It's Not Clear that Mundell-Fleming Is the Right Model Here...
David Leonhardt on the Ratf*^#: Understanding the U.S. Reponse to the Great Panic

Understanding Critics of Stimulus: Part LIX

Paul Krugman is reduced to psychology, and writes:

The Seductiveness Of Demands For Pain: Mark Thoma is astonished at Raghuram Rajan’s... desire to find some argument... for raising interest rates even though unemployment is near 10 percent.... I realized... I’d seen something like this before. Back in the summer of 2008, as the world was sliding into recession, Ken Rogoff demanded that the Fed and the ECB raise rates because of rising commodity prices and inflationary pressure in developing countries. Again, it was very hard to understand what model lay behind the demand. And let me throw Jeff Sachs into the mix... the recent Sachs op-ed calling for fiscal austerity now now now, in which he claims that fiscal expansion has had all sorts of negative effects that are, in fact, completely absent from the data.

What’s going on here? I don’t think you can resort to class-warfare arguments. What I think is happening is that we’re seeing the deep seductiveness, for many economists (and others), of taking what sounds like a tough-minded position in favor of inflicting pain.... Calling for austerity and tight money feels courageous, tough-minded, and virtuous; it allows the economist making such calls to take the pose of a Serious Person standing firm against the easy-money guys.

Yes, I know that’s insulting. But what’s so striking is that in all three cases I’ve cited you had highly trained economists — that is, people who have spent their whole lives arguing in terms of carefully laid out models — making arguments that aren’t backed by any model I can see... at a time when we really need clarity of thought, they’re adding to the intellectual murk...

Back a year and more ago, when the Richard Posners and the Robert Lucases were arguing that Larry Summers and Christy Romer were lying frauds for believing that expansionary fiscal policy could cushion the recession, when Eugene Fama was saying that it was arithmetically impossible for fiscal (and--although he did not realize that his argument implied this--monetary) policy to affect unemployment, when Luigi Zingales was claiming that because the problem was in the banks it couldn't be eased by having the government spending money, it was quite clear to me that you had a bunch of people who had never done their homework--intellectually lazy people whom, as Posner later admitted, had never even read John Maynard Keynes or the others who grappled with how a market economy could fall into something like a Great Depression, and who as a result were making Econ 1-level conceptual errors all over the place.

But that definitely is not the case with Rogoff, Sachs, and Rajan: they are all very smart, intellectually omnivorous, unblinkered by knee-jerk ideology, pragmatic, and definitely unlazy. They are not people whose thought processes are likely to be as muddy and murky as Paul suspects that they are.

I think that something different is going on--that Rajan, Rogoff, and Sachs are groping for the macroeconomic model that John Stuart Mill laid out in 1829 supercharged by a set of hypotheses about government debt. Back in 1829 Mill wrote:

Although he who sells, really sells only to buy, he needs not buy at the same moment when he sells... there may be, at some given time, a very general inclination to sell with as little delay as possible, accompanied with an equally general inclination to defer all purchases as long as possible. This is always actually the case, in those periods which are described as periods of general excess.... In order to render the argument for the impossibility of an excess of all commodities applicable... money must itself be considered as a commodity... those who have, at periods such as we have described, affirmed that there was an excess of all commodities, never pretended that money was one of these commodities.... What it amounted to was, that persons in general, at that particular time, from a general expectation of being called upon to meet sudden demands, liked better to possess money than any other commodity. Money, consequently, was in request, and all other commodities were in comparative disrepute... the result is, that all commodities fall in price, or become unsaleable.... [A]s there may be a temporary excess of any one article considered separately, so may there of commodities generally, not in consequence of over-production, but of a want of commercial confidence...

The needed supercharging takes place in two stages:

  • the replacement of the word "money" in Mill's 1829 "Of the Influence of Consumption on Production" in his Essays on Some Unsettled Questions in Political Economy with the phrase "assets thought to be high-quality and AAA": what is in excess demand right now is not liquidity--not balances to conduct current transactions--but rather quality--places to stash that part of your wealth that you want to be certain will still be there in a way.

  • the observation that the only AAA assets around now are the debts of governments thought to have credible long-run plans for managing their deficits.

In such a model, the great fear of Rajan, Rogoff, and Sachs--given the current excess demand for AAA assets and the concommitant excess supply of goods and services--is that governments thought to be fiscally responsible over the long run will lose that status, that their debt will decline in quality, that as a result the supply of AAA assets will shrink, that the excess demand for AAA assets will concomitantly increase, and that increased excess demand carries with it an increased excess supply of goods and services. (At this point Nick Rowe will chime in and say all this is imprecise: that Malinvaud's Theory of Unemployment Reconsidered says important things about how such a scenario plays out that Mill did not understand and that I am ignoring, and he will be correct.) First priority is to restore confidence that those governments whose debts are currently AAA will maintain that status. Second priority is to push more economies back across the line to long-run fiscal stability and so push their assets back into the AAA category and so increase the supply of such assets and diminish excess demand for them. And both of those require fiscal austerity now, because we are dealing with panic and confidence.

The argument, in short, is that if markets demanded that central bankers paint themselves blue, stand on their heads, and sing "Sweet Adeline" in chorus before they would trust that the debts of North Atlantic governments will stay AAA-quality, the proper monetary policy would be for central bankers to paint themselves blue, to stand on their heads, and to sing "Sweet Adeline" in chorus. But, the argument goes, markets aren't demanding that: they are demanding fiscal austerity.

And here is where I lose the thread of what I think is the Rajan, Rogoff, and Sachs argument. I see no signs that markets are demanding this austerity. I see no signs that cutting this year's deficit will boost the prices of American, British, German, or Japanese government bonds by any but a trivial amount. And I see no signs that increasing this year's deficit will lower the prices of American, British, German, or Japanese government bonds by any but a trivial amount. The argument that bond prices are not rational expectations has no bite here--because we are taking government bond prices not as rational forecasts but as thermometers of market panic, and even (especially) when asset prices are not rational forecasts they are still good thermometers of sentiment.