A wee bit more on spending, borrowing, and earthquakes

Regarding Brad’s response post. I view our disagreement as such.  In my view, a low rate of interest on Treasury securities indicates a high chance that the investors will be paid back.  That is all it means.  It is not a market signal that the government output should be produced.  Investment is a normal good and post-earthquake the world is poorer, and riskier, so optimal investment can either go up or down.  The interest rate on debt is not a sufficient statistic summing up all of the conflicting “investment should go up” vs. “investment should go down” forces in our thought experiment.  It is not summing up real consumption risk or output valuations, only whether the government will pay back investors (None of this, by the way, need deny that there might be other, non-earthquake reasons for expanding government spending).

Here is an exaggerated but clarifying example.  Under Ceausescu, Romania could borrow at low rates, but that just meant the government would pay you back.  It didn’t show the outputs were properly matched to risk or to the wealth of the society.

Also note that private firms — whose output has to face a real market test — invest in a manner which is notoriously insensitive to the real interest rate.

This debate needs to revisit Scott Sumner on the dangers of reasoning from a price change.  Don’t consider the price change without also working through the reasons for the price change.  Brad is citing the price change alone.

Another good rule of thumb: when you have a complex problem, and one economist (me) claims “the right answer is indeterminate,” that economist (me) is usually right.

Addendum: Greg Ip has relevant comments, as does Ryan Avent.  By the way, a related response is to take seriously Brad’s endorsement of the liquidity trap idea.  Then a negative supply shock should be expansionary.  What is the implied prediction for interest rates?  Did it come to pass?  There is now also a possible “positive wealth effect” argument for expanding government investment but does Brad wish to make that?  Isn’t the market price response to the earthquake evidence that we are not in a liquidity trap?  I stress, however, that this is a separate line of response.

And a response from Brad.

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