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Monday DeLong Smackdown Watch: Paul Krugman on the Confidence Fairy, The Expectations Imp, and the Rate-Hike Obsession

Confusion: High Public Debt Levels and Other Sources of Risk in Today’s Macroeconomic Environment

The theme is: confusion. Confusion on the theoretical level, confusion on the empirical level, confusion on the policy level. I am confused and astonished that that we are here today facing the global macroeconomic situation we face today. Cast me back seven year, ask me then "what are the chances that we will be this far down in the lower tail of global nominal GDP distributions?" and I will answer you that there is only a 1-in-a-100, only a 1-in-a-1000 chance.

The fact that we are here makes me fear that much of what I thought seven years ago was just completely wrong.


Seven years ago, when asked, I said that as far as macroeconomic policy was concerned I was a fairly orthodox neoliberal monetarist. I agreed with Robert Lucas that the problem of depression prevention had largely been solved. But I would go on to say that the problem of ensuring that inflation expectations remained anchored had not been solved--hence central banks needed to set and meet firm inflation targets. And fiscal authorities needed to avoid even a whisper of a hint of fiscal dominance. Fiscal dominance--a situation in which the political system will not let the government raise the primary surpluses it needs to amortize the debt at the current price level--is the thing that most easily undermines anchored inflation expectations. Thus legislators should be prohibited for even thinking about using large debt expansions for any purpose short of total war. And rebalancing an economy in depression should be left to monetary policy. Central banks were able to do that job, with the unfortunate exception of the 1930s. But, otherwise, central banks had proved themselves very capable of boosting nominal aggregate demand whenever they wished to whatever target they wished. That was the implication I drew then from my belief that the principal macroeconomic stabilization policy problem on the inflation and employment front was that of ensuring that inflation expectations remain anchored.


Seven years ago, when asked, I would have said that the principal macro-financial economic problem was the fact that equity premiums were so outsized from the perspective of the consumption capital asset pricing model. That told me that finance markets were having a very hard time properly mobilizing society's full risk-bearing capacity. Combine that with the fact the problem of preventing financial regulatory capture had definitely not been solved and you are pushed towards thinking that financial deregulation is a very good thing. To the extent that the regulators aren’t regulating that much, their capture can't do much damage. To the extent that financial markets are not mobilizing society's risk-bearing capacity, deregulation to allow experimentation with different business models and different modes of risk-bearing looked like a big winner: if people are not bearing as much risk as they should, convincing them they should bear additional risks is a good.


Were there risks generated by allowing financial experimentation via deregulation? Yes. But they were relatively small. History told us that the modern Federal Reserve could build a firewall between whatever financial disorder emerged and the real economy of production and employment. There was the 25% one-day crash of the stock market in 1987. There was the 1991 discovery that the savings and loans of the state of Texas had been building shopping centers and office towers they really shouldn’t have been building--which led, among other things, to a transfer to Texas of an amount of 25% of a year’s GDP without a burp from the United Stated political system. There was the 1998 collapse of LTCM. There was the 2001 collapse of the dot-com Bubble that took $5 trillion of equity wealth down with it. IN all of these cases the Federal Reserve was able to react swiftly and smoothly to keep these large financial shocks from having much of an effect on the real economy of production and employment.

Thus the big problems were (a) the risk unanchored inflation expectations, as shown by the US and Western Europe in the 1970s, which might be triggered by (b) fiscal dominance resulting from the policies of governments that Rudi Dornbusch labeled "populist", (c ) the perennial failure of financial markets to mobilize society's proper risk bearing capacity, plus (d) financial market regulatory capture. Were there other risks? Yes. East Asia in 1997-1998 showed us that there were. That crisis came as a huge surprise. But the lesson I drew from it was that things could only go badly wrong if a central bank failed to ensure that the banks and others it supervised did not borrow in a harder currency than the one it could create at will.

By the time of the Alan Greenspan retirement party in 2005 at Jackson Hole in August, not just me but a lot of people were feeling very confident. Yes, the financial system was subject to different kinds of market failures. Yes, there were lots of business models being tried that were probably not going to work. But central banks were able to stabilize nominal demand. Surely there was great value attached in trying to find ways to accomplish financial deepening and increase markets' risk-bearing capacity through experimentation with products like derivatives. And the more competition for the Morgan Stanleys, the JP Morgans, and the Goldman Sachses provided by the Citigroups and the Banks of America seemed to be a very healthy thing.

Only a small number of voices were saying: “Wait a minute! We don’t understand what we are getting into”.


Of these still small voices the most prominent, in August 2005 at Jackson Hole at least, was Raghu Rajan with his declaration that we were building much larger systemic risks that we did not understand than we thought we were. I won't say that it provoked a near-riot from the conference audience. I will say that, as I recall it at least, Alan Blinder was the only person who stood up to even half-defend Raghu, and Alan's defense took the form of musing about the extraordinarily convex compensation schemes of investment bankers and traders. We had gotten away from the partnership structure in which every partner of an investment bank, knowing that they are on the hook personally, jointly, and severally for the liabilities of the entire firm, is a risk manager. We had gotten away from the world in which every 30 year old knows they become rich only if they do a good job and their firm survives for the next 30 years, and hence is a risk manager. But in a world in which people are paid high cash bonuses based on their mark-to-model positions as of the previous December? But even Allan was cautious in his willingness to back Raghu.


The more canonical reaction was that of the brilliant and rich Arminio Fraga, who knows both how to be a central banker and how to be a portfolio manager. In his view, the system we had in 2005 was far superior to what had come before it, and was getting better all the time.


Then we had the housing bubble. Then we had the US financial crisis. Then we found ourselves with an extremely large slowdown in the growth of nominal spending below its pre-2007 path. Then we found we had a lack of traction on the part of North Atlantic central banks that would have been much happier if their policy tools could have returned the economy to its pre-2007 growth path, but found that they could not do so by normal or even by abnormal policies--at least the abnormal policies they were willing to risk.


And now we have the ongoing catastrophe that is the collapse of subsequent flattening of the employment-to-population ratio throughout the North Atlantic. The collapse was initially largest in the United States. But now Europe is catching up, and by the end of this year is likely to have surpassed the United States in the magnitude of the employment gap. And there is the major fear that a substantial chunk of those who lost their jobs and dropped out of the labor force over the past five years are not going to be coming back, with its implications for potential output and for the ability of governments to amortize their growing debts.

This last I find very disturbing. I did not think this kind of thing happened. I used to teach my students that the US economy had a very flexible labor market: the way to bet was that 40% of excess unemployed will get jobs in a year. Thus three years after a recession trough your employment gap will be down to 20% of its peak value, and after four years it will be down to 12%. But we are coming up on four years, and we haven’t closed 88% of the employment gap. We’ve closed zero. And we've closed zero, in spite of policies that look extraordinarily simulative among a number of dimensions.

That’s not something that I thought would happen.

Moreover, ten years ago I would have said that the debt capacity of even the most credit-worthy sovereigns was likely to be limited. Back in the early 1990s, when I was doing staff work for the Clinton administration-to-be and then the Clinton administration, I would have put the U.S.'s debt capacity at 50% of a year's GDP. Throughout the 1980s, whenever there was bad news about the size of the US deficit the dollar appreciated--people said: “Aha, this means that interest rates are going to be higher, here is a nice opportunity to reach for yield, so let’s buy dollars”. When a country nears its debt capacity that flips, and people say instead: "Bad news about the deficit means that this is a potentially unstable place that we we don’t want to invest in", and the vale of he dollar would drop. It seemed in the early 1990s that the United States government was on nearing this tipping point--thus the urgency the Clinton administration and the Greenspan Federal Reserve felt was at stake in getting the debt-to-annual-GDP ratio on a declining trajectory.

Back then, people said that the U.S. couldn't be approaching its debt capacity because the debt-to-annual GDP ratio had been much higher immediately after World War II. Our answer back then was that debt capacity had been artificially boosted by financial repression--Regulation Q, a Federal Reserve that in pre-Accord days viewed its task as keeping interest rates low, a world of narrow banking, etc. That world, we said then, wasn't the world that we were in, and was not a world we wanted to return to. The 1970s, we said, had made people aware of the risks of lending to the U.S. government in nominal terms. And the memory of the 1930s had ebbed. Both of these had reduced the U.S.'s debt capacity substantially.

Yet the past five years have taught us that US and German and British and Japanese government bonds are regarded by the market as extraordinarily safe places to put your money. This demand for them seems to outstrip any possible limit that 10 years ago I would have confidently placed on maximum demand for these securities.


Why is it that central banks have not been able to get traction to return nominal GDP growth to its pre-2007 path through their normal, or even their extraordinary, monetary policy tools? The natural place to start thinking is with the quantity theory of money, written in logs: lower-case price level p plus lower-case output y equals lower-case money stock m plus log velocity v that depends on the interest rate i, with "interest rate" here being broadly construed as including everything that strikes people as an opportunity cost of holding money balances:

p + y = m + v(i)

How is it that in this framework boosting m by an amount dm doesn’t boost nominal GDP? The answer has to be that when you boost the money stock. You are also doing something to interest rates, to the opportunity cost of holding money, and hence to velocity. m goes up. i and v go down. And so nothing happens.

Thus in order to make monetary expansion effective in a low-interest rate environment, you need to do something to keep the side effects of monetary expansion from lowering the opportunity costs of holding money. And the effects of the reductions in this opportunity cost i are truly extraordinary. If, ten years ago, you had told me that the Federal Reserve was going to take the high powered money stock of the United States from $700 billion in mid-2008 on up to $3 trillion by mid-2013 and say that it was going to keep raising it by $1.2 trillion a year as long as it felt like it, what would I have said in response? I would have said: is the Federal Reserve quadrupling the U.S. price level for some reason?

Karl Smith of the University of North Carolina has convinced me that to understand why the opportunity cost of holding money falls so much with monetary expansion these days, and reduces velocity so that monetary expansion has no or next-to-no traction on nominal GDP, we need to go from the money market over to the bond market to see what the bond market has to tell us about the joint determination of interest rates and output levels.


Smith takes a Stiglitzian perspective. Supply-and-demand for bonds are in balance when savings of the citizenry flowing into financial markets on the left hand side are equal to the willingness of financial intermediaries to accept newly-issued debt and other wealth instruments on the right hand side. If financial intermediaries aren’t willing to hold bonds and make loans, then interest rates are going to drop and you are going to find that your monetary expansion isn’t going to have any effects. So what are the determinants of financial intermediaries' willingness to enlarge their portfolios?

S(Y, Y-T) = FI(i, Δi, π, Q)

They are financial intermediaries' current nominal cost of funds i, beliefs about likely future changes in that cost of funds Δi, expected inflation π, and the quality of the loans they are making and the bonds they are holding measured relative to financial intermediaries' risk tolerance: call this Q, for loan quality. I was being a naive Hicksian, saying: how can expansionary fiscal policy not boost output Y when interest rates are at their zero lower bound? After all:

S(Y, Y-T) = I(r ) + (G-T).

Karl Smith pointed out to me that the standard Hicksian IS-LM framework assumed that when financial intermediaries bought newly-issued government bonds in amount G-T this did not use up any of their risk tolerance--that issuing more government bonds raised the average quality Q of the bonds and loans financial intermediaries were holding as assets. And, as he pointed out to me, in the case of Greece that was not true. An assumption smuggled into Hicks's 1937 framework--an assumption Hicks probably did not even know that he was making--is that government debt is by necessity debt of high quality, and thus that the government is not going to have any trouble placing its debt. That may well be false: we have seen that it can be false. And the question of whether issuing more government debt will raise average loan and bond quality is a question that is, I think, underthought.

Those of us who think not just that fiscal rebalancing should be postponed but that fiscal unbalancing should be extended for another year or two or three--until the employment-to-population ratio gets higher than it is--need to stop underthinking this question. Clearly at some point issuing additional debt will crack any borrower's status as a provider of safe high-quality assets. Ricardo Caballero will tell you that demand for safe high quality assets is absolutely through the roof, beyond the moon, and will stay so for the next generation bcause in 2007 private-sector investors were holding about $10 trillion of paper they regarded as AAA that had been created by investment banks and guaranteed by rating agencies but that no sane investor will ever regard anything created by an investment bank and rated by Moody’s or S&P as AAA ever again. That left a $10 trillion hole in people’s desired safe-asset portion of their portfolios which can only be filled by credit-worthy government and government guaranteed debt. Ricardo Caballero will say that filling this hold has to be an essential part of full macroeconomic rebalancing. That may be true. I’m inclined to think that probably is true. But that’s a set of considerations that we have to think about.


Behind everything, there are what I call the Stein-George-Feldstein worries. Banks need to make 3% per year nominal on assets or they report losses. For a banker to report a loss is a quick way for a banker to exit from his or her job. Therefore commercial banks are going to reach for yield so they can report operating profits this year. Esther George, Marty Feldstein, and Jeremy Stein say: banks are only able to report profits in this environment because they are somehow selling out-of-the-money puts, and we really do not want asset prices to move in such a way that reveals what puts they have been selling. If you are Marty Feldstein, you think there is a 20% chance of normalization of interest rates in the United States in each year looking forward, that because of large debt outstanding, the normalization of 10-year Treasury rates carries them not to 4% per year nominal but to 6%, which means that should normalization come that’s a 36% capital loss on bank and shadow bank holdings of 10-year Treasuries and other things of equivalent duration. Given underlying political currents it is not at all clear that the political support for a second rescue of the banking system anywhere exists in any North Atlantic democracy. Hence Stein, Feldstein, and George draw the conclusion that it is time to start raising interest rates so banks can get a wedge between the zero cost of funds from depositors and the amount of money they earned by holding safe medium term assets. Otherwise, they fear, we will soon face a financial crisis worse than 2008-9.


For those of us who want to see further fiscal unbalancing over the next several years, we have to explain why it is that we see a non-disastrous future following in the medium- and long-run from additional run ups in national debts. As a first cut, consider three scenarios: fiscal dominance, financial repression, and normalization to something very like the current macroeconomy as the new normal.

Fiscal dominance: Suppose that countries have political systems that will allow them to run primary surpluses as share of GDP of σ, but no more. Suppose that interest rates will normalize to r. Suppose the real growth rate of the economy is g over the long run. Call the nominal debt D, the price level P, and real GDP Y. Then the basic debt amortization equation is:

(r-g)(D/P) = σY

That means that the price level is going to be:

P = ((r-g)/σ))(D/Y)

If your r-g is relatively large, if your debt-to-annual-GDP D/Y is relatively high, and if your attainable primary surplus share σ is relatively small, then you have ordered a much higher price level and the market will get you there in short order after interest rates normalize, and the financial, fiscal, and economic chaos generated by this arrival of the long run in the form of fiscal dominance may be considerable and unpleasant. This was, in fact, the advice Keynes gave to the French government in the early 1920s when they asked him how they should halt their inflation. His response was: you can't. In such a situation of fiscal dominance, there is no escape from inflation. So that is scenario 1. And it is unpleasant.


Financial repression: It is possible to escape from fiscal dominance if you can find policies that keep the economy's interest rate on Treasury debt r at or less than its growth rate g. Then no primary surpluses are necessary. But how do you find people willing to hold all of the--large--amount of Treasury debt at an interest rate of only r

Thus financial repression is a second possible post-normalization scenario. However, it is also a place we would wish to avoid. It’s a first order distortion in the financial market. It’s a tax on savers. It's a tax on financial intermediation. It's a tax on financial deepening. And it is likely to be a bad tax--good taxes have broad bases and low rates, while bad taxes have narrow bases and high rates. The only thing good you can say about financial repression is that it may be an effective way of getting around the limits on the politically-attainable explicit primary surplus from taxation to the extent that its forms of seigniorage remain invisible to a political system that lacks financial sophistication. We really should not go there, and I would rather not go there. But Carmen at least thinks that is the way that the North Atlantic is heading, and the higher the debt with which we enter post-normalization financial repression the more painful it will be.

The new normal: The third scenario is that we escape both fiscal dominance and financial repression because the normalization of interest rates never comes--that Treasury rates stay low, lower than the growth rate of the economy, without requiring any great imposition of implicit-taxes-through-regulation on the financial market.

It was Philippe Weil who used to say that the equity-premium puzzle is really or is also a risk-free rate puzzle--that a high spread between stock and bond returns produces both high stock and low bond returns.

Since the end, in 1896 with the discovery of how to extract South Africa's gold, of the late-nineteenth century deflation, we have had a high equity premium. We used to attribute the high equity return premium to money illusion--that too-many investors did not understand that there was going to be inflation and that bond returns were nominal and stock returns were real. Then we attributed the equity premium to an unwarranted fear on the part of the investors that we would repeat the Great Depression. Then we attributed it to a shortage of patient capital. But, we thought, the memory of the Great Depression was ebbing and with it the extraordinary aversion to short-run stock market fluctuations it had generated, and financial deepening was broadening the ability to mobilize society's risk-bearing capacity, and the memory of the 1970s had disabused investors of the illusion that bonds were truly safe, and so the equity premium was ebbing. Olivier Blanchard wrote a very nice paper to that effect--was it 15 years ago? Very nice paper. From today’s perspective completely wrong.

The SN&500 is now yielding 7% per year real, at a time when short and medium treasuries are in minus 2%. That’s a 9% point annual return gap. I don’t know what people in the United States think that the labor share is going to rise and the profit share shrink with unemployment still above 7%. There does seem to be every sign that the big equity premium is back, and if anything bigger than ever. Perhaps we are in an r < g world.

That would put the credit-worthy reserve-currency-providing sovereigns of the North Atlantic in much the position of the medieval Medici bank. You don’t put your money in the Medici bank in order to earn interest. You put it there for it to be safe. So that in case the pope excommunicates you and you have to flee from Florence to Paris you’ll be able to get your money from the Medici bank there. Issuing debt then becomes a profit center for the government, rather than a drain. These thoughts lead to hopes that maybe we don't have to worry about a big conflict between our short-run goal of boosting employment and production and our long-run fears of somehow triggering fiscal dominance.


Maybe we can summon the confidence fairy: maybe cutting the deficit is the real expansionary policy because putting government finances on a clearly-sustainable track will raise banking sector perception of loan quality, both public and private. But that would seem to require that we see some action on long-term interest rates when we do cut the deficit, and we don't. You’d expect anything that discouraged private investments would reduce the valuation of old capital as well. But equity values seem to be recovering very well from their panic lows.


There is Greg Mankiw's hope that we really don’t have to worry about too-rapid a pace of fiscal consolidation because monetary policy pursued with sufficient expansionary and expansionary zeal can do the stabilization-policy job. Maybe we can get the real interest rate down further via monetary policy alone by summoning the inflation-expectations imp. But how does a central bank succeed in producing expectations that inflation will be only a little bit higher? As Ken Rugoff warned back in 1998, when Paul Krugman wrote his first liquidity track paper then about Japan, how do you push an economy and deflation from having inflation expectations of minus 1% up to inflation expectations of 4% without pushing them to expectations of 20% per year?


Paul’s rejoinder then was for Japan to target the value of the yen, but you can’t do that for the world as a whole.


If you are the 2009 vintage IMF, which believes in an open economy multiplier for a typical European country of 0.5, and a closed economy multiplier for the North Atlantic as a whole of 0.8, the risks of expansionary fiscal policy are not worth it even in the current interest rate environment. If you are today’s new model IMF, which says open economy multipliers for your typical European country are 1.5, which means the closed economy multiplier for the North Atlantic as a whole is 2.5, all of a sudden it is. The risks of triggering fiscal dominance have to be very large and immediate indeed to think that you can leave this policy tool on the table.

I’m sufficiently confused I don’t have much confidences in my priors. My priors seven years ago, were that Central Banks could push nominal GDP to whatever path they wanted through normal policy tools, and that the US economy at least would erase 40% of its unemployment gap in any one year.


With the exception of 1980-1985 the United States at least has typically been in an rg. The fact is that the people holding US Treasury bonds appear to be both a and risk-averse to an extraordinary degree--perhaps they are the combination of the central banks of the world plus the rich of emerging markets, all of whom are trying to insure themselves against various forms of political risk, who may well play the same role that Japan's inertial postal savers have played in the Japanese economy for the past twenty-five years. But I don’t pretend to understand Japan.

Last, let me refer to the paper that I wrote with Larry Summers last year--the one that tried to upset the entire problematic by saying that in fact the debt to GDP ratio has a denominator as well as a numerator. When you take account of how low interest rates are for credit-worthy sovereigns right now. If they stay credit for the sovereigns and if you take account of what plausible multipliers are. If you take a look back at what’s happening to labor force participation in the United States and elsewhere. It’s pretty difficult to say that what happens to the denominator is less important, than what happens to the numerator of the debt to GDP ratio.


Certainly Britain’s experience over the past now three years is not terribly heartening as to what even aggressive attempt to cut your deficit through policy will do in terms of reducing the anticipated long run burden of the debt. We wish that it had been otherwise. The question is: are there unusual things happening to Britain over the past three years that should keep us from taking Cameron-Osborne-Clegg as a horrible warning that cutting government purchases will in fact make debt burdens worse?

Suppose that interest rates do normalize, governments then take a look at the interest burden of supporting the government debt, and decide on financial repression under the pirate flag of "macroprudential regulation". Suppose they force investment and commercial banks to hold huge numbers of Treasuries, require public and private pension funds to do so as well, and so forth. What are the costs to the economy as a whole of such policies? Reinhart and Rogoff argue that there are significant growth costs to undertaking such financial repression policies even though they keep interest rates and inflation rates low.


The natural argument is then a technocrat one, a cost-benefit one. But we have, unfortunately, not been having that argument over Reinhart and Rogoff.

Here's one road to that argument. Suppose that the multiplier is 2.5. Spend an extra 10% of a year's GDP on a fiscal boost and we then have a short term boost to GDP of 25% of the year’s production now. That's a temporary gain. According to Reinhart and Rogoff there might be a long run permanent cost of 0.6% of a year's GDP, but some of that is due to reverse causation.


We never had that debate.

We had congressmen saying: “You mean there is a cliff at 90% and we dare not let the debt-to-annual-GDP ratio go that high?" We have people running around saying: "There is an error in their spreadsheet and so we don't have to worry about growth costs of debt burdens!" Neither of those is an intellectually edifying way to deal with the issue.

We do need estimates of what the costs of adopting post-WWII like debt management strategies afar normalization would be, and balancing them against the benefits of postponing fiscal consolidation.


And there is yet another issue. Last month Olivier Blanchard said that the technocratic calculation I am calling on people to make is a red herring because what we really should be worrying about are the "unknown unknowns" of debt accumulation--just as nobody understood the systemic risks produced by subprime. And "unknown unknowns" are, by definition, unknown.

So: My conclusion. I have very serious doubts about my ability to analyze the situation we are in. Whenever I cast myself back in time and think how confident I was ten years ago, and how wrong, my first response is maybe I should give up this business and stop pretending I have knowledge. Because certainly I would not have thought we would be here now.


The failure of Central Banks to have sufficient traction to push nominal GDP to the target paths where we all want it to be suggests that somehow monetary expansion needs to be more effective by some other policies that gain traction for it. Summoning the confidence fairy? Right now I make fun of the people who claim they know how to do so. But it is the case that credible fiscal contraction in the future is expansionary now precisely because it has effects on perceived likely future interest rates and future tax rates. To the extent that you have to do a deficit reduction down-payment now to make fiscal contraction in the future credible fiscal contraction now can be expansionary. That was the basis of Clinton administration economic policy in 1993 and 1994. And that seems to have worked relatively well. Summoning the confidence theory via fiscal contraction is not an obviously silly thing to do.

Another possible road to traction is to summon the inflation expectation imp--people’s expectations of the future price level change and the economy recovers. Neville Chamberlain, according to Nick Crafts, did this quite effectively when he was Chancellor of the Exchequer at the early 1930s. It is, indeed, only due to accidents of history and the unfortunate events in German politics Nevillel Chamberlain now as the person who failed to assemble the anti-Nazi coalition in the late 1930s and rank Churchill far above him. We might be sitting here regarding Neville Chamberlain as the wizard who pulled Britain out of the Great Depression in the early 1930s and scorning Winston Churchill as the person who caused the problem by overvaluing the pound in 1925.

It is unfair for Keynesians to be making fun of the people who call for austerity by saying "confidence fairy" when they are making similar expectational-shift arguments themselves.

There’s the possibility of gaining traction by improving banker perceptions of average loan quality/risk tolerance via expansionary fiscal policy, which succeeds too the extent that the sovereigns issuing the debt remain credit-worthy. But that can also be accomplished via loan guarantee programs. In the United States, the low hanging fruit, of course, is use of the GSEs to rebalance housing finance--but the fact that Tim Geithner did not replace Ed Demarco as head of the FHFA and choose somebody willing to use housing finance as a tool of macroeconomic policy closed that policy option off.

The aim is to try to give traction to expansionary monetary policy without pushing the economy over into the land of unpleasant fiscal dominance. One possibility is to take an end run around this entire problematic by following the DeLong and Summers (2012) line that interest rates are so absurdly low and the debt-to-annual-GDP ratio has a denominator as well as a numerator that there are not benefits and costs to fiscal expansion at the margin but rather benefits and benefits because spending more now produces a lower debt-to-annual-GDP ratio. I believe that many fewer people buy this argument than should. But even I have to admit that DeLong and Summers (2012) is not a consensus position. It is be a bridge too far for many central bankers and economists--although do note that each month that passes with falling US labor force participation and stagnant US employment-to-population ratios increases my confidence at least that DeLong and Summers (2012) is right.


If interest rates were to start to rise, governments are, as Reinhart and Sbrancia have convincingly documented, adept at using "macroprudential regulation" to keep their borrowing costs low. Thus there is a good equilibrium out there, an equilibrium which would support considerably more government debt than we have. In that equilibrium, markets recognize that postponement of fiscal consolidation or even additional fiscal expansion right now does not in fact run large additional risks of fiscal dominance over and above those that are already out there as a result of rising medical costs and the aging of North Atlantic populations. In that equilibrium markets do not blink at additional deficit spending as long as economies remain depressed.

But that markets should recognize this doesn’t mean that markets will recognize this. It doesn't mean that we know that markets won’t get scared of additional deficit spending and tip us over into fiscal dominance.

James Cayne had one billion writing on his belief that he had control over Bear Sterns's derivatives book. You could not have given anybody a larger incentive to gain control over Bear Sterns's derivatives book. The shareholders and directors of Bear Sterns gave James Cayne the right incentives--and look where that ended up.

And let me stop there.