Thursday, June 9, 2011
Some Comments on Paul Krugman and Monetary and Fiscal Stimulus
In a June 3 post, Paul Krugman points out that those who have argued that the current large budget deficits would result in an increase in interest rates even with the high unemployment have been wrong. He demonstrates this with a graph of the Treasury 10-year constant maturity yield (nominal) and, in a subsequent post, the 5- and 10-year real yields of Treasury Inflation- Protected Securities ("TIPS").
Paul Krugman is, of course, correct. His comment about those who, so far, have been wrong: "The apologists offer a series of special explanations; it was the Greek debt crisis driving investors into the dollar safe haven; it's the Fed's purchases; whatever. We'll [see] what happens when the latter end at the end of this month, by the way."
Given this comment, it is interesting to look at the magnitude of Fed open market operations with respect to marketable Treasury notes and bonds. (The government trust funds are usually invested in non-marketable securities.)
Using information presented in Federal Reserve Statistical Release H.4.1, the Federal Reserve's holdings of notes and bonds held outright, including TIPS, increased by about $721 billion from September 29, 2010, to June 1, 2011. This is based on face values, including the inflation compensation which is added to the principal of TIPS, which is not significant for these purposes. The Daily Treasury Statement for June 1, 2011, indicates that the net increase of marketable notes and bonds (issues minus redemptions) for the fiscal year, which began on October 1, 2010, was about $974 billion. This is also based on face values, including the inflation adjustment to principal of TIPS.
Thus, the Federal Reserve has taken up about 74 percent of the increase in the face value of marketable Treasury notes and bonds since the beginning of October. This is unprecedented. As Krugman says, we will see what happens when the market has to finance a much larger portion of Treasury's new issues of marketable securities. I am not concerned about the market's capacity to do this, but I do have a nagging worry that, if the increase in supply occurs too quickly, there could be market effects.
One hopes that the Fed knows what it is doing, and, if something unexpected happens, it can move quickly to deal with it. Of course, the inability of the economy to grow fast enough to reduce unemployment and the debt problems in the Eurozone are additional factors which will challenge policymakers. (A government default, even technical, would also pose a severe challenge, but I continue to view that as unlikely, though it is pretty obvious we will get to the brink.)
Krugman has been a powerful voice for both easy monetary policy and stimulatory fiscal policy. While the end of QE2 has to be managed carefully, monetary policy seems to be able to have reached the limits of its ability to spur real growth. Fiscal policy, as Krugman notes, is hampered by the current political situation which is focused on reducing deficits, both short- and long-term. If fiscal policy cannot be used to stimulate the economy and monetary policy is not that effective, then there is little the Obama Administration can do.
Those who argue that we should reduce current government spending seem to believe is that all that is necessary for the economy to grow is for the government to get out of the way. Maybe, but we may have to wait much longer than they expect for this to happen. They seem to reject the notion that the economy may find an equilibrium point with higher than desired unemployment for a substantial period of time. This idea, of course, is associated with Keynes, and, in some circles, to call someone a Keynesian is considered an insult.
Krugman has recently argued that a major war would result in full employment very quickly, just as World War II ended the Depression. Of course, World War II was not entered into as a way to increase economic growth and increase employment, but that is what it did. Deficit spending worked. While Krugman is not advocating war, he uses the reference to war to make the argument that increased government spending could help us get out of the current slump.
The Administration will not, of course, propose this, given the current political realities. It is hoping that the economy is on the right track and will continue to grow enough so that unemployment begins to come down. In the meantime, the Republicans are using the debt limit impasse to push both current spending cuts and entitlement reform. Current spending cuts are not a good idea with an unemployment rate over 9%, and, as to entitlement reform, this needs to be done, but carefully. Just changing and cutting Medicare drastically without making general reforms to our inefficient health care system is not sensible, and, in any case, is unlikely to be enacted. Tax cuts are always easier to achieve, but anyone who is serious about the long-term deficit should be seeking ways to increase revenues over the long run, not cut them.
In short, the political system is stalled, at least until the next crisis. If anything, the government will reduce its current spending, and it is hard to argue that this will help economic growth, though John Taylor tries. We can all hope that Krugman is wrong and that the economy will grow of its own accord, but I would not bet on it. The Administration appears to have no choice but to make that bet.