Monday 27 February 2017

We're sorry now for ditching the many economic insights of Depression era

Brad DeLong

THERE is only one real law of economics: the law of supply and demand. If the quantity supplied goes up, the price goes down.

Back in the third quarter of 2008, Americans held about $5.3 trillion (€3.75tn) of US treasury bills, notes and bonds. As the recession hit, tax revenue plummeted and government spending rose, that total reached $9.4tn (€6.66tn) by mid-2011.

We're on target to have $10.7tn (€7.58tn) outstanding by mid-2012 -- doubling the treasury debt held by the public in just four years. Supply and demand tells us that a steep rise in treasury borrowing should produce a commensurate fall in treasury bond prices and thus higher interest rates and that increase should crowd out other forms of interest-sensitive spending, slowing productivity growth.

Yet, the market has swallowed all these issues without so much as a burp. By all accounts, it's smacking its lips in anticipation of the next tranches.

In the years of the Clinton budget surpluses (remember those?), the US government was repaying $60bn (€42.5bn) of debt each quarter. The Bush administration worked hard to make that surplus evaporate. It succeeded.

From 2002 to 2007, the treasury issued, on average, $70bn (€49.6bn) of debt per quarter. Like many watching this shift, I concluded that this expanded supply would exert substantial pressure on interest rates to rise.

The demand for treasuries was inordinately high, in part because the supply of alternatives was low. Lacking confidence, corporate executives held back investment, reducing private issues of bonds. In addition, China and other emerging economies, eager to keep their currency values low, directed dollars earned from exports into US treasury debt. Reinforcing this demand, wealthy individuals around the world purchased treasuries as a hedge.

Thus by late 2007, the 10-year US treasury rate was exactly where it had been when the Clinton surpluses ended at the close of 2001. 'How long could this go on?' We wondered.

Eventually the market's appetite for treasury bonds at high prices and low interest rates had to reach its limit, right?

Supply and demand isn't just a good idea; it's the law.

At the end of 2008, as the economy collapsed and the pace of net treasury debt increases quintupled, it seemed we were about to discover that limit. I presumed we had a little time for expansionary fiscal policy to boost the economy, a year, maybe 18 months, before the bond-market vigilantes would arrive. They would demand higher interest rates on Treasury bonds, which would begin seriously crowding out the benefits of fiscal stimulus.

US government would have to react, pivoting from fighting joblessness, via deficit spending, to reassuring the bond market via long-run tax increases and spending cuts to Medicare and Medicaid.

But it didn't happen in 2009. It didn't happen in 2010. And it isn't happening in 2011. There are no signs from asset prices that the market is betting heavily that it will happen in 2012.

Although I worked for three years in the Clinton treasury department, and am a card-carrying member of the economist guild, I predicted none of this. Like most of my peers, I was wrong. Yet the most interesting thing is that I could have, should have, been right. I had read economist John Hicks; I just didn't quite believe him.

Hicks, one of the clever young Brits dotting Is and crossing Ts in the writings of John Maynard Keynes in the 1930s, was responsible for the workhorse formulation of Keynesian economics -- the IS-LM model -- that has been the bane of many an macroeconomics student. It was his version of the IS-LM model that formalised and elevated a key insight: that interest rates paid by creditworthy governments would remain low after a financial crisis.

A financial crisis initiates a sudden flight to safety among bondholders; widening interest-rate spreads, diminishing the private sector's desire to sell bonds to raise capital and encouraging individuals to save more and consume less as they, too, hunker down. Thus bond prices rise, and interest rates drop. As rates fall, firms see that they can get capital on attractive terms and so issue more bonds; households see the low interest rate earned on their savings and lose some of their desire to save. The market heads toward equilibrium.

But something else happens on the path to equilibrium. The decline in interest rates and the rise in savings are accompanied by an increased desire among businesses and households to safeguard more of their wealth in cash. As a result, the speed with which cash turns over in the economy, the velocity of money, falls. And as the velocity of money falls, total spending drops, workers are fired, and their savings evaporate with their incomes.

Eventually the equilibrium turns negative, with high unemployment and low capacity utilisation.

In responding to a small financial disruption, the Federal Reserve can inject more money into the economy by buying bonds for cash, increasing the amount of cash so that even at the lower velocity of money we retain the same volume of spending. This eases the decline in interest rates, spending, employment and production into a decline in interest rates alone.

Hicks's conclusion: as long as output remains depressed and there is slack in the economy, printing more bonds will have a negligible effect in increasing interest rates.

I had read Hicks. I even knew Hicks. But I thought that his era, the Great Depression, had passed.

On my shelf is a slim, turn-of-the-millennium volume by Paul Krugman titled 'The Return of Depression Economics'. In it he argued that we mainstream economists had been too quick to ditch the insights of Hicks. Krugman warned that their analysis was still relevant, and that if we dismissed it we would be sorry.

I am sorry.

(Brad DeLong, a former deputy assistant secretary of the US treasury, is a professor of economics at the University of California at Berkeley.)

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