5/31/10 5:49 PMMorning Bulletin: The Group of 30 Has Lost Its Collective Mind... - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchMay 28, 2010

Morning Bulletin: The Group of 30 Has Lost Its Collective Mind...

Paul Krugman blogs:

Martin Wolf Is Not A Serious Person : And neither am I. Wolf writes:

I have now lost faith in the view that giving the markets what we think they may want in future – even though theyshow little sign of insisting on it now – should be the ruling idea in policy.

Amen. Yet most of the men in the room where I’m now sitting believe the contrary. With a few exceptions, everyone iscalling for fiscal austerity everywhere, right now.

Awesome.

As Ricardo Caballero says, the big problem right now is that the world economy has too little safe high-quality financial assets,and thus excess demand for them is, by Walras's Law, producing excess supply of goods and services:

It’s the general equilibrium, stupid: [T]he fundamental problem... is a shortage of safe “AAA” assets. The world seems toneed more US Treasury-like instruments than are available.... The demand for these assets has expanded as a result of thefear triggered by the crisis.... But this time the private sector industry created to supply these safe assets – thesecuritisation and complex-assets production industry – is severely damaged. Much of what we see that confuses us todayis the equilibrium consequence of living in an environment with this shortage. There is enormous asset price volatility,especially as assets transit out of the safe assets category... the recent difficulties in the Eurozone can be seen in this light,with Greece and others dropping from the potential safe-asset producers list. This shortage also leads to chronically lowsafe real interest rates.... These however, are the consequences, not the source. The US Congress and the Bank forInternational Settlements’ knee-jerk reactions are (mostly) bound to reallocate the malady, rather than cure it.... [A] moreeffective goal would be to focus on expanding the real supply of AAA assets... two basic ways of achieving this in the shortrun... governments in safe-asset-producing countries [could] produce a lot more of them [by running fiscal deficits]... theprivate sector create the AAA assets and for the governments (at a fair price) to absorb only that part of the risk the privatesector cannot handle.... [F]unding fiscal deficits is very inexpensive these days... as long as one remains within the safe-asset-producer category...

In short, expansionary fiscal policy (credit-worthy governments print up a huge honking tranche of AAA assets, and then use themoney to buy goods and services) or expansionary monetary policy (credit-worthy central banks take on duration and interestrate risk by buying securities for cash, and by increasing the money stock increase the supply of the most AAA of AAA assets) orexpansionary banking policy (Treasuries and central banks turn leaden risky assets into golden safe ones by offering guaranteesof one sort or another). The hope is that, by Walras's Law which tells us that excess demands across all markets must sum tozero, that relieving excess demand for AAA assets will produce as a consequence the relief of excess supply and full-employmentbalance in the markets for goods, services, and labor as well.

This is the line of policy that was recommended by John Stuart Mill in the aftermath of the very first industrial business cycle--the 1825 crash of Britain's canal bubble:

John Stuart Mill: It must, undoubtedly, be admitted that there cannot be an excess [supply] of all other commodities, andan excess [supply] of [AAA assets] at the same time. But those who have, at periods such as we have described, affirmedthat there was an excess of all commodities, never pretended that [AAA assets] was one of these commodities; they heldthat there was not an excess, but a deficiency of [AAA assets]. What they called a general superabundance, was not asuperabundance of commodities relatively to commodities, but a superabundance of all commodities relatively to [AAAassets]. What it amounted to was, that persons in general, at that particular time, from a general expectation of being calledupon to meet sudden demands, liked better to possess [AAA assets] than any other commodity. [AAA assets],consequently, was in request, and all other commodities were in comparative disrepute. In extreme cases, [AAA assets] iscollected in masses, and hoarded; in the milder cases, people merely defer parting with their [AAA assets], or coming under

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collected in masses, and hoarded; in the milder cases, people merely defer parting with their [AAA assets], or coming underany new engagements to part with it. But the result is, that all commodities fall in price, or become unsaleable...

And that had in fact been carried out by the Bank of England in 1825-1826. Let me turn the microphone over to WalterBagehot:

The way in which the panic of 1825 was stopped by advancing money has been described in so broad and graphic a way thatthe passage has become classical. 'We lent it,' said Mr. Harman... [one of the Directors] of the Bank of England:

by every possible means and in modes we had never adopted before; we took in stock on security, we purchasedExchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on thedeposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of theBank, and we were not on some occasions over-nice. Seeing the dreadful state in which the public were, we renderedevery assistance in our power...

This is the line of policy that, broadly, the world has been following since the subprime crash started in mid-2007 and excessdemand for AAA assets first became grossly apparent. And this is the line of policy that the Group of 30 now wishes to reverse--without putting anything in its place.

Now it is certainly the case that the government budget constraint holds in the long run--that governments cannot keeprunning deficits and raising their debt and taking on tail risk forever without cracking the AAA status of their own debt and sonot relieving but instead aggravating the excess demand for AAA assets which is the Walras's Law balancing entry to excesssupply in the markets for goods and services and high unemployment. As Ricardo writes:

[W]ere we to continue along this path, at some point it will make sense to decouple fiscal deficits from asset production--lest we find ourselves cast in an epic Greek tragedy. The US Treasury would have to start buying riskier private assetsrather than running fiscal deficits as the counterpart for its supply of Treasuries.... [In the medium term] the second,private-public approach is probably... sounder.... The private sector is much more efficient than the government inproducing micro-AAA assets, but the opposite is true for macro-AAA asset production. Issuing public debt leaves thegovernment in charge of bundling and producing both the micro- and the macro-AAA assets. Instead, if the governmentonly provides an explicit insurance against systemic events... we could have a significant expansion in the supply of safeassets without the corresponding expansion of public debt...

But we are extremely far from cracking the U.S. government's status as the supplier of AAA assets to the global economy rightnow. When we see signs that further issues of Treasury bonds or loan guarantees by the U.S. government are starting to erodethe AAA status of U.S. government debt, then will be the time to back off of expansionary U.S. fiscal, monetary, and bankingpolicy. Then--not now.

Brad DeLong on May 28, 2010 at 10:06 AM in Economics, Economics: Macro | Permalink

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Neal said...(quote)

U.S. Debt Shock May Hit In 2018, Maybe As Soon As 2013: Moody's

By JED GRAHAM, INVESTOR'S BUSINESS DAILY Posted 05/05/2010 07:56 PM ET

....The great uncertainty about how much debt is too much has tended to make fiscal discipline seem less urgent, rather thanmore. There is no obvious threshold beyond which investors will demand higher real yields for holding U.S. debt. Vaguewarnings from ratings agencies about the loss of America's 'AAA' status haven't added much clarity — until recently.

In the wake of the financial crisis and recession, Moody's Investors Service has brought new transparency to its sovereignratings analysis — so much so that 2018 lights up as the year the U.S. could be in line for a downgrade if Congressional BudgetOffice projections hold.

The key data point in Moody's view is the size of federal interest payments on the public debt as a percentage of tax revenue. Forthe U.S., debt service of 18%-20% of federal revenue is the outer limit of AAA-territory, Moody's managing director PierreCailleteau confirmed in an e-mail.

Under the Obama budget, interest would top 18% of revenue in 2018 and 20% in 2020, CBO projects.

But under more adverse scenarios than the CBO considered, including higher interest rates, Moody's projects that debt servicecould hit 22.4% of revenue by 2013....

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could hit 22.4% of revenue by 2013....

(end quote)

The clock is ticking.

Now is the time to get things moving. Wait and see is not an option. Get a plan--act on it.

Reply May 28, 2010 at 10:27 AMJohn Howard Brown said...As others have noted, no one involved in making policy knows anyone who is unemployed, or even knows anyone who knowssomeone who is unemployed. There appear to be a LOT more than six degrees of separation between policy makers and thosewho are suffering due to the Great Recession. The only solution is to make a lot of policy makers unemployed. This is not veryappealing in the US at least since the alternative is the wing-nut and Teabagger dominated Republican party whose policy viewsare even more absurd. (That's a very kind characterization.)

Reply May 28, 2010 at 10:58 AMPithlord said...Noah's fire department.

PS. Sorry to be pedantic, but 1844 (when Mill wrote those words, mutatis mutandis) is hardly the aftermath of a crisis 18 yearsearlier.

Reply May 28, 2010 at 11:01 AMBrad DeLong said in reply to Pithlord...I think he actually wrote the piece around 1830 or so, but kept it in his desk drawer until 1844...

I may be wrong, however..,

Yours,

Brad DeLong

Reply May 28, 2010 at 11:03 AMJeff V said...Quick question;

Why didn't high unemployement hold down inflation in the 70's; i.e., how did we get stagflation back then?

I assume the answer would be something along the lines of it being a different kind of recession, i.e., not driven by bank runs,but that is just a guess - I really don't know...

- Jeff V

Reply May 28, 2010 at 11:28 AMAnon said...I don't know any group of individuals that understands the future well enough to create safe assets.

Reply May 28, 2010 at 11:43 AMcsissoko said...There is a very serious problem with replacing JS Mill's use of the word 'money' with 'AAA assets' in the quote. It is precisely thefailure of the economics profession to deal with both the similarity and the differences between money and assets that got us towhere we are today (i.e. the decision to put finance and monetary economics into separate disciplines). Obfuscating thedifferences between the two is not going to help.

On the other hand, carefully setting out why you think your substitution is okay and why the differences don't matter so much inthis case, might help.

Reply May 28, 2010 at 11:57 AMA said in reply to Jeff V..."in the 70's..." we had the oil price shocks. And also a Federal Reserve denouncing government deficits (before Regan, who couldmaintain his 'fiscal responsibility' posture while amassing huge deficits [by that time's standard], and thus bring about, byKeynesian deficit spending, a 'Morning in America').

Reply May 28, 2010 at 12:17 PMMaynard Handley said...So let me get this straight. There is a demand for AAA assets, a demand that "the government" should fulfill.

How much is this demand worth to those who demand it (which does NOT include me, the homeless guy on the street, and95%+ of the US electorate)?Because I, for one, am pretty fscking pissed off at hearing how terrible it is that the government "steal" the income of the richand in return offer them so little. It might be nice to have an actual dollar value tied to this little favor being done to the rich thistime round.

We had an episode a year or two ago --- remember that? --- when some of us pointed out that it might be worth the non-plutocracy getting what THEY wanted (decent finreg including, eg, transaction taxes, leverage caps, and a new personal taxationmodel for those in finance). But no, we were told, more important to give the rich what they wanted and, in gratitude, theywould surely give us what we wanted after the crisis has passed. Well we all know how that turned out. Yesterday we getcongress telling us that hedge fund billionaires do such a fine job of steering our economy that we need to give them apreferential tax rate.

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preferential tax rate.

I'm sorry, but now ANYONE whose response to any economic crisis starts with "let's FIRST rescue the plutocracy and THENwe'll rewrite the legislation" rather than the reverse order strikes me as not serious.

Reply May 28, 2010 at 12:48 PMrobert said...The fact that there is a shortage of safe AAA assets doesn't help if by issuing more of these assets, they start to lose their AAAstatus.

Reply May 28, 2010 at 12:53 PMBrad DeLong said in reply to robert...Robert Horrocks wrote: The fact that there is a shortage of safe AAAassets doesnt help if by issuing more of these assets, they start tolose their AAA status.

Indeed.

But unless and until that happens, and the long run in which thegovernment budget constraint binds tightly arrives suddenly, you canput a lot more people to work making useful stuff...

Reply May 28, 2010 at 01:51 PMOmega Centauri said...Brad, shouldn't the concern be what will happen if we do happen to approach the limit? Will we be able to make a seemlesstransition to better finances? Or will we suffer an American version of the current Europanic? I'm not reassured that wecollectively will be able to identify the signs in time, that wasn't the experience with private debt, or real estate bubbles. It isn'tthe case with impending peakoil problems. When the decision to see the looming problem involves politics, it seems thatdenialism wins the day.

Reply May 28, 2010 at 03:47 PMcsissoko said...You set me off on a role: http://bit.ly/cfX7Zl.

Reply May 28, 2010 at 05:11 PMBen Ross said...When you've got us back in 1825, please don't say "As Ricardo writes..."

Reply May 28, 2010 at 05:13 PMmalcolm said...I am confused by terminology. Is the bond market in equilibrium? If the bond market is in equilibrium, then there is no excessdemand which Walras law suggests should be matched by an excess supply. The rhetoric is clever...but is it empty?

Reply May 28, 2010 at 11:28 PMGA said...So far as I can tell, there is very little discussion now of the nature of the government deficit, and tilting it towards investment.When the first stimulus was enacted, the key phrase was 'shovel ready' projects. It is an embarrassment that the last 18 monthsor so have not been used to prepare the pipeline of investment projects.

Government spending is always treated as an outright expenditure - but there are government expenses (bridges, airports,roads, water plants, sewage plants, government buildings, schools, hospitals, some types of power plants, etc) that are reallyinvestments. Older stuff needs to be replaced, newer stuff will need to be built in a few years.

It's a no-brainer to move government's investment/replacement forward to now. To the extent some of this can be replacementof less efficient stuff with more efficient, it may even reduce some longer-term expenditures.

Many/most of these investments would be made in future years, and hence the path to future deficit reduction - we stopbuilding new stuff - would be clear to the Masters of the Bond Universe. Maybe even Moody's would get it.

And yes, in some cases it will result in somewhat less efficient outcomes - refurbishment of an airport before it would otherwisebe necessary, replacement of cooling unit 'A' with today's technology when A-prime technology is about to come out - but thishas to be measured against tax and employment losses/expenditures now.

I repeat: it is an embarrassment that the last year has not been used to prepare and identify projects that could be shovel-readytoday. And that the polity is not discussing this.

There is room for investment in different stuff than monster houses.

Reply May 28, 2010 at 11:56 PMNicholas Gruen said...Yes, I got confused by references to 'Ricardo'.

Reply May 29, 2010 at 08:02 AMOrganicGeorge said...Basically it was the oil shocks of the 70's, price of oil skyrocketed overnight, economy went into the tank but the higher oil pricestriggered inflation.

There was a lot more economic factors that just the oil prices for stagflation, however the spike in oil served as the catalyst.

Reply May 29, 2010 at 08:39 AM

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Nick Rowe said...I think Walras' Law is wrong (or, at the very least, highly misleading). It's wrong because: it ignores monetary exchange, and soonly speaks of one excess demand for money; it ignores the effect of quantity constraints in disequilibrium.

For example, suppose rent controls create a permanent excess demand for apartments. Does that mean there must be an equalexcess supply for other goods? No. Unable to rent extra apartments with their income, people re-compute their optimalexpenditure plans, taking that additional constraint into account, as well as their budget constraint, and spend their income onsomething else instead. In other words, there may be a "notional" excess supply of other goods, but not a "constrained" excesssupply of other goods (Clower/Barro/Grossman, etc.). The apartment market has an excess demand for apartments matched byan excess supply of money; all other markets can be in equilibrium. Walras' Law only includes one excess demand/supply formoney. But in a monetary exchange economy, there are as many excess demands/supplies for money as there are non-moneygoods.

For "apartments" read "bonds" instead. If the argument doesn't work for apartments, it shouldn't work for bonds either.

The excess demand for bonds/apartments will only create a general glut of other goods if it spills over into an excess demand formoney. Money (as medium of exchange) is special. There are always two ways for an individual to satisfy an excess demand formoney: sell more stuff; buy less stuff. In a general glut, individuals cannot sell more stuff; but they can buy less stuff. That'sbecause the short side of the market determines quantity exchanged. So each individual tries to get hold of more money bybuying less stuff. Each individual can succeed, but in aggregate they fail (given fixed total supply of money). The "Paradox ofThrift" is really a Paradox of Hoarding. Thrift alone (excess demand for bonds) cannot cause a general glut. Hoarding (excessdemand for the medium of exchange) can.

Reply May 29, 2010 at 10:53 AMBernard said...it just seems to me that looking at the short term vs the long term is what the focus needs to be about. in the short term weneed to rebuild American infrastructure. since Government is the only "mover" capable of doing this, due to the vast sums ofmoney and projects involved, this would be a short term investment with a long term future. re-investing would employ moreAmericans who would spend and increase tax revenues, which could be used to pay down the long term and present deficit. but politics always gets in the way of fiscal reality, now that the Rich own America. i doubt we shall see any sense of investment,long or short term anytime soon, until the bubble of the Corporatist Congress/Military/Industrial complex. and being anEmpire the focus will remain with those that have the power. stupid as most wars are, we will bankrupt ourselves, not the richthought, and then we will have a chance to start anew.

until then, all this dialogue is empty rhetoric

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Galbraith: The danger posed by the deficit 'is zero'Washington Post (blog) - May 12, 2010... as demonstrated by both economic history and public knowledge of Ben'sopposition to higher inflation rats(google Brad DeLong and 3% inflation target). ...Related Articles » « Previous Next »

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