StanCollender'sCapitalGainsandGames Washington, Wall Street and Everything in Between

Alan Greenspan v. Paul Krugman

18 Jun 2010
Posted by Edmund L. Andrews

Paul Krugman and Alan Greenspan came out with dueling op-eds Friday about budget deficits gone wild.  Krugman: we're slitting our wrists by trying to slash our deficits now.  Greenspan: cut spending now, right now, and don't worry your pretty little head about a double-dip recession.

Neither was convincing, and there's a reason: the fiscal debate has become so polarized that combatants on both sides are glossing over what they don't know.  I would argue that we ought to be doing the opposite: the unknowables right now are huge, and we ought to talk about them.  Put another way: we need insurance.  Against our next mistake.

Here's Greenspan:

(T)he fears of budget contraction inducing a renewed decline of economic activity are misplaced. The current spending momentum is so pressing that it is highly unlikely that any politically feasible fiscal constraint will unleash new deflationary forces. 

Watch out when Greenspan says something is "highly unlikely.''  That's what he said in October 2004 about the risk of a housing bubble and bust.

But the real problem is that Greenspan's one piece of empirical evidence about a looming panic over  deficits is incredibly thin.  He can't cite any flight from Treasuries, because yields are low and demand is strong across the board.  He can't point to inflation, which has been negative the past two months. And he sure can't cite evidence of an overheated economy.

So he cites a really obscure derivative indicator called the "swap spread'' on 10-year Treasuries, which he said recently plummeted to "an unprecedented negative 13 basis points." This, he writes sagely, is "the canary in the coalmine."

Don't know what he's talking about?  Neither did I.  But the swap spread is the difference between the yield on Treasuries and the "swap rate'' -- the fixed rate that investors demand when they're agreeing on a fixed/adjustable interest rate swap.   When the spread goes negative, investors are demanding that the Treasury pay higher rates upfront than they are getting on interest rate swaps.

But all that tells you, if it tells you anything, is investors expect interest rates to climb before long. Well, duh.  That's the Fed's official gameplan.   Pricing that assumption into swap spreads hardly makes them a sign of panic over government spending.   Greenspan is fear-mongering.

But Krugman isn't convincing either.  Writing from Berlin, he can't believe that those fusty German deficit hawks are so frightened of a market rebellion that they're cutting spending and raising taxes right now.   

What’s the economic logic behind the government’s moves? The answer, as far as I can tell, is that there isn’t any... Arguing with German deficit hawks feels more than a bit like arguing with U.S. Iraq hawks back in 2002: They know what they want to do, and every time you refute one argument, they just come up with another.

When the Germans fret about the "market reaction'' to unsustainable deficits, Krugman fumes: “But how do you know how the market will react? And anyway, why should the market be moved by policies that have almost no impact on the long-run fiscal position?”

But the German fiscal hawks aren't crazy.  The markets can panic, without much warning in advance, just as they did about Greece and to some extent the euro-zone itself.   No one knows where the tipping point between acceptance stops and panic kicks in.   But there's also no dispute that deficit and debt levels are in uncharted territory in the U.S. and in Europe.  Nobody knows whether they will get back to sustainable levels or how long it will take them.  Nobody knows what the bond markets' tolerance will be like, or how all the moving parts will interact with each other.  

If the mortgage meltdown taught us anything, it was how little anybody knew about the interplay between housing prices, bad mortgages, securitization, credit-default swaps and off-balance-sheet financing vehicles.   Not even the most prescient critics of the housing bubble like Robert Shiller or Dean Baker had any idea of how subprime mortgages would ripple through the global economy.

Today, we're still in utterly uncharted territory, and we're doing things we never imagined before.  So far, the results have been better than we dared hope.  But let's not fool ourselves about how smart we are.

We need insurance.  We need to plan for the possibility of getting our next move wrong.   I agree with Calculated Risk that Greenspan is flat wrong about the need to slam the brakes on spending right now.  But we need to recognize that there's a non-trival risk of a bond-market rebellion.  

On this point, look up Bruce Bartlett's very smart recent warnings on two points.  First, the U.S. is much vulnerable than most people think to a ratings downgrade on Treasuries, a move that would probably cause a long-term spike in interest rates  Second, that right-wing Republicans and Tea Partiers could in their ignorance trigger an actual default by refusing to approve an increase in the government's legal debt ceiling.

What would an insurance plan look like?  At a minimum, it would include a credible plan for reducing long-term deficits.  It would require targets for government spending and revenues. If I were king, the plan would allow for another round of stimulus spending but call for real belt-tightening around 2015.   It would include agreements to limit future entitlements, limit our military ambition, rein in health care costs and increase tax revenues. And it would include back-up options, triggers to shift policy in case the economy performs better or worse than expected.

Again, there are too many things that are unpredictable or unknowable.   Surprises are inevitable on the upside and the downside.   Instead of pretending we know it all, wouldn't it be better to plan based on a range of risks?







I don't understand why

it is so hard to differentiate between the short-term, medium-term and long-term. In the short term, we need (or at least needed) more fiscal stimulus than we got--I am convinced that fiscal contraction by the states essentially offset all the federal stimulus. I don' think we are going to have a double-dip recession like Krugman, Reich and DeLong worry about, but I do worry about a prolonged period of slow growth a la Japan. In the longer term we need fiscal consolidation--the structural deficit is clearly unsustainable. That leaves the medium term in which we need to continue stimulus but start to make commitments toward long-term consolidation. I don't think anyone on either side really rejects this analysis; it's all a question of timing and commitment. Why is it impossible to combine an increase in short run stimulus with long term consolidation? Perhaps this could be done on a present-value basis--long-term savings paying for short-run spending. This would get us away from the cash-flow accounting that seems at the heart of the current political impasse.

Why it is impossible...

I agree with your sentiments. However, there has been a large effort to fight taxation of the wealthy to spend money on domestic social programs (or on lowering unemployment for that matter). These wealthy special interests have made gains that they are not about to give up for the good of the overall economy. This is why they will not support more stimulus now. They don't care about unemployment. They don't care about GDP growth. They care mostly about their personal wealth in comparison to others, zero sum economics. Those who believe in zero sum are winning the fight over faster economic expansion.

I like that idea.

I like that idea. Theoretically, it has the problem that today's government may not be able to make credible commitments on behalf of future governments. But I regard that as more a feature than a bug. The commitments don't have to be credible to the market, as long as the future government actually follows through. If investors distrust the commitments, that is all the better, because it makes them more likely to invest in real assets that would better withstand the inflation the would likely result from a future government's failure to honor the commitment. In a time of inadequate aggregate demand, we want investors to invest in real assets.


A big part of the problem is that few people seem to differentiate between countercyclical deficits (which IMO are both necessary and largely inevitable) and long term structural deficits (which need to be controlled).

The lion's share of the current deficit falls in the former category and is mainly due to the precipitous drop in tax revenues that resulted from 3 consecutive quarters of massive GDP declines along with near 100% unemployment combined with one shot spending on TARP and ARRA (both of which were necessary to head off an even steeper economic decline).

If the unemployment situation reverses, much of the deficit problem will go away on its own. Long term we do need to reform the tax system to broaden the tax base, but that can wait another year or two. Much of the recent panic over the deficit is misplaced, and rushing thoughtlessly to address it by significantly cutting spending and raising taxes will likely only make the deficit worse (and harm the economic recovery).



If I accept your thesis that the bulk of the deficit is a combination of countercyclical spending and depressed tax revenues, wouldn't that imply that the deficit would return to lowish levels after the recession is over?

Given that OMB projects the recession to end this year (meaning 2 straight quarters of growth), can you help me understand why deficits sit between 4 and 5 percent of GDP for the entirety of the decade?

That does seem a bit inconsistent with your thesis doesn't it?


.....the OMB has a horrible track record at long term forecasting. This is partly due to unrealistic assumptions, and partly due to the fact that long term economic forecasting is extremely difficult in general and no one does it well. Let's not forget that in the late 1990's, the OMB was forecasting budget SURPLUSES out as far as the eye could see, and there was real worry that the Treasuries market would dry up as the national debt was paid down. Seems pretty silly in retrospect, as today's forecasts ten years from now almost certainly will as well.

And the fact

That the CBO has an even worse forecast from a deficit perspective is, I assume, because they are really bad at forecasting too. Oh, by the way, the error bars on their forecasts only run one way so their forecast error suggests it's going to be worse than forecast not better.

I'm glad we can count on your forecast however. If you would be so good as to publish it, it would be great to know why all is going to be well.

RueTheDay is missing some

RueTheDay is missing some important parts of the explanation here. It's not just about forecast accuracy. Cyclical deficits depend on where the economy is relative to its potential. During a deep recession, the economy moves far below its potential. The end of a recession doesn't necessarily immediately move the economy back any closer to its potential. It begins a slow process (and this time around, apparently a very slow process) whereby the economy, we hope, moves gradually toward its potential. Even the existence of a recovery is no guarantee that the economy will move toward its potential, though, because potential rises over time, due to a growing population and improving technology. So basically, in order to reduce the deficit, the recovery has to move faster than population and technology. Hopefully this will happen -- it always has in the past -- but it is expected to happen only very slowly, and the cyclical budget deficits along the way will continue to be large.

Another factor is the level of interest rates, which are expected to rise as the economy recovers. The government's interest payments are thus expected to rise, offsetting a most of the gradual improvement expected due to an improving economy. Indeed, the CBO projects the primary budget -- new revenues minus new spending -- to move into surplus in the middle of the decade, so ultimately the deficit will (according to projections) be all interest payments. If that situation could be maintained (but it won't, unfortunately, under current projections, largely because Medicare is projected to grow astronomically in the subsequent decades), then our creditors should be reassured, because they would, on net, be getting a little money out of the US government each year instead of putting more money in.

On the mark

Excellent commentary by Mr. Andrews, and follow-up comments as well.

But I wonder, who is giving advice to the deficit hawks in Congress to cut spending now? It surely appears that whomever they are listening to has no concern about driving unemployment past 10%. Society is fractured enough, but another year or two of continued high unemployment will only increase the acrimony we're currently seeing. Krugman mentioned the "50 little Hoovers" last year, the net effect of states making their own budget cuts which offset the federal stimulus, and we're seeing it happen right now.

It really is different this time. As Calculated Risk points out, housing will not lead the recovery for a long time due to the enormous housing inventory and high unemployment. And to top it off, another potentially enormous wave of Option Arm resets/recasts are beginning now that won't peak until late next year.

I don't know what the solution is, but we need some big ideas now. Yet our leaders appear either timid, content, or just completely misled by economists they choose to hear.

Germany is Different..

I was a bit confused by the Krugman piece. He has for years correctly diagnosed Europe's problem: monetary policy for all, fiscal policy for individual countries. Without the ability to coordinate monetary policy, there is a much higher probability of the markets turning on Germany if deficits get too high well before the US, since, technically, we can never default unless it becomes a political issue (i.e as Bartlett points out, crazy tea party folks).

It amazes anyone still allows Greenspan to appear in their op-ed pages. The Greenspan op-ed is more a reflection on the WSJ, and how useless and hyper partisan it has become.

Deficit Rhetoric

I don't believe the deficit hawk rhetoric is really about the deficit - it's a tool used to generate votes. It's all about what can be used to get re-elected, not what will have a material and positive impact on the country's finances.


It can be said of Prof. Krugman that he has forgotten more about economics than most people ever learn -- and that's precisely the problem. The only thing about economics he seems to have retained are the Keynesian superstitions.

swap spread

I think you're misunderstanding the swap spread (and I think Greenspan is also either misunderstanding it or contradicting himself). A negative swap spread doesn't tell you that people expect interest rates to rise, because rising interest rates are priced into both sides of the spread. (The rate that the fixed payer pays on a swap reflects the expectation of rising rates over the term of the swap, and so does the fixed rate that the Treasury pays on the 10-year note.) If the swap spread went negative whenever people expected interest rates to rise, then negative swap spreads would not be so rare. (AFAIK they are unprecedented.)

A negative swap spread means that investors are unusually eager to receive their fixed rate via the swap rather than receiving it from the Treasury (since they could always just borrow the money at the short-term rate and use the borrowed money to purchase a Treasury note, thus obtaining the equivalent of a near-zero swap spread). Actually, even if Greenspan were right that people are worried about Treasury interest rate risk, it would still be surprising to find a negative swap spread, because it seems to imply that investors think the Treasury's payment stream is even less reliable than that of their swap counterparty, which would imply a ridiculously high (i.e. measurably different from zero) risk of default on the part of the Treasury (especially since Greenspan acknowledges that the Treasury cannot actually default).

Nemo at Self-evident has a better explanation for the negative spreads that were actually observed. Essentially, when I said in the last paragraph, "...they could always just borrow the money at the short-term rate," I was making an assumption that isn't true. We learned in 2008 that even highly creditworthy borrowers sometimes find it impossible to borrow. Theoretically, this should be reflected in a prohibitively high jump in the interest rate (LIBOR, the relevant rate for the swap), but it turns out that (contrary to what people believed before September 2008) the reported LIBOR doesn't necessarily reflect a rate at which banks can actually borrow, so the reported rate doesn't necessarily jump prohibitively at times when banks' source of funding dries up. So, Nemo hypothesizes, they are sometimes willing to accept a fixed rate less than the 10-year Treasury rate, in order to protect their ability to borrow at the reported LIBOR, since that's the rate that they are agreeing to pay on the swap.

Interestingly, this tends to suggest the opposite of what both you and Greenspan interpret the inverted swap spread to mean. Investors pay floating on swaps specifically because they don't expect interest rates to rise too much. Think about it this way: right now, long-term rates (10-year Treasury) are much higher than short-term rates (LIBOR), so you can make a lot of money by borrowing at LIBOR and investing the proceeds in 10-year Treasuries. But the risk is that short-term rates will rise too much, and you'll end up losing money. Only if you think this risk is acceptably low will you engage in that transaction. Or you can do the same thing by paying floating on a swap (which you may choose to do instead so as to avoid the possibility of someday being unable to refinance). But if the swap spread is negative, your return is lower, so the risk of rising interest rates has to be even lower to justify the transaction. So a negative swap spread means that investors are particularly confident that short-term rates are not going to rise to a level that will put them in the red.

In my last paragraph above,

In my last paragraph above, the implicit assumption is that swaps market participants are more sensitive to changes in the anticipated distribution of possible paths of interest rates than are Treasury market participants. Now that I think about it, that assumption contradicts what I said in the first paragraph about the same rates being priced into both sides of the spread. Nonetheless, I would guess (thought there are others who could make a better guess than I) that the assumption is true to some extent, based on my impression that the swaps market contains a lot of unhedged floating-payers, who will need to be very sensitive to changes in their risk-return profile, whereas I imagine the Treasury market as being dominated by those who are serving the needs of investors who are taking less risk and are therefore less sensitive to such changes.

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