Monday, October 25, 2010

Understanding Deficits during Great Recessions

Paul Krugman has a post on his NY Times blog which explains in very simple terms why government deficits make sense in situations like today, i.e. during a Great Recession. Here is the start of his post:
One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. (Sam and Janet who? If you’d grown up in my place and time, you’d know the answer: Sam and Janet evening / You will see a stranger … But actually, I’m thinking of the two kinds of agent in the Kiyotaki-Moore model.)

In this world, we’ll assume that no real investment is possible, so that loans are made only to finance consumption in excess of income. Specifically, in the past the Sams have borrowed from the Janets to pay for consumption. But now something has happened – say, the collapse of a land bubble – that has forced the Sams to stop borrowing, and indeed to pay down their debt.

For the Sams to do this, of course, the Janets must be prepared to dissave, to run down their assets. What would give them an incentive to do this? The answer is a fall in interest rates. So the normal way the economy would cope with the balance sheet problems of the Sams is through a period of low rates.

But – you probably guessed where I’m going – what if even a zero rate isn’t low enough; that is, low enough to induce enough dissaving on the part of the Janets to match the savings of the Sams? Then we have a problem. I haven’t specified the underlying macroeconomic model, but it seems safe to say that we’d be looking at a depressed real economy and deflationary pressures. And this will be destructive; not only will output be below potential, but depressed incomes and deflation will make it harder for the Sams to pay down their debt.

What can be done? One answer is inflation, if you can get it, which will do two things: it will make it possible to have a negative real interest rate, and it will in itself erode the debt of the Sams. Yes, that will in a way be rewarding their past excesses – but economics is not a morality play.
Go read the rest of his blog post to find out why and how government debt is in fact a solution to this problem.

Krugman has a wonderful way of explaining economics. Sadly the politicians don't listen to him. Worse, they grab the public microphone and shout the very wrong economic platitudes that Krugman warns against. Politicians make the problem worse, not better!

I thought a smart guy like Obama would grab the microphone like FDR did during the Great Depression with his "fireside chats" and explain to ordinary folk the situation the world is in and what needs to be done to get out of it. But sadly Obama has sold his soul to Wall Street like the rest of the politicians, so there will be no help coming from him. The American people are going to have to solve this problem themselves. And, as Paul Krugman points out, that means a "lost decade" because it is so hard for a disorganized people to do the right thing when the right thing seems counter-intuitive and especially when politicians are shouting in your ear their wrong-headed sound bites.

You might think that Obama would listen to a Nobel-prize winning economist. He hasn't. Obama didn't even listen to his CEA, Christine Romer. Instead he was in thrall to Larry Summers, Ben Bernanke, and Tim Geithner, the trio who worked hand-in-hand with the rabid right wing Republicans to create the problem by ignoring the housing crisis, by advocating "deregulate, deregulate, deregulate", and by coming up with half measures and the empty platitudes of the past in the face of the greatest economic crisis in 80 years.

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