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.