Fukushima This Morning...
Paul Krugman: Yes, We're In A Liquidity Trap

Department of "Huh?!'

Tyler writes:

Earthquakes and spending and deficits: Brad titles his post: “I Genuinely Do Not Understand Why There Is A Question Here…” and after quoting my post from yesterday writes:

If people thought that government debt was risky, its price would be falling as well. The fact that people are willing to pay more for government debt indicates that it is increasingly valuable–and so we should make more of it....

A few points:

1) My post and question is about spending, but Brad has shifted the discussion to borrowing.  It’s easy enough to borrow more without increasing spending, if that is needed.  It’s still an open question whether spending should go up...

No it is not.

We are economists.

We are not at a corner solution. There are two ways for the government to borrow more: it can borrow more and tax less, and it can borrow more and tax more. Unless there is something really weird going on, a government that borrows more should both tax less and spend more. You have been spending until the marginal value of spending just equals the cost of financing that expenditure by borrowing, and now the cost of financing expenditure through borrowing drops...

2) The countervailing forces which might favor lower government spending simply aren’t mentioned.  Those include lower wealth and higher tail risk....

Which, if they were of first-order importance, would show themselves as higher interest rates on government debt.

They haven't.

There could be an argument that more government debt right now would be a bad thing and that investors are highly myopic and do not understand the risks that they are running. But you have to make that argument--and make it convincingly. Otherwise, the purpose of a market is to tell you what things are valuable so that you can make more of them. Right now with the decline in interest rates on government debt the market is telling us that government debt is more valuable than it was last week. So we should make more government debt--pull spending forward from the future into the present and push taxes back from the present into the future.

3) The earthquake and related events are a negative supply shock, so on Keynesian grounds they need not increase the case for activist fiscal policy.

If the negative supply shock were the dominant factor then, once again, interest rates on government debt would have gone up: a poorer economy means less desired savings means a rise in interest rates holding private investment plans and government borrowing plans constant.

That is not what we see.

5) In 1936 Keynes argued that the rate of interest did not allocate investment properly, or correctly signal the proper amount of investment, because interest rates also channeled liquidity preferences.  Today this is a claim which DeLong and Krugman are arguing against.

Markets are telling us today that, right now, demand for safe high-quality financial assets is higher than it was a week ago. If the government does not borrow more, that excess demand for high-quality financial assets will slop over into the money market--for money is, among other things, a safe high-quality financial asset. The amount of money balances held for what Keynes called "speculative" and what I would call "insurance" motives will rise. The quantity of money available for transactions balances will fall. And that will put more downward pressure on aggregate demand.

Would anybody claim that with 9% unemployment here at home the right response to an earthquake in Japan is to cut the transactions money stock?

That is what leaving government borrowing unchanged right now would do.

And, once the government is borrowing more, it should operate on both margins--it should pull spending forward from the future into the present, and push taxes back from the present into the future.

And then Tyler demonstrates that he hasn't eaten his wheaties:

Megan McArdle had some to-the-point words:

It’s hard to argue that we should become more willing to borrow because Japan had an earthquake that will cut into global GDP.

No. It is not hard to argue. It is easy to argue.

The Japanese earthquake might well have been accompanied by a rise in interest rates on U.S. Treasuries, if it had had no effect on the global demand for safe assets and if the dominant expectation had been that Japanese reconstruction efforts were going to be competing for the world's limited pool of savings. In that case we should have become less willing to borrow--and, once again, in that case interest rates on U.S. Treasuries would have risen.

What we have seen is something different: not just an earthquake that will cut into global GDP but a flight to safety that leads to a shortage of high-quality assets like U.S. Treasuries and thus to a bigger shortage of global demand than we had before.

If you don't take the time to accurately paraphrase the argument I am making, it is very difficult for you to make a coherent critique of it.

It gets worse. Tyler quotes again:

And the bad signals aren’t just to the federal debt market–the flight to quality is ultimately going to push things like mortgage rates down too.  Would the people urging the government to take on as much debt as possible also urge our homeowners to once again leverage themselves as far as the banks will allow?

Where does this take on as much debt as possible come from? Where does this once again leverage themselves as far as the banks will allow come from?

Yes, to the extent that mortgage rates drop, people can afford to buy bigger and more expensive houses.

And they should do so.

To argue that people should not respond to falling mortgage rates by buying bigger houses is simply silly, like arguing that people should respond to falling computer prices by buying fewer and simpler computers or should respond to falling clothes prices by making more of their own garments.