What are markets demanding?

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

Why, then, are Very Serious People demanding immediate fiscal

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

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.


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