A client sent me a link to an interesting article, about what we have learned concerning the intersection of fiscal policy with financial markets. The article’s author, PBS correspondent Paul Solman, makes some observations about who is honest enough to learn from their mistakes, and who is not.
It turns out Paul Krugman takes the prize in honest learning. Back in 2003, Paul Krugman, New York Times columnist, Nobel laureate, and Princeton economics professor, trashed the Bush administration for failing to pay for its expensive wars, and predicted that financial markets would ultimately exact a heavy toll in the form of rising interest rates.
More recently, Krugman has been entirely on the other side of this debate, arguing strenuously that rates will not go up, regardless of how much the government spends or how large the deficits. That being the case, we should borrow liberally and spend hugely, in order to build infrastructure, hire teachers, or just dig holes and fill them up, all so we can get the economy moving again. Fear of deficits, Krugman argues, is a sort of right-wing witch craze — irrational, ignorant and deliberately regressive in its policy effects.
With the national debt having doubled during the Bush years, and doubled again in Obama’s first term, I thought we were already borrowing like crazy, but Krugman believes that deficits in excess of $1 trillion a year actually represent dangerous austerity, and that our borrowing and spending should be much bolder.
On the other hand Gregory Mankiw, who was President Bush’s chief economic adviser back when Krugman feared rate-increasing deficits, recently made a point of juxtaposing Krugman’s 2003 comments with his recent position, wondering at the inconsistency.
It turns out this apparent inconsistency is simply intellectual growth on Krugman’s part. He retracted his beliefs about the dangers of deficits in 2010, because (in his phrase), “My thinking has evolved. If you haven’t updated your views in the face of new experiences, you’re not doing your job.” Solman of PBS approves of Krugman’s evolution, and observes that Mankiw remains stuck in error, still thinking budget red ink can result in higher interest rates.
I think this is the wrong conclusion to reach. Here are my takeaways:
1) Economists, across the political spectrum, consistently over-estimate their ability to predict the future consequences of present acts. They are hardly alone in this persistent error, which is characteristic of human beings as a species. Research shows that sophisticated economic models are essentially valueless in predicting economic activity, from GDP growth to interest rates to unemployment.
2) Since the late 1970s, a variety of economic models have competed to predict the direction of interest rates. In the late 1970s and into the 1980s, flow-of-funds models were dominant, which predicted that large public-sector deficits would “crowd out” private investment, driving up rates. Instead, interest rates fell from 1981 to the present, even as deficits swelled during the Reagan years. In the 1980s and into the 1990s, many economists switched to a rational expectations model, which asserts that rates will rise or fall according to the expectations of investors about the effects of economic policy. After 2008, some conservative economists (not to mention radio talk-show hosts) predicted rates would rise as Fed stimulus triggered higher inflation. So far we’ve seen only modest inflation, and absolutely no rate spike. Another model bites the dust.
3) The greater the degree to which your economic perspective is informed by your political preferences, the more it compromises the value of your insights. (I’ve talked about this at length in terms of investment decision-making.) What Krugman is engaging in here, and arguably Mankiw as well, is an adjustment of perspective based on whether the observer is sympathetic or opposed to the policy ends for which deficit spending occurs, and the political party engaged in the borrowing.
We seem to have wandered into a sort of parallel intellectual universe, in which Krugman, the Keynesian, is arguing that the bond market’s pricing of interest rates is so perfectly efficient that it deserves to be the final arbiter of the wisdom of public policy. He is buying the efficient markets hypothesis in toto, less than five years after the EMH model’s spectacular failure in the financial crisis of 2008-09 cratered the entire world economy.
4) So what is the relationship between deficits, debt, and interest rates? Given the experience of Japan over the last twenty years, and of the U. S. over the last five, I think we must conclude that it is neither simple nor linear. But are we really prepared to believe that debt and deficits are unrelated to inflation and interest rates, as Krugman appears to argue? How then to understand the experience of Greece, Spain and Italy in recent years, the nightmare of rising inflation and interest rates in the United States in the late 1970s, and Argentina’s serial disasters every decade or so for the last century?
As I’ve noted in prior posts, rates stay low until they don’t, and if you have large debts when rates rise, you are in a world of hurt. Once rates move, it is too late to fix your fiscal problems without profound pain.
My own conviction remains that our debt is perilous. The fact that we can borrow cheap does not mean it is smart to do so, any more than the fact that in 2007 a bank would give a McDonalds fry cook a half-million dollar negative amortization mortgage meant it would end well for either the bank’s balance sheet or the burger flipper’s credit rating.
I fear that both inflation and interest rates will rise at some point, and that we will eventually suffer a debt crisis, somewhat like Greece, somewhat like what we had in the late 1970s under Carter. I think the size of our structural budget gap can’t be sustained long-term, and probably not medium-term. Krugman disagrees.
Which begs multiple questions: When? How bad? And what if I am wrong?