What are markets demanding?

by on June 7, 2010 at 4:34 am in Economics | Permalink

Paul Krugman, like many other bloggers, asks a good question:

Why, then, are Very Serious People demanding immediate fiscal
austerity?

The answer is, to reassure the markets – because the markets
supposedly won’t believe in the willingness of governments to engage in
long-run fiscal reform unless they inflict pointless pain right now. To
repeat: the whole argument rests on the presumption that markets will
turn on us unless we demonstrate a willingness to suffer, even though
that suffering serves no purpose.

And the basis for this belief that this is what markets demand is …
well, actually there’s no sign that markets are demanding any such
thing. There’s Greece – but the Greek situation is very different from
that of the US or the UK. And at the moment everyone except the
overvalued euro-periphery nations is able to borrow at very low interest
rates.

Here is a short bit from today's morning news:

The euro slid 2.5 percent last week versus the greenback as
credit-default swaps on France, Austria, Belgium and Germany rose,
sending the Markit iTraxx SovX Western Europe Index of contracts on 15
governments to a record.

The French in particular are having serious and formerly unexpected problems and that is one of the two major EU countries, not Greece or Iceland. The French also don't have one of those impossible debt-gdp ratios.

In the blogosphere, discussions of market constraints are too heavily influenced by interest rates, which also "measure" an ongoing flight to safety.  (U.S. rates have fallen of late, but does that mean our fiscal position has improved?  Hardly.)  All of these austerity-promoting leaders are in constant communication with their finance ministers and departments and many of them are hearing glum, on the ground reports from relatively competent bureaucracies.  Furthermore many of these politicians seem to have the discipline to engage in a bit of worst-case thinking, rather than just looking at modal outcomes.

Call me naive, but I believe that most of these politicians would in fact prefer to spend the money and hand out goodies to favored constituencies.

What may be destroying economic recovery is not fiscal contraction, but rather lack of trust,  "Trust" is an underused word in macroeconomics.

Also, do not forget Cowen's Third Law, namely that: "All propositions about real interest rates are wrong." 

The real interest is only one indicator of where fiscal policy is at.  The point that interest rates serve multiple functions, and don't always communicate direct market information very well, comes from…John Maynard Keynes.  Let's at least keep that possibility in mind.

1 Mike Huben June 7, 2010 at 5:05 am

No matter how intelligent Tyler is, his analysis is slippery at best.

For example, “Cowen’s Third Law” is a glib assertion of the well-known fact that every proposition about the real world is wrong in some sense. But the question of interest is how accurate such propositions are: whether they give us accurate enough information to make a useful decision. Tyler seems to be simply practicing denialist tactics here.

Call me naive, but I believe that most of these politicians would in fact prefer to spend the money and hand out goodies to favored constituencies.

Here’s another example. Simple cynicism is hardly a basis for economic or political analysis. When you’re talking about being able to end recession and grow the economy Keynesian style, you must also take into account that there are other political motivations. (Including other cynical ones, such as the history of the Democratic Party claiming credit for ending the Great Depression for 70+ years.)

2 MostlyAPragmatist June 7, 2010 at 6:22 am

It’s interesting to ask oneself: Would your position change if instead of “austere” spending cuts, France, Germany, and the US were contemplating large tax increases to support current levels of spending?

On the current point, increasing revenue vs cutting spending should make little difference, but my guess is that Krugman and Cowen’s positions would reverse (Cowen less inclined to support immediate budget balance, Krugman more inclined to).

3 david June 7, 2010 at 6:43 am

Krugman supported payroll tax cuts as fiscal stimulus.

Cowen would probably (and reasonably) oppose large tax increases for Laffer curve reasons.

4 E. Barandiaran June 7, 2010 at 7:55 am

This Friday the World Cup will start in South Africa and sport reporters and pundits are giving a lot of information and a lot of opinions and predictions. We know that we can ignore 99.999% of what they are saying without any consequence to our welfare, but we don’t know about that 0.001% that we will benefit us to know. There is too much noise to find what may be important so most likely we are going to miss it.

We can say the same about what macroeconomists have been saying for a long time but especially for the past two years. This Tyler’s post is another good example of what we can ignore. Just the question that he asks doesn’t make sense. The relevant question is what people are demanding from their politicians. It seems that usually they demand too little –and then when a disaster happens they demand too much from people that hardly know what to do and whose interest in keeping or strengthening their political power is their overriding concern. Fund managers caught in the middle of this conflict know that their primary responsibility is with their creditors not with their debtors but the latter have political power. Indeed, despite his “public choice” credentials, Tyler has yet to say which is the relevant theoretical framework to analyze this situation. I hope Tyler meets soon with some of GMU colleagues and they are able to outline this framework.

5 TracyW June 7, 2010 at 8:52 am

It’s a very odd post by Krugman. He talks about health care spending being the source of the problem, not stimulus spending. But fiscal deficits already include government healthcare spending. If governments chose to cut healthcare government spending and keep stimulus spending their fiscal deficits would fall, all else being equal, and I presume markets would be as happy about their future long-term fiscal stability. I suspect the reason that governments are not cutting healthcare spending is domestic pressures.

Also, Krugman ignores that in 1981 Margaret Thatcher cut UK government spending in the middle of a recession, and against the advice of 391 economists that it would worsen the recession, and UK GDP started its recovery the same quarter. In 1991 Ruth Richardson in NZ cut government spending against the advice of 15 economists, and NZ GDP started its recovery the same quarter. There are a number of other cases of expansionary fiscal consolidations, and there’s a causal theory to explain why this can happen – see http://ideas.repec.org/p/cpr/ceprdp/417.html (shortly, it’s that cutting government spending improves people’s expectations about the future of the economy and taxes, so they start investing more right now). Of course, correlation does not prove causation, and perhaps there is something about the EU countries now that is so different as to the cases I cite as to make those results no longer likely to hold, but Krugman writes as if he has forgotten entirely about the 1980s and 1990s.

6 Bill June 7, 2010 at 9:04 am

oops, I guess there shouldn’t have been a their there in the about post, as if anyone is awake at this time in the morning to notice.

7 chris June 7, 2010 at 9:20 am

Call me naive, but I believe that most of these politicians would in fact prefer to spend the money and hand out goodies to favored constituencies.

OK, you’re naive. Cutting domestic nonmilitary spending IS the goody they want to hand out to favored constituencies. There is a substantial number of people now who are (a) convinced that someone somewhere is getting an unfair handout from the government and (b) really, really pissed off about it. That’s the constituency that spending cuts are intended to woo. It’s not rational economic self-interest on those voters’ part, but it’s effective politics to play to it anyway.

IOW, the pain caucus exists in symbiosis with the spite constituency.

Of course, many of the same politicians would also love to cut taxes on their favored constituencies, but I don’t know if you would count that as “spending the money” or not. From a deficit perspective it is.

8 E. Barandiaran June 7, 2010 at 9:40 am

Bill, yes you may be right and we are all bad people. I look forward to better times in which macroeconomics is no longer a theory of national accounting and public policy is based on a much better understanding of how government works. In the meantime, I’m trying hard to deal with too much noise. Fortunately, starting this Friday and for a month, I will be paying attention only to the World Cup.

9 TracyW June 7, 2010 at 10:13 am

Bill, yes I have indeed considered that possibility. I said in my earlier comment that “Of course, correlation does not prove causation, and perhaps there is something about the EU countries now that is so different as to the cases I cite as to make those results no longer likely to hold…”

However, have you considered the possibility that the reduction in government spending was not offsetting, but instead a contributor to economic recovery?

We could have an EU austerity bath with the US being called upon to stimulate its neighbours out of a world recession. We could also an economic recovery because of the EU austerity bath.

10 Yancey Ward June 7, 2010 at 10:37 am

This is what annoys me:

There’s Greece — but the Greek situation is very different from that of the US or the UK.

And, of course, a year ago the Greek situation was very different from that of Greece today.

11 E. Barandiaran June 7, 2010 at 11:02 am

Bill, I’m glad to know I can rest quietly since you’re considering all options your great politicians have. You have made my day with your idea that Obama may introduce a VAT (take this from a veteran of many economic reforms). Please, when discussing how national austerity works in the world economy, don’t forget that balance-of-payments accounting implies that 2 – 2 = 0, except for the gross mistakes in measuring all relevant concepts for each country.

Yancey Ward, I bet you that a year from now the Greek situation will be very different from that of Greece today, especially if they are kicked out ot the World Cup in the first phase.

12 E. Barandiaran June 7, 2010 at 11:12 am

Bill (sorry I’m addressing this to you but Tyler doesn’t answer the phone), what do you think of Laffer’s prediction in today WSJ
http://online.wsj.com/article/SB10001424052748704113504575264513748386610.html?KEYWORDS=ARTHUR+LAFFER

13 Greg Ransom June 7, 2010 at 11:16 am

Fiscal austerity — it works every time it’s tried.

Keynesian economics — it fails every time it is tried.

Any questions?

14 Greg Ransom June 7, 2010 at 11:25 am

The point that interest rates serve multiple functions, and don’t always communicate direct market information very well, comes from … Friedrich Hayek.

Not all quotes come from Lincoln, not all economics comes from Keynes.

15 Andrew June 7, 2010 at 11:31 am

libert,

To attempt answer your question, if a bond buyer decided that he wanted something safER than US bonds, where would they go?

16 The Money Demand Blog June 7, 2010 at 12:08 pm
17 chris June 7, 2010 at 1:07 pm

@Andrew: Gold, or if you’re really pessimistic, ammo.

And there actually *are* people rushing into gold under the belief that they are flying to quality because massive dollar devaluation is inevitable. Maybe they’re right — come back in 20 years and see.

People are much wiser with their spending than governments.

Because real estate was such a great investment, right up until it suddenly wasn’t? People are damn fools with their spending. Governments may be just as bad, but that’s not much of an indictment of governments.

Additionally, people are susceptible to the tragedy of the commons. The government is less so — that’s its reason for existing. If you left everything up to the people to spend or free-ride on an individual basis, who would build roads or enforce the law or defend the nation?

18 Ed Dolan June 7, 2010 at 2:15 pm

It seems to me that an element missing from this whole long discussion of Krugman vs. the OECD is an explicit recognition of the importance of policy lags. Starting to talk now about tightening policy is not just a psychological, macho thing, like holding your hand over a candle to show you can stand pain. It is also a matter of timing. We need to talk about future tightening now, and plan for it, and commit to it, because if we put off doing so, it will be too late when we finally do it. A superficial reader of Krugman might get the idea that we should keep chanting “stimulus, stimulus” until the unemployment rate is back down to its natural level, and only then pull in the reins. But unemployment is itself a lagging indicator, and there are more inside and outside lags–a year to two years, at least–built into the policy process itself. I am afraid that Krugmanism is a recipe for procyclical policy.

19 figleaf June 7, 2010 at 3:01 pm

“Call me naive, but I believe that most of these politicians would in fact prefer to spend the money and hand out goodies to favored constituencies.”

And actually we saw how that turns out (and will turn out again) when the Republicans were in charge. The problem, I think, is that whereas doling (I think that’s the appropriate term) out goodies and/or tax breaks to one’s buddies is a horrifically inefficient way to stimulate… or in the current economic climate simply to buttress… an economy.

You instead have to spend it on things for which constituencies that aren’t really anybody’s favorites. Keep schools open when layoffs are faced (or, if you’ve got a Republican axe to grind with public education, opening more daycare centers so parents who remain employed can still go to work.) Fill pot holes and repair bridges even though no one ever named a bridge repair after a politician. Drop money into national research grantors such as the NSF or the NIH even though a) virtually no one in politics is genuinely excited about funding research that won’t generate a Nobel Prize for at least a generation but will b) direct quite a lot of funding that will be immediately spent with high multiplier-efficiency.

Since hardly anyone is interested in doing that kind of stimulus for those kinds of “constituencies” it hasn’t been done. And probably won’t.

One can no doubt argue that’s all for the best. And perhaps it is. But I agree that rather than do the best thing politicians would rather dole out their goodies as economically-inefficiently as possible: to their friends, cronies, and other “core” constituencies.

figleaf

20 JoddeHaa June 7, 2010 at 4:26 pm

Cowen’s Second Law: “There’s a literature on everything.”
Cowen’s Third Law: “All propositions about real interest rates are wrong.”

Is there a first law? What is it? Are there more? Where do they come from?

Pray tell!

21 anon June 7, 2010 at 7:25 pm

Krugman isn’t an economist.

Surprised no one noticed – Tyler didn’t call him an economist:
Paul Krugman, like many other bloggers

Good joke, Tyler!

People are much wiser with their spending than governments.

Because real estate was such a great investment, right up until it suddenly wasn’t? People are damn fools with their spending. Governments may be just as bad, but that’s not much of an indictment of governments

Hahahaha.

And, sadly, I bet you’re not kidding. Yes, governments should make all economic decisions rather than individuals, so that only wise, sensible, less-foolish investments will be made.

I would rather be a fool with my own money than have you, or anyone else, be a fool with my money.

And just a minor point: the government was, and still is, encouraging people to invest in “real” estate.

22 Duracomm June 7, 2010 at 7:45 pm

chris said,

Because real estate was such a great investment, right up until it suddenly wasn’t? People are damn fools with their spending.

You neglect that a raft load of government policies helped inflate the housing bubble.

Government spending often combines the foolishness of uninformed people with the leverage of lots of taxpayer money. Which, naturally increases the damage bad government policies cause.

23 anon June 8, 2010 at 7:20 am

no one at all predicted those effects.

Incentives matter!

(Several folks bet money on the consequences, and made a lot of money doing so. See http://www.amazon.com/Profit-Coming-Real-Estate-Bust/dp/1579548709 and Bad News Bears: The Guys Who Bet Against the Bubble and Won)

24 Popeye June 8, 2010 at 12:01 pm

Several folks bet money on the consequences, and made a lot of money doing so.

The fact that some people made money betting on the decline of the housing market is hardly proof (or even evidence) that government policies were the critical driving factor in creating a housing bubble. These people *bet against the rest of the market*.

The people who are now convinced that it’s all the gummint’s fault are the same people who in 2006 were sure that housing was correctly priced because the market reflected the very best information and only arrogant naysaying busybodies would not trust the market.

25 http://www.nicecoachhandbags.com August 5, 2010 at 10:24 pm

Macroeconomists are all navel-gazing tautologists. Stop living beyond your GD means. It’s not very complicated. No wonder economists are always wrong, but never in doubt.

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