You Know We're Good For It

As more facts, figures and graphs emerge from the organizations that both to compile such things, here's a bit more detail on what shouldn't really be called the "Krugman-Ferguson Debate," but for the sake of simplicity will be called that anyway.

Essentially the argument boils down to this: we're in a nasty recession and the government wants to spent a lot of money to make the recession a little bit less nasty. At the same time, the government already owes a lot of people a lot of money. Recently, interest rates on government debt have gone up a bit. So, as Martin Wolf summarizes:

Prof Ferguson made three propositions: first, the recent rise in US government bond rates shows that the bond market is “quailing” before the government’s huge issuance [i.e. those who buy and sell government debt are worried that all these fresh IOUs aren't going to find enough reciprocal lenders willing to pony up, which would push up interest rates and push down bond values, so as a self-fulfilling collective response, bond-traders are hesitant to buy up the new debt, worried that these investments would devalue]; second, huge fiscal deficits are both unnecessary and counterproductive [i.e. since U.S. government debt securities sit at the center of the world bond market, any increase in U.S. treasury rates ripple throughout the economy. Higher rates across the board make it harder for businesses to expand, home-owners to refinance and, in short, for the economy to recover]; and, finally, there is reason to fear an inflationary outcome [First, because all the government spending will push more money into circulation which is by definition inflationary and second, because when bond-holders start selling U.S. government debt and buying the debt of other countries, they are selling U.S. dollars and buying foreign dollars, which devalues the dollar, and pushes up the prices of imports and most commodities in general]. These are widely held views. Are they right? (Source: FT)

Martin Wolf says "No." So does Paul Krugman. And Brad Delong. And Brad Setser.

First, the concern that all this public deficit spending is pushing up on our overall deficit levels. Not to worry, says Setser, and he has the graph to prove it.

In fact, according to Setser, the increase in government largess is more than offset by the decrease in private debt. In other words, companies are continuing to "deleverage" and households continue to be "responsible" faster than the Treasury can issue its securities.

Of course, the simple fact that we're only borrowing slightly less than last year isn't necessarily encouraging. This is especially true if many of our foreign friends are loosing their appetite for our collective dead-beatishness. Are they? Setser says:

Foreign demand for Treasuries — as we have discussed extensively — hasn’t disappeared, unlike foreign demand for other kinds of US debt. But foreign demand hasn’t increased at the same pace as the Treasury’s need to place debt. The gap was filled largely by a rise in demand for Treasuries from US households. (Source: CFR)

Which is where Krugman comes in. According to him, it would be one thing if China and Friends were becoming less willing to lend and U.S. households were saving at 2006 levels (the technical term is "zilch"). But that isn't the case. U.S. households are suddenly, frantically saving a lot. That's kind of the key reason for this whole recession thing. So we have a lot more saving than usual and, because borrowing has decreased so severely, less private demand for it. Filling in that gap is Uncle Sam.

This is not to say that chronic deficit spending is something to shrug off, nor is it to say that we shouldn't start planning to slow things down once private borrowing starts to pick back up. But the idea that the recent increase (though by historical standards, it's really a normalization) or interest rates is a text-book case of "crowding out" is pretty questionable.

Martin Wolf again:

The jump in bond rates is a desirable normalisation after a panic. Investors rushed into the dollar and government bonds. Now they are rushing out again. Welcome to the giddy world of financial markets.

Which is to say that, yes, investors are becoming somewhat less willing to lend to the U.S. government, but this is relative to late 2008, the height of the financial panic, when, seeing potential default and economic demise in every stock, commodity, derivative and commercial bond, every Tom, Dick and Mutual Fund was suddenly willing to take close to nothing in return just as long as their cash was held by the most reliable borrower there is.

There could of course be some considerable undershooting in the bond market, since that market is only as saavy as its participants. If everyone starts to freak out about inflation and devaluation, rates could keep climbing. But if that is the case, I would imagine that the Fed will keep buying up Treasury bonds to keep rates low and wait until investors remember how high the unemployment figures really are.

Numb to the Stimulus?

The most common and predictable argument levied against the stimulus (against any stimulus really) is that increased government spending is immediately offset by a proportional decrease in private spending and investment. Here's how the hypothetical "crowding-out" scenario goes:

Step 1: the enlightened representatives of the public interest recognize that the economy is dire need of some of well-honed and intelligently crafted fiscal stimulus and sign the corresponding bill in good faith

Step 2: the Treasury Department (or some such ministry depending on the country) raises the funds prescribed by bill by either a) drawing on current tax revenue or b) borrowing money

Step 3: Since we're talking about the U.S. government, which is already in a serious amount of debt, obvious choice "b" is selected; the mechanism for borrowing the selling of bonds, pieces of paper that investors "buy" for a certain price in exchange for a corresponding rate of return. Note that while the Treasury department is "selling" these treasury bonds--the terminology of "buying" and "selling" maybe implies the exchange of an ordinary good, the bonds are simply i.o.u.s; when the Treasury Department "sells" new bonds, it is only selling future, higher payments for current payments (another word for borrowing money at interest)

Step 4: the increase in the supply of tradeable treasury bonds pushes down the market price for these bonds. If a bond is said to pay $1000 in 6 months, a fall in the price of the bond from $900 to $800 is effectively an increase in the rate of return on that bond from 11% to 25% (this is hypotethical; these yields are insanely high). Therefore you can think of the price of a bond being inversely related to the yield on that bond; when bond prices go up, yields go down, and when bond prices go down, yields go up. Therefore, if a flood of treasury bonds causes the price of various treasury bonds to drop, the yield rises. Likewise, this trend might be amplied by the concern of investors. If the U.S. government is spending more money there may be a) fears of inflation in the future which would mean that future bond yields will be worth less or b) fears of default. In both cases, this makes investors in the treasury bond market less willing to purchase bonds at the going price. Therefore, this decline in quantity demanded for treasury bonds pushes prices lower and thus yields higher.

Step 5: Higher treasury bond yields reverberate throughout the economy. Since lending money to the U.S. government is seen as about the most riskless investment activity there is, a higher yield in the treasury bond market pushes up interest rates throughout the economy. Think about it with the following example: Sol Bank can lend out $100,000 at a rate of 6% to Dave the home buyer for 15 years, or he can invest in Treasury Bonds at a rate of 4% over the same period. Depending on whether Sol wants to take the risk with Dave for the higher return or not, he will make his choice accordingly. But if interest rates on Treasury Bonds rise from 4% to 6%, the choice for Sol Bank is pretty obvious; don't lend to Dave, lend to Uncle Sam. If thousands of bankers (and equity investors and bond investors) are making similar calculations about the tradeoffs between higher rates or less risk, higher rates for treasury bonds will drive money away from mortgage and other commercial loans (and the stock market and the private bond market), and towards the treasury bond market. This decline in available funds for the private lending sector will cause interest rates throughout to increase (if there is less money available to lend to Dave and Sol can just invest in U.S. bonds, Sol Bank is only going to lend to Dave at a higher interest rate.

Step 6: Higher interest rates throughout the economy mean, among other things, less consumption of homes and other high value durable goods, less lending to private companies, less stock market activity, and less investment. Also, the increased interest rates will cause foreign investors to hold less foreign bonds and more U.S. assets; being denominated in U.S. currency, this will cause the U.S. dollar to appreciate, making our exports less attractive. The over all effect then is negative and, according the "crowding out" argument, sufficient to completely negate the effect of the stimulus. Except that now the government is in more debt.

Summarized somewhat more concisely:

Unprecedented deficits to fund stimulus and bailouts means flooding the market with Treasuries to raise funds. Flood the market with Treasuries and you get higher interest rates.* Higher interest rates means asset prices get hammered more than they already have been. Knock asset prices down any more and already tattered household and corporate balance sheets will simply get obliterated.

In other words, massive “stimulus”—or more precisely massive government borrowing—could be the very thing that turns this deep recession into a nasty depression. (Source: Option ARMageddon)

Some economists, even left-of-center ones, find the above argument fairly presuasive (particularly given the current U.S. public deficit, the size of which, it is assumed, will make private investors that much more reluctant and risk-averse when it comes to lending the government more). Of course, we can all take refuge in the fact that this, like all else that currently ails America, can be blamed on Bush:

Everything would be different if we had spent the last 8 years preserving the budget surpluses that Bill Clinton bequeathed to George Bush. Then we would have paid down a big share of the national debt by now, instead of doubling it. We would be in a strong enough fiscal position to undertake the expansion today that we really need. (Source: Jeff Frankel)

But then, there are also those (and based on the support which the stimulus recieved, I'd say a less hysterical majority) who aren't really buying the standard talking point:

Crowding-out is real. Is it likely to happen? Well, if it were going to happen we would have seen the interest rates on U.S. long-term government bonds spiking upwards to scarily-high levels as the stimulus bill moves through the congress and its chances of final passage grow. Did we? No. (Source: Brad DeLong)

I'm not sure how convinced I am by this. Just because the bond market doesn't react based on future expectations of higher inflation, increased default possibility or a future decline in stock prices, does not mean that the expectations expressed by the market are correct. Financial markets are notorioiusly "inefficient" in this respect (see the Dot Com bubble); afraid of lending to the private sector, of investing in the stock market, of doing just about anything else with their money, high levels of panicked demand for (safe) treasury bonds may be keeping prices artificially high. That demand might very well subside in the future.

But then again, numbers are numbers:

But even if central banks bought about $700 billion of US treasuries in 2008, private investors also increased their holdings of Treasuries by over $1 trillion. In a year. That too is a record.

Some of those Treasuries were used to fund the Fed’s crisis lending, some funded the TARP and some funded the fiscal deficit. But in some sense it doesn’t matter. The market absorbed that huge increase in stock – and Treasuries even rallied in the process.

Facts are facts. The US has already proved it can raise over $1.5 trillion in a single year … without pushing yields up.

Therefore, despite a huge and sudden increase in the U.S. projected deficit, Treasury bond prices proved relatively resiliant. And in respond to my speculation that the financial crisis may soon subside, leading flighty investors to venture away from the warm and bountiful bosum of the American government, don't worry, say's Brad Setser: fear is here to stay.

The financial crisis should subside this year. The US government isn’t going to let a big bank fail. But the financial crisis has turned into a severe economic crisis. Consumption is falling in the US and globally; investment is tumbling. That frees up funds for the Treasury market. (Source: Brad Setser)

Update: A more substantial criticism:

Richard Kahn had argued in his famous 1931 article that an increase in the fiscal
deficit, far from "crowding out" private investment (we ignore net capital exports), generated through a
"multiplier" process, at any given interest rate, a larger output and employment
in the economy, such that private savings at this larger output exceeds private
investment by an amount exactly equal to the fiscal deficit. Indeed, private
investment is likely to increase within this period itself, or in subsequent
periods, on account of the larger output, in which case we have "crowding in"
rather than "crowding out". (Source: Amit Bhaduri)

To summarize: even if fiscal spending does increase interest rates, that same spending will also (hopefully) increase aggregate demand, employment and overall income. If we then assume that the amount of money saved through an economy is partially, perhaps heavily dependent upon total income, then the fiscal boost will increase the amount of savings and therefore loanable funds which may help to bring interest rates back down and to stimulate the private investment that so many predicted was about to be crowded out.