March 13, 2003

The Economist Is Also Worried About Government Bankruptcy a Generation Hence

The Economist is also worried about government bankruptcy--which usually takes the form of serious inflation--a decade hence. But it is more scared of deflation now: it doesn't want attachment to long-run fiscal and monetary rectitude to stall stimulative short-run policies.

Economist: ...Governments everywhere should certainly fret about their long-term fiscal health, not least because of future pension and health-care costs; but not if it means choking their economies now. Japan has shown graphically how trying to trim a budget deficit when an economy is weak can actually worsen a country's long-term fiscal position. America and Europe must not risk following suit...

Posted by DeLong at March 13, 2003 08:34 PM | TrackBack


Running out of base points is not the same thing as running out of ideas. One swallow doesn't make a summer, and one Fed paper - even a good one - doesn't mean we've understood Japan. The real lesson from Japan is that thinking economics exclusivel in terms of monetary/fiscal mix, like love in a time of cholera - simply isn't enough. Fortunately we do have science, but only if we are willing to climb out of the box, learn to think critically and try to understand what is happening. My feeling is that institutional and structural factors need more attention than they are getting. We could also put some historical time (rather than abstract state space) back into economics. Either way, this is neither the time nor the place to develop these points.

Unfortunately fiscal bankruptcy does not necessarily imply inflation. Recourse to text books doesn't help here, since they all carry those 'ceteris paribus', 'buyer beware' stickers. Becuase if other things are not equal.........

And they aren't. For the trillionth time, when were we last looking at these demographics? National Income it will be remembered is commonly assumed to be a function of capital and labour, and capital formation stands in some relation to the saving habits of those who are working, so if the proportion of people working in any society goes down, then we might just expect to see some interesting changes in the direction of national income, or, put another way some unpleasant consequences associated with the unwinding of the ninetees 'participation squeeze'. It all depends on what kind of vicious circle we manage to get into.

My hunch is that inflation has something to do with forward-looking growth expectations and liquidity constraints. An interesting point of departure for understanding the mechanism could be Kiyotaki and Moore's 'Evil is the Root of All Money?

The US and Japan, remember, are not Argentina (and even there inflation has been remarkably restrained of late, given everything). In fact Japan's enormous saving's surplus means that the government can benefit from remarkably low interest rates into the indefinite future (the 30 year yield curve is, in fact, flattening out). It would be a rise in interest rates which would precipitate national bankrupcy, that's why no-one in Japan expects inflation any time soon. I don't see in principle why it should be any different in the US. When push comes to shove interest rates are, after all determined by the supply-of and demand for savings.

My feeling is that Paul Krugman might well live to regret that fixed interest mortgage decision. (Better still, sell now, pocket the money and rent, but it's just a thought. If deflation really sets in the only asset with a rising value might just be: cash. Certainly the uncertainty level suggests that the smart money now is liquid, but of course that's why everyone is meticulously going the other way and evacuating their bank accounts to sink their hard earned savings in concrete). Which all goes to show that even the best of economists can make the same mistakes as everyone else. Although developing a bit of theory to help explain what's going on could prove to be a useful investment.

Posted by: Edward Hugh on March 14, 2003 01:23 AM

Not everybody has sunk all their cash into real estate. Take a look at the yield curve. There is lots of cash in cash. That rush for a stable hiding place in uncertain times is probably exaggerating the impression that market participants expect an ease next week. And, in fact, the curve has flattened a bit this week, without much acknowledgement from the "market is telling me" sort of analyst.

Posted by: K Harris on March 14, 2003 05:00 AM

Dear Edward Hugh

Please continue to further clarify and develop your most interesting post. This is worth arguing quite fully.

Posted by: jd on March 14, 2003 11:17 AM

The demographics of Europe and Japan are worse than those of the USA, but it is the USA that is the principal capital importer. These capital exports (primarily from Japan, but other sources as well) are bound to shrink - forcing American interest rates up. Savings increase, spending, profits, investment, employment and velocity all go down...
Yes, Edward´s scenario is correct. Savings already have doubled in the US recently - just like energy prices. But in order to reach Japanese levels, these already heightened savings levels would have to quadruple again. There certainly is not as much upside in raw materials prices, even considering the fact that they have probably embarked on a decade-long bull market...

Posted by: Joerg Wenck on March 15, 2003 05:59 AM
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