Krugman – Ferguson Slugfe(a)st – Part 1
The appetizer – ‘Crowding out’
It all started with Krugman (PK) posting this on his blog. He sighs, expresses exasperation with Niall Ferguson’s ‘ignorance’ and alludes to some ‘dark age of macro-economics’. Strong stuff. Link here.
In fact, there is some history to this. PK, perhaps, was having this at the back of his mind when he reacted strongly to Niall Ferguson (NF). By the way, this is not justification for Paul’s reaction but an explanation.
In a downturn, characterised by waning or weak animal spirits in the private sector, non-government investment spending does not happen to the extent that savings exist. In fact, the gap between the two widens (i.e., savings > investment). So, the talk of ‘crowding out’ (of private investment by public investment) here engaged in by Fama and Cochrane (that PK criticises) is ideological warfare. The Gold Standard (TGS) sides with PK on this issue in the current circumstances in the US.
‘Crowding out’ happens when government wades in with its own deficit spending in a pro-cyclical manner – something that Government of India did between 2006 and 2008.
So, that is not the issue here. The issue is whether government spending and borrowing could cause interest rates to climb when there is excess saving. In theory, when there is excess saving, cost of borrowing remains low. It cannot rise. But, theory and reality are two different things.
In fact, if one goes through the transcript of the roundtable that took place between Niall Ferguson, PK, George Soros and others, it is clear that PK himself provides an answer to this question. Yet, he went ahead and posted an exasperated comment on his blog. He supplemented it here and here.
Somewhat pompously, he even outsourced further comments on the topic to Bradford de Long – some mutual backs-scratching, of course. Now, that was too long an appetizer. Let us serve the main course now.
I think PK and NF are arguing on two different planes. PK’s points are all correct but that probably is true only for the short end of the money demand curve. If you look at 2y UST rates it has not risen much. While NF is taking comfort from the rise in the 10y UST to justify his point and its true. All the arguments on falling demand for money and rising savings will cap short term interest rates but the higher deficit and consequent fear of debasing the currency will manifest in higher risk premiums for term borrowings. In that respect this trend of the curve steepening will continue. Even the Fed buy-backs will not help in arresting that trend as its a change in risk perception for term funding. I tend to agree with NF in this debate as term money will be costly even if short term money is cheap
I think Krugman makes more sense here…a rise in LT yields on US Treasuries is, in fact, welcome if it’s a harbinger of higher economic activity, or the anticipation thereof (could be due to the massive rescues of the financial sector, which will dissipate greatly any economic dislocations, and huge fiscal stimulus). Nobody knows if that’s the case, or if it’s a reflection of credit risk…but in the face of compelling current economic evidence of credit aversion and excess savings, which Krugman effectively presents as evidence, Ferguson’s reliance on point-of-time rise in yields does not seem very convincing, at least to me. Which is not to discount the fear of future inflation, but Krugman already acknowledges that.
And further, China risks more damage if it allows the renminbi to appreciate, hence am not sure if they are in any position to let the USD depreciate (and US rates to rise) by too much.
There is no risk of renminbi appreciation from US dollar depreciation since it is still de facto pegged (crawling peg or tightly controlled float – we can choose our labels) to the US dollar. The only risk of a weak dollar is the risk of valuation loss in its foreign exchange reserves
Good points, Vishy
[...] debate with Niall Ferguson, NF did not fare as badly as PK tried to paint. We have commented on it here and [...]