Krugman and Hamilton on deficits, debt, and interest rates
Yes, the future deficits are worrisome, says Jim Hamilton at Econobrowser. He's responding to a series of articles and blog posts by Paul Krugman--most recently this column on "the phantom menace"; see also this blog post on invisible bond vigilantes--arguing that the dangers of public borrowing are being exaggerated.
It's an important discussion and you should go to the sources. But here's a summary. Krugman stresses two main points. First, to make fiscal policy sustainable, you don't need to reduce the ratio of debt to output, you just need to stabilise it--and there is no compelling reason why you should aim to stabilise it at current levels, rather than at the higher levels which several more years of big deficits will cause. Countries like Belgium and Italy have much higher debt ratios than the US. So what's the problem? Second, economic growth makes deficits and additional debt easily affordable, so long as interest rates are low enough in relation to the growth rate to keep a lid on debt-service costs. Interest rates are (very) low at the moment, so what's the problem?
Hamilton does not have a compelling answer to the first point, because it is hard to say how much debt is too much. You know it when you see it--that is, when you can no longer borrow at good rates. At some point that could happen, even to the United States, but the Treasury continues to sell debt very easily at the moment, so the danger hardly looks imminent. On the other hand, Krugman would surely agree that some dangers (climate change, for instance) are not imminent but are still worth addressing--and the sooner the better, other things equal, if delay makes the problem harder to solve later. Unsustainable fiscal policy falls into that category.
On the second point, Hamilton does have a compelling answer--or so it seems to me. He argues that interest rates cannot be expected to stay this low.
But the question before us is, what will the situation be another two years down the road, when the government will need to go back to bond markets to roll over the debt it issued on Monday along with new debt to cover the several trillion added to the federal debt between now and then? Krugman's position is that we should trust the term structure of interest rates to give us the answer. If markets anticipate an explosion of short-term interest rates a few years down the road, why is anyone today buying the longer term debt at such low yields?...
I agree with Paul that the long-term treasury yields are hard to reconcile with a market worried about the solvency risk. But I would add that the run-ups we've seen in commodity prices are hard to reconcile with a market sold on the deflation scare. What I see is investors buying both bonds and commodities, suggesting that people are spreading their money across a variety of strategies to be in position for several alternative scenarios from here.
That seems correct. And is it not especially odd to read Paul, of all people, saying "trust the market" when it comes to interest rates? That has not been his position on other matters lately. His scorn for such a view has been constant. Now the bond market knows best?
I think Krugman is right that another shot of stimulus is required. He wants to make that case as forcefully as possible (even to the extent, as Hamilton points out, of forgetting the fiscal conservative principles he voiced in 2003). But the critical distinction here is between the short-term fiscal position and the long-term. As I've argued before, what the White House needs to do is explain how deficits will be brought back under control once the recovery is secure. Its plans for health care--desirable as they may be on other grounds--make this all the more pressing.
Credible proposals for long-term fiscal consolidation would likely make short-term fiscal stimulus more effective, by lifting uncertainty about future tax increases. They would also grease the political wheels for short-term stimulus on the needed scale: voters are resisting a second stimulus because they are concerned, with reason, that the long-term position is running out of control. From Paul's own point of view, it seems to me that dismissing concerns about long-term public borrowing is counterproductive.