One reason why the Obama stimulus plan isn’t larger

Paul Krugman writes:

…the traditional immunity of advanced countries like America to third-world-style financial crises isn't a birthright. Financial markets give us the benefit of the doubt only because they believe in our political maturity — in the willingness of our leaders to do what is necessary to rein in deficits, paying a political cost if necessary. And in the past that belief has been justified. Even Ronald Reagan raised taxes when the budget deficit soared.

But do we still have that kind of maturity? Here's the opening sentence of a recent New York Times article on the administration's budget plans: ''Facing a record budget deficit, Bush administration officials say they have drafted an election-year budget that will rein in the growth of domestic spending without alienating politically influential constituencies.'' Needless to say, the proposed spending cuts — focused only on the powerless — are both cruel and trivial.

If this kind of fecklessness goes on, investors will eventually conclude that America has turned into a third world country, and start to treat it like one. And the results for the U.S. economy won't be pretty.

Of course that's from 2004, when the budget deficit was far lower, so it holds all the more today.  Arnold Kling makes a related point.

It is, of course, still a completely coherent position to think that without a fiscal stimulus there will be no recovery and thus this default risk will be all the higher; I presume that is Krugman's position.  Still, in absolute terms, our worry about default risk should be relatively high.  And if there's anything we've learned over the last two years, it is that "once in a lifetime" outlier events can happen.

Keep in mind that banks still need a lot more money.  So that's a reason to be quite fiscally conservative on as many other things as possible.

Here are some interesting thoughts from Robert Waldmann.  (How long will the liquidity trap last anyway?)  And Greg Ip writes: "Last week, markets pegged the probability of a U.S. default at 6 percent over the next 10 years, compared with just 1 percent a year ago."

Comments

That US default rate, by the way, is from CDS spreads. The CDS market is hurting for counterparties on any loan default, not just the US government. It's a good gig for those who have the liquidity to risk.

I still wonder how we will run the decades of budget surpluses to pay back the soon-to-be 11 trillion dollars of debt, or will we just roll it over for all eternity?

Don't worry, the stimulus plan will grow one way or another. State and local pension funds need to be bailed out in a big way.

"without a fiscal stimulus there will be no recovery and thus this default risk will be all the higher; I presume that is Krugman's position"

That'll be Krugman's position after the 20th. While a Republican is in office, it's third world fecklessness.

Krugman's comment seems to be more about the policies of the administration than the size of the deficit. Isn't he saying that it is the expectation of poor policies by the administration that is going to lead to investors to treat America like a third world country? You can believe that the new administration will follow reasonable economic policies even if (or maybe because) they choose to implement a large stimulus in the current situation.

@MW:

That US default rate, by the way, is from CDS spreads. The CDS market is hurting for counterparties on any loan default, not just the US government. It's a good gig for those who have the liquidity to risk.

I may be misinterpreting, but does this basically mean that the 6% "market rate probability" of default is inflated or deflated because the insurer has to additionally compensate counterparties for their wariness that the insurer itself will default?

@David Wright:

how many months of recovery "fast-forwarding" do they believe we are buying? Once one has estimates for this, one can compare the cost and decide under what discount rate such a purchase is justified.

As Tyler mentions, it's not just a probability-weighted estimate of GDP gain from recovery fast-forwarding, but presumably also the avoidance of thickened-tail catastrophic events.

The thickened tail may be the idea of this century, given how often it pops up (global warming, default risk, the "one percent doctrine" of preventative action). Basically as humans we're all freaked out by uncertainty, and regular number crunching, which is supposed to alleviate the uncertainty, cannot necessarily do it.

Congratulations to Mr. Obama-like many great powermongers, he represents himself
as heading up the sole organization that can save us. At least his enemy is ethereal&amorphous, unlike
previous powermongers who had human enemies (the burgeoise, the jews, etc).

Now everybody do jumping jacks to protect us from the elephant stampede. OK, ready, go-see
no elephant stampede, it worked.

You can't really read much into the rising default risk assumption as it has gone up for every country. On a relative bais the US default risk assumption has risen much less that most OECD countries.

@MK:

That's a good point. Presumably, we could introduce a risk premium on top of probability weighting to account for that. But even once we agreed on a cost-benefit analysis framework, we would have some serious problems:

1. Standard Keynsian macro-economic theory (IS/LM model) does not produce a probability-weighted distribution of outcomes -- it purports to calculate the actual equilibrium. Even if one probability-weights across uncertain input values, there is no well-defined "economic collapse" state whoose probability one could compute -- just a continuum of output levels.

2. No macro- or micro-economic theory of which I'm aware purports to model a time-dependent return to equilibrium from an out-of-equilibriums state, so any predictions at time-scales for recovery are at best based on past emperics and at worst wild guesses. In this sense, economists are like engineers who have learned Newton's third law (statics) but not Newton's second law (dynamics). So even if we could predict probabilities, we couldn't predict time-scales.

3. There are presumably outlier catastrophic outcomes associated with doing a massive fiscal stimulus as well as ones associated with not doing one. In the absence of a reliable predective framework for such outcomes, people end up cherry-picking their catastrophes to suit their ideological bent.

I notice how Krugman phrases the notion of political maturity in terms of our willingness to raise taxes when necessary, not in terms of our willingness to cut inefficient spending from the federal budget. Telling.

Anti and Bernard,

You've hit the essential point - the U.S. cannot default on dollar denominated debt.

Of course, we might pay much more for financing this debt at some point. With yields on our long term debt under 3%, this does not seem to be a realistic worry at least for the next year, assuming that markets have in fact priced in a few trillion dollars in debt issuance over the next few years. Given their recent record, I would be skeptical they have priced this issuance in to current market prices.

As for the markets predicting default, I wonder who is actually buying this insurance and what the exact terms of these CDS contracts are, as non-payment cannot happen. I will have to look it up and recommend to Warren Mosler that he sell this insurance if he is not already. Payment in worthless dollars can happen, but non-payment, in all cases but the destruction of modern civilization, is impossible.

Additionally, we've seen the utility of using markets to predict the fiscal future, and apparently, they may slightly mis-price derivatives and assets occasionally, when the rare outside forces that are not part of the markets and economic theory, throw markets out of equilibrium.

I think what we are seeing in Paul Krugman's view on deficits is the madness of the current theory of money creation in a fiat monetary system. Waldman has to go through lots of hoops to demonstrate that well, there can be a special case where in the recent past, issuing more debt was bad, but now, in crisis, it is good. It is almost impossible to reconcile PK's views of 2004 with his views of today, because his operating theory of budgets is incorrect. 2004 was not all that great of an economy, either, particularly when you consider it in the broader scheme of the last decade. So why was spending then bad and now good?

If the treasury can always print more money to cover the debt, how are treasuries different than cash money? Once you start thinking about what the treasury is able to do, you see the treasury is just setting the term structure of interest rates with treasury issuance.

If Waldman would use a better model of how money is created and the meaning of government debt and deficit spending with a fiat monetary system, the need for a model where there is a discontinuous jump between debt indifference when demand is below a level, but then jump to wanting the debt low to be when some number is reached would disappear.

"Keep in mind that banks still need a lot more money."

Why?

Did we rush in to save pets.com when the tech bubble collapsed? Did cosmo.com demand a bailout in the name of delivering ice cream and rental videos to needy apartment dwellers? The banks have an obsolete business model. It is based on expensive information, aggregation and computation. The Fed should just open a retail window and lend money based on the same credit scores that anyone can buy.

While many folks are skeptical of the government, the banks and corporate collectives are asking the government for help, not the other way around. If they were part of the solution, they wouldn't be standing around with their begging bowls out.

I wouldn't worry about a government default. At 0% interest, they could borrow $10 trillion and pay nothing for it. If they could get negative rates, they could even borrow and make money on it. I doubt we'll see much "crowding out" for a while. The banks haven't been lending despite having hundreds of billions of dollars thrown at them. I'm not one of those who says you can't fix things by throwing money at them, but I think it makes sense to aim when you throw.

That's a good point. Presumably, we could introduce a risk premium on top of probability weighting to account for that. But even once we agreed on a cost-benefit analysis framework, we would have some serious problems.I will try this just after my 70-446 for Designing a Business Intelligence Infrastructure by Using Microsoft SQL Server 2005 about which I am confident to pass in first attempt because I have already pass 70-503 which is for Microsoft .NET Framework 3.5 - Windows Communication Foundation as well as your page concern I must say that you have done a great job I must return on your page to read you more.

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