Category: Political Science

I've been thinking about this question more and I've come up with a speculative possibility.  Right now banks are earning their way back into profitability by playing the spread.  They're paying close to zero on deposits and earning fair sums on long-term loans.  Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans.  (These inflationary expectations may be changing; if you wish pretend I am writing this six months or a year ago.)

So let's say we move from zero expected short-term inflation to three percent short-term expected inflation.  The nominal short rate rises to three percent and the real short rate remains more or less constant.  Long rates would go up a bit but not much, since beyond the short run there is already an expectation of moderate inflation.  In sum, the spread between short and long rates might narrow.

Here is the key point: from the bank's point of view, what is the correct measure of the real rate of interest?  Is it defined by the nominal rate relative to the expected growth in the CPI?  I doubt it.  When you're near the bankruptcy or nationalization constraint, it's often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not "real profits" defined relative to the CPI.

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread.  Maybe we need that zero nominal short rate or at least the Fed thinks we do.

I don't wish to push too hard on this hypothesis, it is speculative rather than confirmed by evidence.  And propositions about the term structure of interest rates do not always run the way you think they will or should.  I'm aware of other problems.  What kind of zero profit condition is imposed on the banks?  Given the odd objective function of the banks, how exactly does the Fisher effect work in the short run?  Or is it imposed from without by competition from non-bank lenders?  I'm not sure on these questions and they suggest possible holes in the above speculation.

I also regard this as a somewhat gruesome hypothesis.  It means that "Main Street" is paying for "Wall Street" (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one's savings.  Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn't cleaned up soon, heaven forbid.  The spread, as a means of restoring bank profitability, won't last forever.

Felix Salmon writes:

Remember too that when you have a progressive tax system, especially when there are surcharges on people making seven-figure incomes, you also have a system where for any given level of national income, the greater the inequality, the greater the government’s tax revenues. And indeed federal revenues have been rising faster than median wages for decades now, thanks to the rich getting ever richer.

Given the government’s insatiable appetite for cash, it’s only natural that it would prefer to tax plutocrats, spending some of that money on poorer Americans, rather than move to a world where poorer Americans earn more (but still don’t pay that much in taxes), and the plutocrats earn less, depriving the national fisc of untold billions in revenue.

The government’s interests, then, are naturally aligned with those of the plutocrats – and when that happens, the chances of change naturally drop to zero.

Whenever there's an MR post categorized under both "economics" and "political science," it's usually pretty brutal.

I'm still thinking about this fascinating article from the NYT magazine last week, titled "Is There Such a Thing as Agro-Imperialism?".  Here are two excerpts:

…one of the earth’s last large reserves of underused land is the billion-acre Guinea Savannah zone, a crescent-shaped swath that runs east across Africa all the way to Ethiopia, and southward to Congo and Angola.

And:

…as of earlier this year, the Ethiopian government had approved deals totaling around 1.5 million acres, while the country’s investment agency reports that it has approved 815 foreign-financed agricultural projects since 2007, nearly doubling the number registered in the entire previous decade. But that’s far from a complete picture. While the details of a few arrangements have leaked out, like one Saudi consortium’s plans to spend $100 million to grow wheat, barley and rice, many others remain undisclosed, and Addis Ababa has been awash in rumors of Arab moneymen who supposedly rent planes, pick out fertile tracts and cut deals.

Foreign investment can do wonders but the interaction between such investment and corrupt foreign governments can also be negative if workers and citizens are not granted adequate rights.  This article caused me to revaluate possible paths for some African futures.  The Coase theorem is finally kicking in.  I see corrupt politicians deciding it is more profitable, and also more secure, to "sell off" their countries than to oppress them in the traditional manner.  I see a new kind of tax farming, based on the extraction and exploitation of resources and raw materials, with African labor along for the ride.  It will mean higher living standards and better infrastructure, but probably not along a path that will look very appealing to most Western observers.

There have been many posts on this topic lately, start with Paul Krugman and Brad DeLong if you need to catch up.  Today I have a few simple points:

1. Even if "it is fine to borrow more" is the most likely scenario, it is not the only scenario.  Let's take a page from Marty Weitzman on climate change.  The worst-case scenarios matter too, because they can be very, very bad.  We need to think probabilistically about this issue.

2. Are there current intelligent discussions of the implied interest rate volatility embedded in current options prices?  If we are looking for market tests, why not start there?  Focusing on the point estimate of the market interest rate(s) discourages you from thinking probabilistically.

3. I know less about Belgium but I am not reassured by Krugman's point that "Italy can do it."  I and many other observers consider Italy's economy to be a basket case which will only get worse.  Nor is Japan in a satisfactory place, economically speaking.

4. Krugman writes: "Belgium is politically weak because of the linguistic divide; Italy is
politically weak because it’s Italy. If these countries can run up
debts of more than 100 percent of GDP without being destroyed by bond
vigilantes, so can we."

I would interpret this evidence differently.  A high deficit often is an unfavorable symptom of bad politics, even if you think the high deficit is economically OK on its own terms.  It's a sign that you have dysfunctional institutions and decision-making procedures, as indeed they do in Belgium and Italy.  I believe that the not-always-swift American voter in fact understands high deficits — correctly — in this light.  They don't hold theories about "crowding out," rather they sense something in the house must be rotten.  And so they rail against deficits, as do some of their elected representatives.  It's a more justified reaction than the pure economics alone can illuminate.

When water regularly overflows from your toilet, you want the toilet fixed, whether or not the water is doing harm.