OT: Keynes and Krugman

There are some that are actually interested in economics.

Not my comments, of course.


History lesson for economists in thrall to Keynes

By Niall Ferguson

On Wednesday last week, yields on 10-year US Treasuries -- generally seen as
the benchmark for long-term interest rates -- rose above 3.73 per cent. Once
upon a time that would have been considered rather low. But the financial
crisis has changed all that: at the end of last year, the yield on the
10-year fell to 2.06 per cent. In other words, long-term rates have risen by
167 basis points in the space of five months. In relative terms, that
represents an 81 per cent jump.

Most commentators were unnerved by this development, coinciding as it did
with warnings about the fiscal health of the US. For me, however, it was
good news. For it settled a rather public argument between me and the
Princeton economist Paul Krugman.

It is a brave or foolhardy man who picks a fight with Mr Krugman, the most
recent recipient of the Nobel Prize for Economics. Yet a cat may look at a
king, and sometimes a historian can challenge an economist.

A month ago Mr Krugman and I sat on a panel convened in New York to discuss
the financial crisis. I made the point that "the running of massive fiscal
deficits in excess of 12 per cent of gross domestic product this year, and
the issuance therefore of vast quantities of freshly-minted bonds" was
likely to push long-term interest rates up, at a time when the Federal
Reserve aims at keeping them down. I predicted a "painful tug-of-war between
our monetary policy and our fiscal policy, as the markets realize just what
a vast quantity of bonds are going to have to be absorbed by the financial
system this year".

De haut en bas came the patronizing response: I belonged to a "Dark Age" of
economics. It was "really sad" that my knowledge of the dismal science had
not even got up to 1937 (the year after Keynes's General Theory was
published), much less its zenith in 2005 (the year Mr Krugman's
macro-economics textbook appeared). Did I not grasp that the key to the
crisis was "a vast excess of desired savings over willing investment"? "We
have a global savings glut," explained Mr Krugman, "which is why there is,
in fact, no upward pressure on interest rates."

Now, I do not need lessons about the General Theory. But I think perhaps Mr
Krugman would benefit from a refresher course about that work's historical
context. Having reissued his book The Return of Depression Economics, he
clearly has an interest in representing the current crisis as a repeat of
the 1930s. But it is not. US real GDP is forecast by the International
Monetary Fund to fall by 2.8 per cent this year and to stagnate next year.
This is a far cry from the early 1930s, when real output collapsed by 30 per
cent. So far this is a big recession, comparable in scale with 1973-1975.
Nor has globalization collapsed the way it did in the 1930s.

Credit for averting a second Great Depression should principally go to Fed
chairman Ben Bernanke, whose knowledge of the early 1930s banking crisis is
second to none, and whose double dose of near-zero short-term rates and
quantitative easing -- a doubling of the Fed's balance sheet since
September -- has averted a pandemic of bank failures. No doubt, too, the
$787bn stimulus package is also boosting US GDP this quarter.

But the stimulus package only accounts for a part of the massive deficit the
US federal government is projected to run this year. Borrowing is forecast
to be $1,840bn -- equivalent to around half of all federal outlays and 13
per cent of GDP. A deficit this size has not been seen in the US since the
second world war. A further $10,000bn will need to be borrowed in the decade
ahead, according to the Congressional Budget Office. Even if the White
House's over-optimistic growth forecasts are correct, that will still take
the gross federal debt above 100 per cent of GDP by 2017. And this ignores
the vast off-balance-sheet liabilities of the Medicare and Social Security
systems.

It is hardly surprising, then, that the bond market is quailing. For only on
Planet Econ-101 (the standard macroeconomics course drummed into every US
undergraduate) could such a tidal wave of debt issuance exert "no upward
pressure on interest rates".

Of course, Mr Krugman knew what I meant. "The only thing that might drive up
interest rates," he acknowledged during our debate, "is that people may grow
dubious about the financial solvency of governments." Might? May? The fact
is that people -- not least the Chinese government -- are already distinctly
dubious. They understand that US fiscal policy implies big purchases of
government bonds by the Fed this year, since neither foreign nor private
domestic purchases will suffice to fund the deficit. This policy is known as
printing money and it is what many governments tried in the 1970s, with
inflationary consequences you do not need to be a historian to recall.

No doubt there are powerful deflationary headwinds blowing in the other
direction today. There is surplus capacity in world manufacturing. But the
price of key commodities has surged since February. Monetary expansion in
the US, where M2 is growing at an annual rate of 9 per cent, well above its
post-1960 average, seems likely to lead to inflation if not this year, then
next. In the words of the Chinese central bank's latest quarterly report: "A
policy mistake ... may bring inflation risks to the whole world."

The policy mistake has already been made -- to adopt the fiscal policy of a
world war to fight a recession. In the absence of credible commitments to
end the chronic US structural deficit, there will be further upward pressure
on interest rates, despite the glut of global savings. It was Keynes who
noted that "even the most practical man of affairs is usually in the thrall
of the ideas of some long-dead economist". Today the long-dead economist is
Keynes, and it is professors of economics, not practical men, who are in
thrall to his ideas.

The writer is Laurence A. Tisch professor of history at Harvard University
and author of The Ascent of Money (Penguin)




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