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David Romer: The Need for Fiscal Policy

It's Maynard Keynes's World...

Paul Krugman:


  1. There has been no crowding out; interest rates outside the euro area have remained low despite massive government borrowing, which is what you’d expect in a liquidity trap.

  2. Inflation has been quiescent despite huge increases in the monetary base, again what you’d expect in a liquidity trap.

  3. Fiscal austerity has deepened the economic downturn everywhere it has been put in place.

Were these predictions different from what non-Keynesians were saying? And how. Go back to Niall Ferguson, or Brian Riedl, etc., and you’ll find confident assertions that all that government borrowing would send interest rates soaring. Go back to the likes of Allan Meltzer or the Austrians, and you’ll find confident predictions that all that money printing would cause an explosion of inflation. And just about everyone on the right bought into some version of the doctrine of expansionary austerity.

But, but, the Obama stimulus didn’t bring unemployment way down! Indeed — and those of us who took our Keynes seriously warned of just that.

So what the anti-Keynesians are left with are the sovereign debt troubles in the euro area. But as many of us have tried to explain, these are really balance of payments crises exacerbated by the refusal of the ECB to act as lender of last resort.

And bear this in mind: no country has driven itself into a debt crisis with stimulus — nor has any country with significant debt regained investor confidence through austerity.

Look, I know that many people can’t bring themselves to even consider the possibility that Keynes was right — or, for that matter, that I personally might have gotten anything right. But reality has been really clear here.


The truly puzzling questions are: Why is the world right now so "Keynesian"? And what might make it stop being so Keynesian?

A "Keynesian" world is a world in which three things are true:

  1. Spending is held down not because of a shortage of liquidity but because people's portfolios don't have enough or the right kind of savings vehicles to make them happy.

  2. Investors are eager to hold the nominal liabilities of governments that can print money at will and so turn those liabilities into cash with certainty--never mind any long-term political-economic inconsistency between spending plans and tax rates.

  3. Private-sector leverage is sufficiently high that adjustments to reduced spending via lowering the path of the price level are perverse--that they create enough bankruptcies and moral-hazard credit-channel problems that they such adjustments push the pace of production not up but down.

That these things are true right now seems to me to be indisputable. I think I understand why (1) and (3) are true. But I don't think I have a good understanding of why (2) is true. The Princes of Canary Wharf and Midtown I talk to say that at this conjuncture they think that if they take on risk and then have a bad year that they are then out of the game--lose their existing clients whose money they manage and cannot attract new ones. Thus, they say, their only option is to hunker down and try to hold as low risk a portfolio as possible so that they will still be in the game when the return to normalcy comes about.

I then say: I understand that in that case you would like to be holding cash. But why the #$$&*@^! would you be eager to hold 30-Year U.S. Treasuries at a nominal yield of 2.79%/year? 30-Year TIPS at a real yield of 0.68%/year? Houses in Elmwood are selling at a price-annual rental ratio of 12, for Jeebus' sake! The earnings yield on the S&P Composite is 6%/year. Those are extraordinary return gaps in expected returns. Why not sell some of your long-duration U.S. Treasury and Agency assets and try to take advantage of them?

And the answer to that is: we will, but we won't start selling our long-duration Treasury and Agency assets until the market turns and Treasury bonds start to fall in price.

US Generic Govt 10 Year Yield  USGG10YR IND Index Performance  Bloomberg

And I say: What if you are not first? At the moment, you are earning 2%/year on your 10-Year Treasuries relative to zero on your cash, but if the 10-Year interest rate normalized to its 2007 level tonight you would have lost 23% of your principal... by dawn