Alan Greenspan v. Paul Krugman
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.
(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?