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August 04, 2011



What is your response to Krugman's claim to have been vindicated:

Nathan Smith

Professor Charles Rowley and I wrote in 2009 that

"The United States economy is rich both in physical and in human capital. Within itself, it contains powerful restorative impulses capable of moving through the trough of contraction into the next upturn of the business cycle. In late 2008, the key obstacles to such restoration were the financial crisis, the massive private and public debt overhang, and pessimistic expectations. Since then, a wave of government interventions has introduced new obstacles that may prove even more debilitating: political risk, and incentives for rent-seeking. Unfortunately, plans seem to be underway to introduce still more policies that impede market recovery." (Economic Contractions in the United States: A Failure of Government, p. 95)


"The United States has enjoyed much greater success in the past quarter of a century because its system is far more laissez-faire, and can anticipate similar success in the future if the recent drift to state dominance is reversed. We anticipate that a return to the kind of laissez-faire capitalism that evolved so successfully throughout the last two decades of the twentieth century once again will enjoy majority support in the not-too-far-distance future once the electorate beings to suffer the severe economic downside of the Bush and the Obama administrations' anti-capitalist policies."

Rowley may be a bit more hardline than I am and if it had been a sole-authored book I might not have used the word "anti-capitalist" there; that really just means big fiscal deficits, spending, regulation, bailouts and the like. Anyway, can Rowley and I claim vindication here? Things have played out pretty much the way we said, and it's not surprising that Krugman did no worse than we did, at least by his own account. What's implausible in Krugman is that he thinks a program of much larger borrowing, driving debt well above 100% of GDP, would have revived the economy in a more or less unproblematic way, e.g., without just causing a worse crisis slightly down the road.

Suppose the stimulus had worked, i.e., the economy had recovered strongly after ARRA passed. Rowley and I would find our pessimism rather embarrassing in hindsight. Krugman, I think, would be saying "See, Keynesian stimulus worked! It's too bad they didn't adopt my prescriptions-- more stimulus would have worked even better-- but at least this helped." Krugman now says stimulus didn't work because it was too small, but there isn't actually a theoretical basis for saying that stimulus should have that kind of non-linear effect, initially zero and then zooming upwards after a certain point. You can say "liquidity trap" if you like, but the point of a liquidity trap is just that monetary policy doesn't work; fiscal policy should still work.

So to the extent that Krugman has been right at all (which I can't confirm in detail), I'd attribute it to some combination of (a) lazy extrapolation, and (b) secretly using conservative models of the economy for prediction, because deep down he knows they're right, while advocating liberal ones, because they fit his political preference not to see poverty up close (which is why he advocates both a welfare state and immigration restrictions). The Wall Street Journal should have known better than to predict rising interest rates, because while logically one might think government borrowing would drive up interest rates, that doesn't seem to be borne out empirically. I certainly wouldn't trust Krugman not to cherry-pick his links to the Wall Street Journal, though, and I'm open to the possibility that their analysis has been much sounder than that in general.


I think the point was that both Krugman and WSJ* were pessimistic, but there is checkable numerical evidence against which their justifications could be compared. Could you share any countervailing evidence in the same line, or evidence for your own theoretical explanations of the recent poor performance?

*Pretending, for a moment, that the WSJ editorial page was monolithic in its advocacy of a certain model

Nathan Smith

I basically deny the "checkable numerical evidence" point. I think all you mean is that interest rates stayed low despite a lot of government borrowing, and to predict that doesn't take much and doesn't bring Krugman's overall theory into play, and in particular has very little to do with Krugman's most controversial claim, namely that a lot more government borrowing would have engineered a strong recovery. My theory is something like that investors take the future into account, so government borrowing to finance current spending crowds out private borrowing to finance business investment, leaving interest rates about the same or lower, but depressing employment since the government is a lot less efficient than the private sector in creating jobs, and also depressing consumer confidence since consumers foresee that business investment grows the economy in the long run and government spending doesn't. It makes similar predictions about interest rates, and probably a lot of other theories would too, because the lack of responsiveness of interest rates to government borrowing is one of the prima facie odd facts that theories need to explain, or at least to be consistent with.


How does it "crowd out" private borrowing if the price of private borrowing remains low? It seems a misuse of the phrase if Tbills are super low yield. The more correct way of stating this is that no one wants to buy private debt so they flee to Tbills. Also, while this model of business and consumer sentiment is plausible, it seems to assume that everyone else sees the economy in way similar to the modeler.

It's not even that I disagree, really. I think this kind of thinking does have an influence, and high levels of government borrowing discourage investment even without interest rate rises. The effect seems plausibly strong enough to swamp liquidity help from fiscal stimulus, even, given the size of the long term imbalance*.

But I also really doubt that it's the expectation of higher taxation that's depressing growth, or government inefficiency or whatever. I think it's mostly demography. We paid for being old by growing the number of young, and now we're not doing that any more. Things are just going to be fundamentally more expensive in the future (except real estate!) than they were in the past, and we're going to have to pay down the debt because we can't outgrow it any more.

*I'm still inclined toward the liquidity trap argument because it's not really as if our future obligations have grown much recently. However, they did grow a lot in 2002-2003, and we've also had a big reality check on growth expectations after a decade of terrible performance**, so I think a lot of businesses are really reassessing.

**Yes, I know, there were ways in which performance wasn't so terrible, but for the purposes of business considering expansion, the performance has been pretty execrable.


Also, it seems like low inflation puts a lower bound on how much is businesses being unwilling to expand vs. consumers being unwilling to buy. If consumer demand was relatively healthy but businesses held back because of regulatory risk or tax expectations, then one would think prices would go up more.

Nathan Smith

re: "How does it 'crowd out' private borrowing if the price of private borrowing remains low? It seems a misuse of the phrase if Tbills are super low yield. The more correct way of stating this is that no one wants to buy private debt so they flee to Tbills."

No, the problem is not that no one wants to buy private debt, but that private companies don't want to borrow. They don't want to borrow because they don't want to invest. And they don't want to invest because of-- so I would argue-- uncertainty about the level and structure of future taxation and quasi-taxation (e.g., by forcing companies to provide health care for employees or pay a fine), and also a kind of regime uncertainty resulting from the huge bailouts and TARP etc. It is NOT the case, as Nato's remark about "no one wants to buy private debt" remark suggests, that private companies want to issue a lot of debt but investors don't want to buy it. On the contrary, companies are sitting on lots of cash. "Crowding out" seems like a suitable term for that, although it's a bit different from the usual usage.

Demography is a serious challenge, and one of the reasons that entitlement reform is so urgent (and the AARP is Enemy #1) is that entitlements directly attack people's incentives and ability to save and to have children, the two things that the economy needs most. Also, the country's demographic problems are being greatly exacerbated by fascism in Arizona and Alabama, and the worsening immigration crackdown. In short, enemies of mankind are preventing mankind from settling in this country, and harming the economy through a shortage of mankind. However, that "we paid for being old by growing the number of young" in the past does not mean that's the only option. We can work longer, and we can also raise future productivity through various forms of investment, in physical capital, in technology/R&D, in education, and by buying foreign securities.

Note how odd is the claim that "things are just going to be fundamentally more expensive in the future." In recent years, we've seen the price of technological goods fall sharply. Even the price of domestic labor hasn't been rising much, and there's plenty of labor to import from abroad if we run short of it at home. Commodity prices have risen because of worldwide economic growth, and that might continue, although it might also just take a little while for technology to respond to the new incentives. If we did see prices of everything rise, this would be a fundamentally new trend. It contradicts lazy extrapolation! I still think we just need to get long-term fiscal discipline, and business investment will pick up.

Job growth picked up in July: http://www.nytimes.com/2011/08/06/business/economy/us-posts-solid-job-gains-amid-fears.html?_r=1&hp. Very tentative interpretation: businesses saw the debt ceiling deal as likely leading to spending cuts, and started thinking it was time to expand.


"the problem is not that no one wants to buy private debt, but that private companies don't want to borrow."

Sorry; it crossed my mind that my phrasing would be confusing, but I chose to focus on the demand side for debt anyway, since we were talking about demand for T bill debt. Obviously, a more complete statement would be something like "companies aren't willing to issue debt at yields that are attractive to debt-buyers." It works out to the same thing.

As for things being fundamentally more expensive, I was lazily referring to the rising cost structure of life, given that current consumption is no longer financed (as much) by the future. So even though a given quantity of goods might have a lower nominal cost, the provision of a certain level of goods across all of society will require more of workers. I don't imagine we're disagreeing; I'm just clarifying what I was trying to say.

Also, Nathan, did you notice my comment about the implications of low inflation?

Nathan Smith

Well, I don't think it's true that "companies aren't willing to issue debt at yields that are attractive to debt-buyers," or that that "works out to the same thing" as companies not wanting to invest right now. I doubt that companies would issue much debt at ANY interest rate right now, even zero. They're waiting to see how the government is going to pay its bills, and for the new, post-TARP, health-care-reformed economic constitution to settle into place first. Of course, if companies could borrow at, say, -10% interest, some would probably do it, so maybe this is a variant of the liquidity trap argument.

Sure, consumers are holding back as well as businesses. These are two sides of the same phenomenon, though I think the dearth of business investment is more fundamental. As long as business investment is weak, consumers' job prospects are grim, and they won't be looking forward to much rise in asset prices, so consumer spending will be weak. To get consumers to spend, you need to get business investment moving, so that consumers will expect their incomes to rise, in the form of employment/wages and/or capital gains; then consumers will spend more too.


Well, *I* think the egg came before the chicken.


If companies are so worried about future taxes right now because of government deficits, then the solution seems to be to raise taxes considerably right now. Then businesses won't have to worry about *future* tax increases anymore, yeah? So let's go ahead and raise taxes. At least then all of the money floating around out there would be doing some good in helping to knock down deficits.

Nathan Smith

Maybe Tom's joking here, but this is a terrible idea, because "all of the money floating around out there" on corporate balance sheets is just the kind of money taxes can't get without doing terrible damage to America's investment climate. It would be like putting up a big sign: "CORPORATIONS! CAPITAL FLIGHT ALERT! WHATEVER YOU DO, DON'T PARK YOUR ASSETS HERE!" Moderately raising taxes on *labor incomes* (which are the least mobile) might not be such a terrible idea-- but remember that one of Hoover's policies was to hike taxes sharply-- but trying to confiscate the money that corporations have been deliberately keeping liquid would be disastrous. Instead, we need to establish a situation in which corporations are willing to invest that money voluntarily. That means sharply bringing down the long-term deficit and making the regulatory climate more inviting. Repealing Obamacare and Dodd-Frank might be useful there.


I still don't see how the raw repeal of the ACA would improve the business climate. "Repeal and replace" could plausibly help, but simple repeal would seem to increase dysfunction and uncertainty, not reduce it.

And yes, I think Tom was joking to an extent, but the underlying point is, I think, that if we raise revenues to bring things into balance immediately, then that reduces uncertainty and changes the ROI balance between short and long term. If you think taxes will get higher in the future, then you want to make your money now, but if taxes are already at their long term level, then you may as well spend income on investment.


In fact, if taxes go *too* high, then companies might anticipate that politicians will lower taxes in the future, so they will want to shift their income out in time as much as possible. An investment boom!


Yep, Nato is on the money. I was being tongue-in-cheek. Basically, it was a strawman to show how silly (I think) the idea is of businesses hanging onto money because of future tax uncertainty. I was just carrying that idea out to its ridiculous conclusion.

Nathan Smith

I have not the pleasure of understanding Tom. How is his proposal the "ridiculous conclusion" of the idea of trying to improve confidence so that business will invest... or of anything else? However, I do agree with Nato's point that raising taxes now (but on labor, not trying to confiscate the liquid reserves of corporations) might boost investor confidence by making it clear where the burden will fall. It's SPENDING that I'm against, not so much taxes.


But everyone everyone agrees we have to cut in the long run. The argument is how suddenly and deeply to do so. The Tea Partiers insist on there being no new revenues, meaning the cuts would have to be incredibly deep and fairly rapid, moving us to pre-depression spending, possibly while maintaining near Cold-War defense spending. That's incredibly radical, and given that most entitlements seem more or less sacrosanct, it would basically mean cutting all discretionary spending, period. No SEC, no BLS, no foreign aid, no Smithsonian, no NASA, no basic research funding, no FBI(!), no federal prisons, a much-reduced USPS... and so on. Even if some of these things might be good in and of themselves, businesses and individuals rely on them and it would take a long time to adjust to overcome the dislocation. I don't know if they don't realize this, or if they realize it and think it's okay, or if they realize that's completely crazy but cynically pretend they don't.

Nathan Smith

Well, this debate is kind of pointless I think. Nato is amalgamating talking points and desiderata and practical plans and negotiating tactics into an amalgam, drawing some dubious deductions from it, and then calling the mass crazy. It's a worse than useless exercise, and the fact that he's claim that "entitlements are more or less sacrosanct" as part of an attack on the House GOP, which PASSED PAUL RYAN'S BUDGET (!!!) shows how wildly unfair this account of the situation is.


I guess it's true that I'm too distracted by the things Michele Bachmann says because she's currently the TP favorite for President (because Paul Ryan isn't running). She backed away from Ryan's proposals because they 'might hurt senors' and made a big show of opposing Democratic proposals as "Obamacare for seniors," which would be a liberalization relative to the current single-payer model. She talks about reforms to keep it solvent, but I'm not aware of her advocating any actual cuts.

But yes, they should get credit for voting for the Paul Ryan budget. Of course, even that continued to run large deficits that eventually level off and reverse as the country somehow collects 19% of GDP as revenue in the CBO report. Maybe they were really implying that they weren't as against added revenue as claimed, or whatever, I don't know really what they were thinking, but yes, there was definitely an advertisement that Medicare would be converted to vouchers, so it has to count as a vote against Medicare being sacrosanct. I'll give Nathan that one. I didn't take it as a signal of actual political will, but since I don't understand a lot of their thinking, I'm willing to admit that my impression that they're not serious about entitlement reform could very easily be a misapprehension based on their unwillingness to verbally touch the third rail any more often than they have to.


NS doesn't understand, so let me try to explain my rationale. The claim is that businesses are loathe to invest right now due to the uncertainty of where future tax increases will lie. The implication is that if taxes are increased now, then the uncertainty will go away and businesses will feel more comfortable investing and hiring. But given the fact that consumer demand is still incredibly weak, there is very little incentive in any case for businesses to expand operations. Therefore, I think that uncertainty about future tax increases are mostly irrelevant to the willingness of businesses to invest right now. I think business confidence is very important under normal circumstances, but there are other factors that are dwarfing the effects of confidence right now (I speculate).


Regarding Medicare reform, from the statistics I've seen, Medicare costs are increasing more slowly than private insurance costs, and thus if you, say, increase the age of eligibility for Medicare, then you're moving a greater percentage of people from a lower costing health plan to a more expensive one. This seems less sustainable to me, though it will be at the expense of private individuals and not tax payers in general.

Nathan Smith

Well, when you put it that way, the conclusion doesn't sound ridiculous. Still, trying to get at "the money that's just floating around," i.e., the cash that companies are keeping liquid, is the worst approach. That would just speed up capital flight. You have to tax what is immobile.


it seems to me that it is an egg and chicken question

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