Wednesday, 6 March 2013


There's a general debate going on as to what to do, short term, with regards to the crisis that is still affecting our benighted economies.

Painting things with a broad brush, two main strategies are being discussed or being implemented. The first one, Keynesian-inspired, recommend running large deficits to compensate the drop in private demand till such times private consumers and private companies resume spending and investing. The second one, often dubbed "Austrian" (supply-siders could often be just as or even more correct but it hasn't quite caught on), insists that we need to cut public deficits by cutting public spending, to avoid an excessive and ballooning debt provoking a sovereign crisis.
 To be complete, one would need to add the competing views on monetary policy. While few politicians and voters feel comfortable running large deficits in times of crisis (how often the analogy with 'prudent' family budgeting and the need to curtail spending in times of crisis has been used?), more people, from a wider variety of theoretical backgrounds, are willing to run 'accommodating' monetary policies. The Keynesians are pro, by and large but so are the Market Monetarists, a newish group influenced by Milton Friedman. Inflation hawks are not all Austrian, far from it (they might be Monetarists or New Monetarists) but it's a convenient short-hand to formalise those two camps.

The debate is not new.

In May 2012, we've had Krugman and Raghu Rajan arguing the two sides via articles. I gave my opinion on Raghu Rajan's article here and, more famously, so did Krugman in 'Easy Useless Economics'.

This week, on the Charlie Rose Show, Krugman, him again, battled it out with Joe Scarborough...

So it's time to ask ourselves: Do we have some answers as to what we ought to do?

The truth is that we do. To take the debate between Krugman and Scarborough above, while everyone thinks that Krugman got his ass kicked, the reality, outlined by many, was that Scarborough basically agrees with Krugman and thinks we should have a fiscal stimulus right now and for the next couple of years.

There might be some slight differences of opinions with regards to the timing of the switch toward 'austerity' but the dual strategy of fiscal stimulus right now coupled with long term fixes to reduce long term deficits meet the approval of a great many economists.

But, to a certain degree, it doesn't matter. To a large extent, the opposite camps are talking past each others. The 'Keynesians' point out that the economy is weak and the future deficits are under control...

... while the 'Austrians' are dead scared about the long term deficits...

The two charts are actually one and the same. The first one concentrates on the 'medium term' - it cuts off in 2022 while the second one extends to 2035 and it is easily possible to find even scarier charts going till the 2080s...

 Are the 'Austrians' right to worry about the long term?

Well, it's surprisingly hard to say. The only thing relatively certain in the CBO or CBPP hypotheses is the demography. We know western societies are getting older and we can make some projections on what our population pyramids are going to look like. But medical costs? Till recently, in the USA, health care inflation was outrageous and certainly warranted dire forecasts. Then, inflation slowed. And it looks as if this slowdown is more than the effect of the crisis and is actually structural.

Going forward, will medical costs go up or down? You tell me. There's just too many moving parts. Technology might make health care cheaper but that very fact could lead to more demand, leaving the overall spending unchanged... or even up! Productivity could also improve if we were to liberalise somewhat the supply of medical services. Will we? Who knows?

My personal take is that it's worth adopting smart policies anyhow (an example of which would be to increase the supply of health care by removing some of the medieval guild-like barriers to entry that exist in this market) and it's definitely worth keeping an eye on things like health care costs but that, in the absence of definitive answers as to the shape the future will take, it's not worth imposing drastic present-day fiscal austerity to avoid a problem we may never have. At the very least, we need other arguments to justify present-day austerity.

And other arguments we have!

Austrians are prompt to point out that rising debt-to-GDP ratios usually end badly - with a sovereign debt crisis, to be precise, with the 'bond vigilantes' forcing very high interest rates on profligate governments or, worse, refusing to buy government debt at any price and thus forcing a default. In an article of late May 2009, the Wall Street Journal felt it could say "The vigilantes (...) appear to be returning with a vengeance now that Congress and the Federal Reserve have flooded the world with dollars to beat the recession".

However, as aguadito from the Daily Kos goes to some length to explain, "In the United States, there is no default risk, save for incredibly stupid politicians who don't quite understand the monetary system (...)“[B]ond vigilantes” [a]re not “protesting” possible inflation, they're merely rational market participants who are analyzing monetary and fiscal policy to gauge the risk of inflation, and inflation occurs in the face of growth. (...) So this has nothing to do with “protests” to chastise policymakers over high spending that could fuel inflation, and absolutely nothing to do with high spending that would lead to an unsustainable debt burden that would fuel default risk as a possibility. Instead, they are merely market analysts who are chasing yields.

(...) [T]he Federal Reserve controls the short-term rates on debt, and if they don't see the inflation, and don't raise rates to attempt to counter inflation, then the bond markets tend not to react. In this sense, markets follow the Fed's lead, which follows the data that comes out, which is all about one thing: inflation. The Fed will not raise rates (or theoretically should not) unless there is a risk of inflation that requires a "cooling down" of growth. The market participants understand this, but the American people don't".

In short, since the US can always repay its debt in debased dollars, there is no default risk and it's all about inflation anticipations, not about debt-load.

This explains why Japan can sustain a Debt-to-GDP north of 200% with interest rates near zero and why the US T-bond yields are so low...

But the Austrians aren't quite yet out of arguments. We just mentioned that the US cannot default because it can always repay in debased dollars. Well, that's inflation! As Austrians and Monetarists especially are wont to remind us, hyper-inflation is just around the corner. The mechanisms by which hyper-inflation is supposed to be just around the corner vary but it is generally linked to the growth of the Federal Reserve balance sheet and the financing of public deficits by the Fed (monetization).

 And you can show some pretty scary charts on how the Fed is increasingly stepping up its purchase of Treasuries. To quote the beautifully named '', "US Treasury Bonds - The Biggest Bubble In History - About to Pop" and "At the current rate, with the Federal Reserve buying up every penny of newly issued government debt in 2013, and then some, it won't be too much longer before the Federal Reserve owns more than China, Japan, the oil exporters and Caribbean bank centers combined". The article concludes that the dollar vigilante chief editor is hitching to go short treasuries...

Well, good luck to him... because...

Image Credit: St. Louis Fed

Or, with pretty colours...

So far, we've seen that the Austrians worry about the long term deficits - which are all about health care cost in the USA and thus very hard to predict, they worry about rising deficits triggering a rise in interest rates as bondholders get scared away - which has not occurred and show no sign of occurring and, finally, they worry that the Fed, forced to step in to compensate for those absentee bondholders, will trigger massive inflation - Again, so far, the Fed buying Treasuries has not triggered domestic banks lending or government spending crowding out private demand.

On the contrary, we are still operating within an economy plagued by an output gap. If anything, the CBO keeps on having to push back its predictions of an economic recovery as reality keeps disappointing...

Does this mean that the government of the United States of America can go on a binge?

In all honesty, my take is that, yes, the US government could do that with very little risk. 

Usually, people eager to demonstrate the inanity of Keynesian policies point out to the Japanese example. The Japanese government has spent significant amount of money...


 Yet the result easily underwhelms...

But, and this is now a famous talking point, if you look at the GDP per capita, Japan performance is a lot less disastrous...

Austrians will also quickly point out to the problems facing Greece or Spain as to warn of the dangers of ignoring their advice and following Keynesian strategies of 'spend, spend, spend'.

After all, Greece really is in the throes of a serious sovereign debt crisis.

Again, the key here is ignoring the fact that Greece, as opposed to the USA, does not have its own currency but uses the Euro. Thus, Greece really does present the risk of potential default, a risk that does not exist in the case of the United States. Another significant factor is the inability of the Greek state to collect taxes. That the US government would find itself in a similar position in the next few years has to be a low probability event.

With regards to the risk of a profligate government turning the USA into a victim of hyperinflation, it has to be noted that the two cases most often bandied about - Weimar Germany and Zimbabwe - were in a very different position than the USA today. More specifically, both were facing a destruction of their output capacity.

Germany was being strangled by the war reparations and, when it couldn't meet the victors' demands and they invaded the Ruhr, a mining and industrial region, its decision to keep paying strikers pretty much guaranteed that inflation would take hold - too much money really was chasing too few goods.

Zimbabwe experienced a similar destruction of its output capacity when its land reforms, to redistribute land and wealth away from the whites, backfired and led to a collapse of its output.

Again, unless the USA is about to experience some severe destruction of its industrial capacities, I would imagine that the risk of hyperinflation is remote.

Some inflation may well occur but, as it would probably indicate that the economy is being revived, I'd say that would be a very good thing!

All that said, it should be obvious that I side with the Keynesians. I see no major risks and many benefits indeed to fiscal stimulus right now, especially coupled with some reasonable long term reforms to try as best we can to guarantee that entitlement spending will not run amok in later decades.


But, to be complete, I am less convinced than, say, Krugman or DeLong of the utter efficiency of fiscal stimulus in our present-day crisis. This is not just a matter of arguing about multipliers and which form of fiscal stimulus might be most/least effective (tax cuts, direct spending, tax rebates etc) based on past econometric studies. It is an interesting and important subject, which has received some recent attention with an IMF study trying to gauge its value and was debated in Congress.

It is also a matter, in my opinion, of taking into account the fact that people's confidence have taken a beating.


In my opinion, as long as people's expectation of future income growth remains stuck at around zero and with 20% people predicting lower income for themselves, I am not convinced that fiscal stimulus would not be treated as a one-off present by the private sector.

That is to say: Even if a fiscal stimulus led to a bump up in activity, my fear is that, in the present state of the world, the consumers and business decision-makers would not trust it to generate an economic lift-off and, such predictions being easily self-fulfilling, the fiscal stimulus would end up failing to generate more than a temporary reprieve.

Maybe it will come as no surprise to my regular readers but, while I have no problem with the mainstream idea of mixing short term stimulus and long term entitlement reform, my own solutions would involve actions designed to alter people's income expectations.

I am not a huge fan of minimum salary increases but, in my opinion, it is starting to ask the right questions i.e. what can we do to make sure people's work is being sufficiently remunerated so that private debt load starts to look manageable and future consumption can be sustainable.

I would love to hear economists on either side talking about this more.