Friday, June 5, 2009

To Print Or Not To Print

History lesson for economists in thrall to Keynes

By Niall Ferguson

Published: May 29 2009 19:23 | Last updated: May 29 2009 19:23

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did with warnings about the fiscal health of the US. For me, however, it was good news. For it settled a rather public argument between me and the Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that “the running of massive fiscal deficits in excess of 12 per cent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds” was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a “painful tug-of-war between our monetary policy and our fiscal policy, as the markets realise just what a vast quantity of bonds are going to have to be absorbed by the financial system this year”.

De haut en bas came the patronising response: I belonged to a “Dark Age” of economics. It was “really sad” that my knowledge of the dismal science had not even got up to 1937 (the year after Keynes’s General Theory was published), much less its zenith in 2005 (the year Mr Krugman’s macro-economics textbook appeared). Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates.”

Now, I do not need lessons about the General Theory . But I think perhaps Mr Krugman would benefit from a refresher course about that work’s historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. US real GDP is forecast by the International Monetary Fund to fall by 2.8 per cent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 per cent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalisation collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is second to none, and whose double dose of near-zero short-term rates and quantitative easing – a doubling of the Fed’s balance sheet since September – has averted a pandemic of bank failures. No doubt, too, the $787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the US federal government is projected to run this year. Borrowing is forecast to be $1,840bn – equivalent to around half of all federal outlays and 13 per cent of GDP. A deficit this size has not been seen in the US since the second world war. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House’s over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 per cent of GDP by 2017. And this ignores the vast off-balance-sheet liabilities of the Medicare and Social Security systems.

It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”.

Of course, Mr Krugman knew what I meant. “The only thing that might drive up interest rates,” he acknowledged during our debate, “is that people may grow dubious about the financial solvency of governments.” Might? May? The fact is that people – not least the Chinese government – are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”

The policy mistake has already been made – to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic US structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings. It was Keynes who noted that “even the most practical man of affairs is usually in the thrall of the ideas of some long-dead economist”. Today the long-dead economist is Keynes, and it is professors of economics, not practical men, who are in thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University and author of The Ascent of Money (Penguin)

There are two separate issues here. Can a central bank necessarily
always create inflation (ie even when it wants to), and why longer
term interest rates are higher than people would like to see.

Let's deal with the second (briefly first). Basically, that long term
interest rates remain higher than hoped for under the initial bout of
QE (that is it is factored in) according to the Krugman theory. Here
an extract from Eggerston and Ostry on the Japan experience
(Eggerston was Krugman's PhD student). This doesn't mean the Krugman
theory is right, just that it says that what is happening will happen,


Since there is a relationship between the future interest rate and
future money supply, another way of stating this result is that
successful monetary easing in a liquidity trap involves committing to
lower the future nominal interest rate for any given price level once
deflationary pressures have subsided (see, for example, Jung and
others, 2001; Reifschneider and Williams, 2003; and Eggertsson and
Woodford, 2003). This was indeed the rationale for the BoJ’s
announcement that it would keep the interest rate low for a
substantial period of time (as it was for the Federal Reserve, when it
announced that it would keep interest rates low for a “substantial
period” once policy rates had been lowered to 1 percent, a point
beyond which it was reluctant to go).

According to the view outlined above, quantitative easing will only
increase demand if it changes expectations about the future money
supply, or the path of future interest rates. The Keynesian liquidity
trap is thus only a true trap if the central bank is unable to move
expectations. There are several plausible conditions under which this
is the case, so that quantitative easing indeed becomes irrelevant.
Krugman (1998), for example, shows that if the public expects the
money supply in the future to revert to some constant value,
quantitative easing will be ineffective.


unless Bernanke commits to holding the rate down for long enough.
This, at least, is the theory. And this is what I expect him to do
next. What happens then we will get to see eventually.

There are doubts, since the US is not either Germany or Japan, so I'm
not clear how long deflation can hit them for.

The German case is clearer. Year on year CPI went negative this month,
and I don't expect it to breal water again for a long, long
time. Which is what will put so much pressure on the Eurozone, since
countries like Spain have to correct vis a vis Germany, and German
prices are already falling.

"The you roll out the printing presses (or start clicking the mouse
real fast), and create inflation"

It doesn't allow for the possibility of a liquidity trap. Also, what
may (indeed I think will) happen is:

The you roll out the printing presses (or start clicking the mouse
real fast), and create inflation.............. in India and Brazil.

What a carry on!

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