to make a significant/worthy of recognition contribution.

    ESM Reply:

    I don’t know anything Keen and Schiff, but Roubini doesn’t understand MMT at all. He has been a chicken little for 25 years who finally got lucky finally with his predictions (although frankly it was pretty obvious to a lot of people that we were in the midst of an enormous credit bubble in 2005-2006). Roubini’s long-time collaborator, Brad Setser, has devoted his entire career (so far) to calculating international capital account flows and trying to figure out how the US will “fund” its current account deficit each year. He actually comes up with some useful information, but the underlying premise of his research is absurd. Roubini was totally on board with that way of thinking, and in fact he considered the so-called twin deficits to be the biggest problem threatening the US economy.

    Bx12 Reply:

    ESM, so I got one author wrong out of 3? You’re talking like MMT is already so self evident that it is not a competitor in the race, but the person who bestows the award to the winner at end of the race or a slap on the wrist on the cheaters (Roubini doesn’t understand MMT at all).

    When I visited this and related sites quite a while ago with similar questions, I was, I guess, a virgin, and bought the EZ/US states analogy and repeated it everywhere I could. So allow me, now, to be a bit more circumspect than you are, although still very interested in MMT.

    Anyway, your labeling of Roubini a chicken little for sticking to his convinctions for 25 years in spite of getting snubbed, is a bit disingenuous.

    anon Reply:

    interesting comment on Setser

    superb analysis of information

    but didn’t understand that the US deficit funds China’s outward net capital flows

    painful

    Ramanan Reply:

    Bx12,

    I don’t think that dismissing the trade deficit as harmless is so easy. Its more complicated. There is an implicit assumption that exchange rates take care of this via some market mechanism.

    I should drop this in the long discussion (marshall’s latest), but in short – in the US there is a lender of the last resort one way or the other since law can be easily broken. In the EZ, there was none recently till an SPV was formed, but with terms and conditions imposed. In the US as well, there are self-imposed constraints. There is a demand side problem for the demand for EZ countries’ bonds. Someone should pay attention to that. The operational details are crucial to understand but are in some sense “supply side”.

    Reply

    Bx12 Reply:

    Ramanan,

    When I said I once took the US states analogy for granted, the only way I could resolve the conflicts I was struggling with, was to accept that the EZ members actually held their accounts at private banks, and dismiss the fact that the ECB is the fiscal agent as something I did not understand. And I think I actually repeated it, and no one took notice or bothered to correct me. So I hope this clarifies where I come from.

    I’m not dismissing your point about trade deficits creating a leakage of reserves from one country to another (or something like that). In fact, when I said earlier that the discussion was worthwhile as it brought to the fore arguments that were previously unheard of, I was certainly including yours, perhaps at even at the top of the pile. It should be developed and confronted to the counter-arguments that were given, not used as a joker card to dismiss my arguments.

    The crux of the matter is that the US states is simply not the right paradigm to think about this. If, as Anon claims, the heart of MMT is that government spending creates net financial assets, that is certainly the case at the Euro-level.

    The ECB and the Fed have the same tools, all-powerful if you believe MMT, albeit constrained by policy decisions, which themselves are not set in stone.

    Sure, some degrees of freedom may have been lost in the process of creating a common currency, but I’d like to see MMT explain how some can be recovered short term (Warren did make some recommendations) or long term (how about my idea to merge all the treasury markets into one?), not hammer recommendations such as Greece should opt out, as the only viable solution, particularly when the US states analogy is trotted along.

    Partisanship, in this kind of rhetoric, is glaring, and the T out of MMT takes a beating as a result.

    As I recall you, you have tried to downplay the commonality between the US and EZ with comments such as “There is a mechanism in the US for the yields to not blow up. There is a central bank which can purchase government debt.”, which only to the deaf and blind accept as the only prerogative of the US, not EZ.

    Then you have aimed your gun at a different target : ““Is there a demand for US Treasuries” and the answer is YES there is. Is there a demand for Greece bonds – No, because the current account deficit causes a demand drain.”.

    What you are saying, in essence, is not that the ability to control sovereign rates is a feature of a fiat currency system (the EZ is one), but depends on the market’s benevolence of sorts. In that sense, Greece, provides a test case, if extreme, for what could happen in the US.

    How could anyone in his right mind settle for this? A theory is constructed of a set of sentences which consist entirely of true statements about the subject matter under consideration (Wikipedia).

    So, what I’d like to see as applied to EZ is a set of sentences, using only the premises of MMT, that explain what is going on in Greece, how the ECB could use its tools properly, or how 12 markets, as opposed to one, creates too many objectives, for the ECB to reign in, without recourse to bold but partisan one liners such as “Checks will bounce” in Greece, that could apply just as well to the US.

    anon Reply:

    Bx12

    I empathize with your request. Your desire for a straightforward interpretation of EZ in the MMT context extends my desire for a more true to form description of existing US monetary operations. Unfortunately, I can’t seem to make that simple point on the other thread without being boxed by a demand to explain why the choice between bonds or reserves is “relevant”, a debate I don’t wish to focus on at this time.

    I have no answer for the EZ diagnosis. You’re probably right that the US states is the wrong paradigm. I suspect that the gold standard is probably the wrong paradigm as well.

    random thoughts: my sense is that Euro yields have blown up in part due to some sort of anti-diversification effect. By that I mean that the problem of not being able to distribute different fiscal and monetary policy solutions selectively across different EZ countries has made the whole system seize up and has amplified bond market fears. Maybe the difference between the EZ and the States is that the EZ is a “multi-issuer” of currency (not a multi-currency issuer). It’s a “multi-issuer” of net financial assets in the sense of MMT. That “multi-issuer” structure complicates the solution space for the right fiscal and monetary policies.

    Bx12 Reply:

    Anon says

    “The EZ is a “multi-issuer” of currency (not a multi-currency issuer) of currency (not a multi-currency issuer). It’s a “multi-issuer” of net financial assets in the sense of MMT. That “multi-issuer” structure complicates the solution space for the right fiscal and monetary policies.”

    Yes, that is a characterization that I would agree too. If I were to risk myself to policy recommendation, I’d say this:
    - To account for the fact the EZ is not an Optimum Currency Area, coordinate the fiscal policies to avoid the problem raised by Ramanan i.e. in the present case, ask Germany to increase its deficit relative to the other members so as to reduce internal trade imbalances.
    - Perhaps merge the Tsy bond markets into one, to divert the market’s attention from what they perceive as the weakest link.

    In this consolidated framework, the Euro would be more comparable to the US system.

    Ramanan Reply:

    Bx12,

    I understand your points. I wouldn’t go on debating about MMT as the MMTers know how the central banks work very well. At the same time, I liked Anon’s comments on how to write it down – maybe in an axiomatic way or something.

    The reason I keep pointing to the demand side is that, benevelant or not, the fact is that the central bank and the Treasury have a lot of control on the yield curve. As the government keeps deficit spending, the wealth of the private sector increases and the portfolio allocation decisions of various sectors of the economy automatically creates a demand for the Treasury securities. One shouldnt be too obsessed with the overdraft rule. There are many workarounds such as Treasury purchases by the Fed in the secondary markets. In fact, the Fed itself lends to the primary dealers to purchase treasury securities. So there is a lender of the last resort for the US treasury in some sense, even though there is no overdraft allowed. One can maybe assign some “degree of availability of the lender of the last resort or so”.

    The problem with the EZ is the not so cooperative nature of the ECB. It is totally upto the markets to decide. In a non-crisis situation, competition in the bidding process helps the EZ governments but the markets certainly can decide to spoil the game. Things have changed because of the bailout but I am not sure if defaults could have been prevented without the bailouts. The conditions of the bailouts are also important.

    Also it doesn’t matter too much if the Treasuries of the EZ have an account at banks or the NCBs – in fact they have both. The US has both as well.

    You are absoluetly correct about the fact that “bond vigilantes” may attack the US. Even Ben Bernanke knows this and he probably will put it as unlikely but not impossible. Just a guess. However he knows that the Fed can put a ceiling on yields explicitly. For example look at this speech http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

    He says

    “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.”

    You may point out that even in the EZ, the ECB is purchasing government debt. However such measures come with a lot of conditions – such as making countries go into an austere mode etc.

    So there are indirect workarounds for the US. The no overdraft shouldn’t bother one so much.

    On the other hand, I tended to like Anon’s posts because Anon’s concern are a bit more different – it is about the present system vs preferred. It is correlated with what we are discussing, though not exactly.

    zanon Reply:

    rsj: can you comment on bernanke?

    he is sayin fed can control yeild through quantity — treating bond as consumtion good, something you say is wrong

    Tom Hickey Reply:

    “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well,” [add} Bernanke said as he patted his bazooka case. :)

    RSJ Reply:

    Zanon,

    Yes, Bernanke is a loanable funds guy — you don’t get the pin unless you join that club.

    Bx12 Reply:

    In response to Ramanan Reply:
May 23rd, 2010 at 12:08 pm

    The main lesson I take away from your message is that the cooperation of the CB wrt the Treasury(s) and that of the primary dealers wrt the CB matter a great deal.

    That such a tripartite cooperation exists in the US, I surmise, stems from the hybrid private/public status of the Fed. Such ‘cozy’ arrangements are by design made more difficult in EZ, a condition that was set by Germany to accept a monetary union. The ECB operates in a straightjacket, the primary dealers fend for themselves, leaving the Tsys caught between a rock and hard place.

    Historically, CB’s were created to prevent banking crises, and this motivation remains…central. So a CB is always liable to adapt to whatever is necessary to ensure fully functioning credit markets. And as you have pointed out, the ECB has softened its edges to allow purchases of government bonds, although not without strings attached. So one can think about the CB not as an unchanging entity, but one whose operational mode evolves in jumps.

    While you adhere to Anon’s call for delineating the contours of what constitutes actual and desirable practice in monetary policy (and taking an axiomatic approach to it), so did I, and think it applies critically to my concern over the EZ as well (more below).

    There is a cost function to minimize under constraint. MMT says remove all the self imposed constraints, and you’ll get the best outcome.

    In practice, some constraints are more politically expensive than others. Purchases of gov bonds, for example, come before overdrafts at the Fed, although operationally there is some degree of substitution-ability between these two. Anon presented the matter in a dichotomous way (desirable vs practice), but there is in fact a discreet set of configurations between these two. What happens if we remove this constraint, or this one, or both etc?

    As regards to the EZ, what are these constraints, and which, if removed, would put it on a manageable level comparable to that of the US?

    In addition to the suggestions I have already made, how about nationalizing a few primary dealers to address one of your concern relating to the ECB’s ability to control the rates of sovereign debt? The over-reliance of the EZ on markets, underlies a shift to market ideology in the past 20 years, but more crucially, in the eyes of Germany, it was thought to be the best way to penalize and therefore prevent deficit/inflation excesses. Now that they realize they are getting too much of what they bargained for (deflation), and the word nationalization is not taboo, it may be question that is politically viable. Rumor has it that Merkel, who is an accomplished physicist, read Mandelbrot in the wake of the crisis. Factually, she also hired William White as a consultant etc. Next thing you know she might be leaving comments under ‘Anon’ at WM’s blog, so we better get started on that one. ;-)

    My overarching argument to not perpetuate the US states analogy is that spending by the government is a vertical transaction i.e. create net financial assets, not the US states. Put differently, the EZ is issuer of the currency, not the user. Do your arguments mitigate that? I think they do, but only to the extent that deficits are more constrained, politically, than in the US. It limits my statement quantitatively, not qualitatively. And as Anon has said, this qualitative aspect of gov spending, is at the heart of MMT.

    By the way, that’s what I implied in opposing keeping an account at the CB vs at a private bank, although you seem to say it does not matter so much (“Also it doesn’t matter too much if the Treasuries of the EZ have an account at banks or the NCBs – in fact they have both. The US has both as well”). Would you care to reconcile that with MMT 101, where I must be stuck ;-), then?

    I notice that I’m getting increasingly philosophical, which probably betrays a shortage of worthy arguments. So I will probably go back to some reading for while, although I will certainly read the answer(s) to this entry, if any.

    Thank you all!

    Ramanan Reply:

    Bx12,

    It would have been impossible for the Euro Zone to remove constraints. Without constraints, the Greece government cant spend a lot and other countries may not like it.

    Now, in that sort of logic, one is reminded of the ongoing discussion in the other thread – there is an immediate question seeking an answer. That question is: the same is true for the US, so even the US should have the problem!

    That is the reason I have stressed the importance of looking at the whole economy. Not only is it less likely for the US to run into problems, even if it does there is a lender of the last resort in an indirect sense.

    However I am reasonably sure that simply looking at central banking operations won’t provide an answer because various sectoral balances have to be considered for an understanding.

    Think of Greece as a car travelling to a hill station with air leakage in one of the tyres. The person driving didn’t bother to take a backup tyre.

    There is another driver who knows that there could be a leakage in the tyres. He makes sure that there are people on the way to provide him the tyres. He himself has a backup tyre when travelling. (Analogy – Foreign reserves held by the Treasury and now: the Supplementary Financing account)

    Ramanan Reply:

    Sorry first para should be

    “It would have been impossible for the Euro Zone to remove constraints. Without constraints, the Greece government CAN spend a lot and other countries may not like it”

  9. RSJ Says:

    Long rates are the sum of short rates, plus or minus a few ’supply technicals.’

    If this were true, the yield curve would be flat (on average), in fact you cannot believe in this statement and at the same time be a banker that makes money off the steepness of the yield curve, so your own bank account disproves this belief.

    On the other hand, I’ve read a few economics textbooks that deny the existence of long run economic rents, even though the textbook itself, costing over $100, is a perfect example of an economic rent. So this type of doublethink is pervasive, and is easy to fall prey to.

    Reply

    ESM Reply:

    I think Warren was trying to account for risk premia in his catch all phrase “supply technicals.” I can vouch for the fact that out to 18 mths, the yield curve is completely driven by expectations of the short rate as set by the Fed. A risk premium really starts to kick in around 2 years, but the curve out to 10 years is mostly driven by reference to rates for shorter maturities. So the Fed really does have quite a bit of power to nail down the yield curve.

    Between 10 and 20 years, things become very technical because liquidity in the Treasury market is not good in that range of maturitied. Beyond 20 years, convexity effects kick in, so projections of market volatility are incorporated into the rates at these maturities (this is why the curve tends to become negatively sloped beyond 25 years or so).

    The Fed does not have a lot of power to determine 30 year rates, but I can guarantee you that if the short rate is 25bps, there are quite a few bond traders who will find a 30-year bond at 5% yield pretty attractive. The positive carry on a leveraged position is hard to resist.

    Reply

    Ramanan Reply:

    Yes good points. In fact, I would believe that the Fed advises the Treasury on what points on the maturity composition. If the yields at the long end is high, issue more bills. If the long end is too low, issue more at the long end. Indirectly the Fed is making some kind of statement about future monetary policy path.

    The argument that it should be flat by RSJ doesn’t hold. That logic depends on the assumption that the rates have equal chances of going up or coming down. Clearly with FF at 25bps, it can only go up.

    Plus the rentiers anyway lobby for high rates at the short end as well. There is no inconsistency about Warren’s statement with the rentiers’ existence.

    Reply

    Scott Fullwiler Reply:

    Yes, well said. Did you see that, Anon?

    RSJ Reply:

    That logic depends on the assumption that the rates have equal chances of going up or coming down. Clearly with FF at 25bps, it can only go up.

    What a confabulation. Warren claimed, by arguing that long term rates are just the expectations of future short term rates, that, on average, short term rates are equally likely to be higher or lower than long term rates. That is what it means for one variable to the expectation of another — the first variable is as likely to be higher or lower.

    I am saying the exact opposite — that because short term rates are not scattered about a long term mean, that it cannot be the case that the long term rate is an expectation of short term rates.

    Moreover, because the real long term rates do not fall when the real short term rates do, this allows for the government to steepen the yield curve artificially during recessions, and as a result it increases bank incomes, promoting financial arbitrage, and therefore boosting rentier profits.

    And this clearly visible in the data. The modern era of using monetary policy — e.g. rate hikes and rate cuts to fight recessions as opposed to fiscal policy corresponds to a steepening of the yield curve far out of proportion from the historical norms. And these movements — in either direction — allow for financial arbitrage.

    Scott Fullwiler Reply:

    “Warren claimed, by arguing that long term rates are just the expectations of future short term rates . . .”

    Warren did not claim this at all. He actually said “Long rates are the sum of short rates, plus or minus a few ’supply technicals.’” I’ve discussed this with him enough to know that his point is basically along the lines of ESM’s post.

    RSJ Reply:

    OK, so the only material difference is the “supply technicals”.

    If it was a second order difference, then still in order for this statement to be correct, the long term rate would need to be an expectation of short term rates, plus the second order “technical” term.

    Nevertheless, Ramanan turned this around and said that *I* was the one claiming that short term rates are as likely to be higher or lower than long term rates, which is a confabulation of the first order. :)

    Min Reply:

    RSJ: “That is what it means for one variable to the expectation of another — the first variable is as likely to be higher or lower.”

    I do not know what determines interest rates, but I have a minor mathematical nit. Whether the expected value of a variable is as likely to be higher or lower than that variable depends on the error distribution. See Poisson distribution, for example.

    RSJ Reply:

    LOL — yes, I was too loose, but not so lose as to be wrong, IMO. “as likely” needs to be interpreted using the original distribution, not with the uniform distribution, as that would make it a median. Point taken, though.

    Nevertheless, if you have just one thing to say about the yield curve, it would be that over long time periods, it slopes upwards.

    The zero-th order description of a yield curve is that it is an increasing function. Not that it is a flat function with some “technicals” adjustment.

    But the standard theory has no explanation for the yield curve — nor for why equity returns exceed any reasonable measure of time preference. That is why Krugman says that long term rates are just expected future short term rates and why other economists say that interest rates obey euler equations that they do not, in fact, obey.

    The overwhelming empirical data is just ignored — but the MMT guys — as they are a cut above — should know better and not mimic these claims.

  10. Ramanan Says:

    Our host wrote ‘ Long rates are the sum of short rates, plus or minus a few ’supply technicals.’

    RSJ quoted this and said:

    “If this were true, the yield curve would be flat (on average),”

    I wrote

    “That logic depends on the assumption that the rates have equal chances of going up or coming down. Clearly with FF at 25bps, it can only go up. ”

    This is not misrepresenting anyone. In fact it is to point to the comment “flat on average” doesnt follow because it assumes a symmetric probability distribution around the present FF target which is not the case with a variable which cannot go below zero.

    Reply

    RSJ Reply:

    “On average” refers to multiple sample points — e.g. “historically”. At any specific point in time — for a given observation — the short term rate may be higher or lower than the long term rate.

    But if you believe that long term rates are expected future short term rates, then over long time periods — or large sample sizes — you would observe a distribution of short term rates and long term rates so that the long term rates tracked the mean of the short term rates.

    This is spectacularly not the case. It’s not even close to being the case. There is an enormous gap, so that on average, real short term rates are 1%, real long term rates are 3% — i.e. the average real long term rate is triple the average (real) short term rate. So if you were going to list the factors that influence interest rates, the dominant one would of course be inflation, but after that, you would not be able to say that expectations of short term rates set the long term rates.

    Reply

    Ramanan Reply:

    “But if you believe that …”

    Don’t believe that .. see para 1 @7:27

    Reply

  11. Floccina Says:

    Tom Hickey wrote:

    “Krugman generally hedges himself about deficit spending, saying something like “it may eventually become a problem but it isn’t now,” giving credence to the notion that the US has a debt problem10.”

    He is right, though it may be a smaller problem than he thinks. Look at it this way if the Government floats bonds to increase aggregate demand the people who are buying those bonds think that they are storing wealth that they can consume in the future but the binds are just accounting entries. So under any system at some time when banks start lending more and those bond holders go to consume that wealth it would require more goods and services to go to those bond holders relative to workers so it could cause inflation requiring higher taxes. IMO it is probably worth it to get more people producing now.

    If you take money right out of the picture and things become clearer. Today we x producers per person on SS and Medicare in future their will be less than x people. I do not see that as a big problem because people become more productive as time goes and we have fewer dependent children.

    There is a related problem and that is that should you need to tax more in the future that can be problem because if you raise the income tax more wives drop out of the taxed work force and choose to work at home paying no taxes.

    So Krugman is right but perhaps it is not worth worrying about.

    Reply

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