The Krugtron, confidence and models

Paul Krugman, Brad DeLong, and Larry Summers have been having a debate about just why they think the Fed might have been premature in raising interest rates.  The conversation surfaced a disagreement between Krugman and Summers over the legitimacy of worries about ‘spooking the markets’ with overly large fiscal deficits at the outset of the crisis.

The conversation echoes comments that Krugman, Simon Wren-Lewis, Jonathan Portes and perhaps others made about the narrative account given by the Coalition government – in, for example, a published piece by outgoing Treasury permanent Secretary Nick Macpherson – of the move to reduce the size of the deficit inherited from plans made by Gordon Brown’s Labour administration.

PK insists that the worry about confidence is not wise thinking that is informing models, but unwise thinking undisciplined by models.

I am going to reiterate my position in the Summers-Macpherson camp.

PK’s train of thought is that markets will never fear default by a sovereign that can print its own currency.  The bonds on which it contemplates default are merely claims to that currency.   Printing presses can be run at virtually zero cost.  So what would ever stop them from being run to cover whatever financing gap emerged?

The case in principle that markets might be spooked seems straightforward enough to me.

That case notes firstly that there have been multiple occasions in the past where countries issuing an independent currency have defaulted.   It also notes that inflation is costly, and very high inflation prohibitively so.  There therefore comes a point where monetary finance – particularly expected monetary finance, which is a very inefficient way to pay for government – imposes greater social costs than a partial default.

PK explains that the expected inflation coming from the ‘spooking’ would be stimulative.  He refers to the effect that this has in lowering the real interest rate – the nominal rate being pinned at the zero bound for now.

However, the default risk and the amplified inflation uncertainty that spooking would bring with it [in all but an uninteresting perfect foresight version of this story] would raise the real cost of finance, eating into the stimulus.

These effects are missing from some models – like the simplest, linearised New Keynesian models of monetary policy.  But they are not un-modellable.

How much it should have borne down on fiscal policy then, and should now, is a quantitative question only, and tricky to answer.

This paper, by Corsetti and coauthors, illustrates the trade-off I sketch above and how it produces the possibility of spooking [multiplie rational expectations equilibria, here].  As a point of detail, [I think] it assumes fixed money velocity in order to simplify algebra somewhat, and therefore, in my estimation, would overstate the benefits of monetary finance.  [Real money demand would more normally be thought to shrink as inflation and nominal interest rates eventually rise].

But the idea is clear enough.  And it lives inside a model.

If it were possible to index the unit of account, relatively costlessly – Shiller described how, for example, Chile attempted to do this with the unidad de fomento – and to correspondingly eliminated inflation’s other costs, the Krugman argument would go through.

But in today’s economy, I maintain it doesn’t.  Markets rightly worry about independent currency issuers’ default.

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13 Responses to The Krugtron, confidence and models

  1. Lyn Eynon says:

    Yes, default by a country issuing its own currency is possible, has happened and can be modelled. But the more important question is whether this was a real risk in 2010 and the evidence suggests not as UK government 10 year borrowing rates were below 4%. ‘Spooking the markets’ was a convenient narrative for the Conservative government to justify austerity and its backers in the City encouraged the story.

    • Tony Yates says:

      No reason to take the markets’ word on what’s possible. After all, that was the lesson of the financial crisis itself. Neither Summers nor myself have need of selling a ‘convenient narrative’. I doubt either Macpherson would have taken the trouble to put his head above the parapet only to tell a story his political bosses wanted told anyway. I’m sure he believed it. And, since it’s plausible, he had every reason to.

      • Peter K. says:

        “After all, that was the lesson of the financial crisis itself.” What was the lesson? The Fed and the BoE printed money and the crisis was over.

        Krugman is talking about expansionary policy which is used in order to hit the inflation target and close the output gap in an advanced economy. Not merely “PK’s train of thought is that markets will never fear default by a sovereign that can print its own currency.”

        That’s the point he made in the lecture Summers was criticizing. There are no historical examples of a default, only scare stories used to limit expansionary monetary and fiscal policy. France in the 1920s was the closest thing Krugman could find.

        In the U.S. conservatives say we can’t do infrastructure spending because we’ll become Greece. That’s the kind of thing you and Summers are pushing.

      • Tony Yates says:

        The lesson of the crisis I was referring to there was the specific one that you can’t presume that if markets don’t see a risk, there is not a risk. In response to the point LE made that since bond yields were low, there was no risk of default.
        PK/SWL/JP have all made the point about default as an independent currency before, multiple times. And it is invoked again in this debate with LS and BDL. You might argue – as I think SWL and JP did last time this came up, that the money-financing would be expected to be calibrated carefully merely to hit the inflation target. But I am sceptical that this is possible. I am most certainly not arguing that doing infrastructure spending will lead the UK or US to become like Greece. I am making a point of economic history about the legitimacy of holding off on much more stimulatory policy than was actually enacted in 2009-2010 on the grounds explained. Things are quite a bit different now. Both countries are clearly benefiting from safe haven flows, far from being ‘like Greece’. On the other hand, the case for a fiscal stimulus, with inflation here at least already expected to head back to target, is weaker. I’d still argue for it, and for correspondingly tighter monetary policy, leaving demand roughly the same. Infrastructure spending anyway can be done under a different fiscal framework. Some may even have hypothecatable revenues associated with them. So, in sum, no, I’m not against further infrastructure spending, financed by extra borrowing, now.

  2. richard reinhofer says:

    re: multiple occasions in the past where countries issuing an independent currency have defaulted.

    Defaulted in their own currency? Or defaulted in borrowed currency? Examples?

  3. srini says:

    Russia in 1998 and Brazil in 1990. uruguay also may have defaulted although I am not sure. During the Gold Standard era, countries defaulted but then they could not print gold.

    • richard reinhofer says:

      Both Russia and Brazil were examples of IMF imposed austerity economics brought on by excessive foreign currency debt by both the public and private sector. This austerity caused the GDP to debt ratio to explode (exactly as Paul Krugman warns will happen in Mundell-Fleming) Those two examples make his point.

  4. Daniel Davies says:

    I think your post maybe introduces a third category of wise thinking, distracted by its model. There are a few examples of countries defaulting in their own printable currency, and some more of hyperinflations. But if you set aside the sunspots and think of these episodes not as draws from a distribution, but as specific historical events with their own sets of causes, what immediately strikes you is that neither the UK or USA is anywhere near being relevantly similar to Russia in 1998. Quite apart from political stability and the rule of law, both countries had sustained and repaid much higher debt burdens in the past.

  5. john says:

    It is likely unhelpful to anthropomorphize “Markets rightly worry about independent currency issuers’ default.” as there is a huge variety of participants, many of the largest of whom actively seek the volatility, risk, dislocation and “spooking”. Why? Simply because option values rise with volatility. These guys seek to own options that will pay off with disruption. And lest one think they are all George Soros, all the large banks in USA have significant similar operations. Generally speaking, they are n the business of transferring value from sheep investors like pensions and mutual funds to themselves. Volatility is their friend. They will always act to create and encourage it.

  6. Richard says:

    I suspect that Krugman might respond in the following manner: printing presses cannot print infinite money, but they don’t need to. In particular, countries with strong economies and legal institutions can print quite a large amount, backed by the stability of institutions and industrial capacity. The excess will cause interest to increase–and that is all.

  7. dsquared is right – its a bit of a theological argument really whether it is possible for countries to be forced to default on debts in their own currency. FWIW I think in theory not, but the relevant point is that a sufficiently incompetent government (or perhaps its masters at the IMF) might in rare circumstances CHOOSE to.

    And there was absolutely no prospect of such circumstances in the UK in 2010, and none for the US now, and the behaviour of bond rates showed the markets knew and know that. This is more of the ‘confidence fairy’ bollocks and Summers should know better.

    I’ve got enough of my youthful Marxist in me to want to ask who gains and who loses by a constant bias to tight money – and guess what, it ain’t the indebted toiling masses. Summers has always been too close to Wall Street, as the UK Treasury has been too close to the City.

  8. mrkemail2 says:

    What government can do, by virtue of the licence that pegs the liabilities of commercial banks to the central bank, is force commercial banks to lend money to the government sector.

    Bank ‘reserves’ are called reserves because they are a reserve liability of the government sector to the commercial bank. To the commercial bank they are an asset. In effect the commercial bank has made a loan to the central bank arm of government.

    And of course by accounting identity when a bank makes a loan it makes a deposit – which ends up in the hands of the person the government is paying.

    So what government can do is *force* commercial banks to expand their balance sheets by spending and *force* them to shrink their balance sheets by taxing. In other words the control of a bank’s balance sheet isn’t entirely in the hands of the bank – if they want the bank’s deposits to be known as ‘Sterling’.

    So you don’t need the central bank or Treasury at all. They are technically surplus to requirements. All you need is the legal right to force commercial banks to create loans for your benefit – at whatever interest rate and term you demand.

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