Keynesians, Please Exit Stage Left

Back in February, amidst the neo-Keynesian rage to spend our way out of recession, I argued that stimulus wouldn’t stimulate.  Pointing to the graph of the 10-year Treasury vs. 30-year mortgage rates I said that the government wouldn’t be able to flood the market with Treasurys without driving up interest rates.  Higher rates on government debt imply higher rates for mortgages, which would hammer house prices and blow an ever-larger hole in bank balance sheets.

The Fed knows long-term rates can’t be allowed to rise because that would run their economic “recovery” off the rails.  Enter “quantitative easing,” the policy by which the Fed prints money to buy fixed-income securities like Treasurys and MBS.  By printing money to inflate demand, they hope to hold interest rates down.

Sounds great, right?  Why can’t the Fed just keep printing money to buy bonds in order to hold interest rates artificially low?

Because bond investors call bullsh*t.  As the Fed prints money, inflation expectations rise.  When investors anticipate higher future inflation they demand higher interest rates to buy debt.  After all, they don’t want to hold fixed-income securities when fixed-incomes lose their purchasing power to inflation.

And so we have a great game of chicken between the Fed and the bond market.  The Fed prints money to keep interest rates down while bond investors zip tight their wallets because Fed printing makes bonds less appealing.  What is the Fed going to do, become the lender of last resort to the federal government?  Print whatever cash is necessary to literally displace vanishing private demand for government debt?  This is no solution of course; in the long-run it implies hyperinflation.

And so we return to the question Keynesians like Krugman simply wouldn’t address when advocating government “stimulus”: how do we pay for it?  If we run up additional debts without making some provision to pay them, then in long-run interest rates have to rise.

You could raise taxes to pay down debt, but that would destroy the positive impact of additional government spending.

The point is there’s no way to financially engineer our way out of this crisis.

Economists love the idea that the Fed is all powerful, that it has some magic wand to wave which can rescue Americans from debt deflation.  I suspect this is because, deep down, they harbor ambitions to be Fed Chairman themselves.  For most economists, the Fed’s printing press is the ultimate toy….one they’ve always wanted to play with.

And it is a powerful one.  Most recessions are easily “solved” because the Fed can always use that printing press to inflate a credit bubble, to inflate demand artificially.  This works great until it doesn’t.  Eventually the credit bubble becomes so big it’s simply impossible to sustain with more printing.

I suspect this is why Keynesians never bothered asking how we’d pay for stimulus.  The answer—”we can’t”—shatters their economic theories.

Krugman offers a rebuttal to this argument in his column today.  He argues that inflation isn’t a big issue right now.  And he’s right: deflation is the real threat.  He argues that Fed printing is necessary to counteract it, but he misses the larger point that, in the long-run, higher government debts imply higher interest rates regardless of what the Fed does.  Debt is not a static thing.  It has to be rolled over, paid down or repudiated (via default).  In ascending order of economic violence, each of these implies a debt deflationary depression.

Outright default isn’t an option.  Imagine the worldwide economic calamity if Tim Geithner stops making interest payments on Treasurys…

Paying down debt means running surpluses.  To do so would require draconian cutbacks in spending by indebted governments, corporations and individuals.  Aggregate demand would collapse, leading to depression.

Both of the above are unappealing so the Fed conspires with government to inflate aggregate demand with more borrowing.  But more borrowing means more debt that has to be paid down later.  More debt means bigger future cutbacks.  The longer we kick the can down the road, the deeper the depression we’ll be faced with in the “long-run.”

The bottom line is that we have to pay down debt.  We’ve no other choice.  Yeah, it’s going to be very painful, but we should have thought of that some time over the past generation as we inflated the credit bubble.


Post Script:

I can’t leave this piece without rebutting the conclusion to Krugman’s op-ed:

But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.

Because Republicans lost their fiscal bearings during the Bush years doesn’t mean that budget arithmetic somehow no longer applies.  Deep down, Krugman desperately wants to support Democratic ambitions to dramatically increase the size of government.  But “Republicans did it so we can too” is not an argument.  Paul knows this but, hyper-partisan that he is, he can’t resist getting in the dig.  He should know that plenty of independents abhorred runaway government spending under Bush.  We were hoping Obama would bring “change” by putting our fiscal house in order.

Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.

Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.

Here, for the first time that I’m aware of, Krugman acknowledges the paradox of his prescription.  Spending creates a long-run budget problem!  But in calling it a “long-run” problem, he gets to kick the can down the road.  Deficits aren’t an issue we have to address now so Democrats shouldn’t let themselves be “bullied” into a policy of spending restraint.

But my goodness: what is the the “groundwork” we should be “laying” to provide a “long-run solution” to this “problem?”  Krugman owes his readers an answer to that question.

Originally published at Option ARMageddon and reproduced here with the author’s permission.

7 Responses to "Keynesians, Please Exit Stage Left"

  1. Wilson Siu   June 1, 2009 at 10:06 am

    Good one Rolfe,someone sent me Krugman’s latest piece to tell me that I am wrong about inflation. After reading it, I am suprised. Very suprised.He even missed the point that quantitative easing in Japan did not lead to inflation because 1. Yen is not the reserve currency in the world. 2. Commodities are traded in US$, not in Japanese Yen. Thus a weak Yen does not leas to global inflation, a weak US dollar does. 3. In the same time because Japan is a trade surplus nation, the yen was not that weak afterall, thus the phenomenon of a weak yen due to quantitative easing somewhat got neutralized versus the US dollar, as the US continued to run a trade deficit.

  2. Irini Fountoulaki   June 1, 2009 at 1:24 pm

    It is also important how this borrowed money is spent – an issue that is virtually taboo on the Beltway right now. It does not seem that much time or thought was given to this in the stimulus bill.If the money is badly spent and grandiose plans like GM and Chrysler restructuring produce new loss-making behemoths, then things are likely to be very grim. Where will there be the cashflow to repay the additional debt burden?Many European countries have followed this failure path and burned their fingers badly, eventually privatizing to get out the mess. Whilst the Obama administration enthusiatically embraces state capitalism (probably for the green pastures of expanded political patronage and empowerment), the EU showed limited appetite to follow Mr. Geithner’s invitation.If interest rates surge on US government debt, the game will soon be over and the Federal Government a new California.Whether this will really happen remains to be seen, most believing that Ben Bernanke will find a way to keep interest rates low.

  3. Guest   June 1, 2009 at 4:34 pm

    Your analysis is absolutely correct, and you are not the only one re-affirming the the laws of economics apply to the present and future, not just the past. I wonder why you hesitate to point out that it was the Monetarists, commencing with Freidman and Schwartz, who insist that the Fed is all-powerful (while fiscal surpluses and deficits are merely sideshows) and that the Fed’s actions regarding interest rates are the sole force leading to depressions and inflations.

  4. David   June 1, 2009 at 10:44 pm

    Here is a flawed sentence from your article.”You could raise taxes to pay down debt, but that would destroy the positive impact of additional government spending.”Wrong!By raising taxes you force people to share in the cost of government-based programs that will improve the quality of lives for the largest number of our citizens. The conservative approach has been to return huge sums of money to the already rich and entitled crowd (aka trickle down).Remove your blinders! Face it – this is about redistribution of wealth and I’m all for it!!Raising taxes is the inevitable way in which the quality of life in America will start to vaguely approach the standards enjoyed by the top European countries

    • Irini Fountoulaki   June 2, 2009 at 3:43 am

      The Republicans have long maintained that Obama policies will lead to higher taxes despite fervent denials of the Dems, so I am happy to see you in agreement on this point.Whether people will accept higher taxes is an open question. Those of means will certainly look to protect their property. An open, global economy offers many options. We have seen this domestically with state governments like NJ where progressive income taxation drives people to Florida and leads to erosion of the tax base.What the overall impact of higher taxes will be to the US economy is another question. Certainly, the US is not going to be an attractive place for foreign investment when most other countries have lower corporate tax rates. It is already pretty unattractive with its convoluted legal system, complex regulations and high transaction costs. Why has outsourcing become so popular with US companies in the first place?Finally if the American consumer’s disposable income goes mainly to paying debt and taxes, where is the room for further aggregate demand? The concept of debt driven consumerism is over. European schemes of government-protected employment failed years ago because they could sustain the high public debt levels. Americans do not seem to have learned yet about this!I think there are some real issues here.

  5. joebhed   June 2, 2009 at 7:28 am

    “The point is there’s no way to financially engineer our way out of this crisis.”Leaving us to somewhat acknowledge that this crisis is about the money system being broken. And broke.As in “How The Debt Money System Goes broke”.Have a quick read. yadda, can’t print new debt-money fast enough to pay the interest on the old debt-money, yadda yadda, achilles heel of debt-money, yadda yadda,Conclusion:…the Fed cannot facilitate the expansion of government debt to fill the breach and simultaneously hold down interest rates. It cannot win the battle to keep debt growth greater than interest charges, the precondition for the viability of a debt-based monetary system. Once started, cascading cross-defaults consume all debt within an economy. The Fed has only two options: institute a new monetary system with a new currency or return monetary authority to the market and shut down.”I’m for a new money system.Let the bankers get back to banking.

  6. Laobaiqing   June 3, 2009 at 11:16 pm

    It is all a matter of proportion. The Fed has only limited capacity to influence long term yield, that is clear. And the present yields are not so bad (implying long term inflation of only one or two percent). There is little corporate demand and for investors there is a mountain of recently acquired financial assets on waiting gvt/Fed books that must be given back to the private sector some day. But sounding hysterical about a fed policy before it is even disclosed is not right. This Fed has been pretty competent so far. And thre is of course always the old argument that you mention in your piece, that they can use when the politicians want too much.As for the US Treasury’s star client, they would like to see a commitment to keeping long term rates low, and then they would move up the yield curve (they are not getting paid right now). I guess that good clients deserve a little extra service, so why not give them that guarantee?