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Why won't we let the market be irrational in our favor?

After listening to Alan Greenspan's presentation Friday, I think it's safe to place him in the camp that would like to see a quick move toward a more austere budget. When Walter Isaacson asked him whether stimulus or deficit reduction should come first, he said "the question is not all that difficult once you recognize that there is far greater momentum in the budget deficit and in spending than in the official figures." In other words, it's time to move on deficits.

The problem, as he admitted, is that "the fiscal strain" that would normally alert the political system to a deficit problem and increase pressure for action is totally absent. "Fiscal strain shows up either as crowding out, inflation or higher interest rates," he said. "There is some crowding out that we can measure, but not much. There's no inflation. And interest rates are, if anything, falling."

Greenspan took that as evidence that the market is being irrational about our debt, largely because it's so afraid of European debt. I don't totally disagree. But when investors spot an irrational market -- particularly an irrational market in their favor -- they exploit it. Greenspan and others seem to think we need to correct it.

Here's an old economics joke: Two economists are walking down the street. One says: "Hey, there's a dollar bill on the floor." The other says: "Impossible. If it were real, someone would have picked it up by now." The austerity take is even weirder: They counsel that we should pick it up, and then hand it over to the police to track down whoever dropped it and make sure they don't do so in the future. Oh, and we should do all this despite a warrant out for our arrest.

If we've got a limited period in which our borrowing costs are low because the rest of the world is in terrible shape, then it would make sense to use this period to frontload the investments we need to make to get short- and long-term economic growth on track. In the short-term, that means things like unemployment insurance and state and local aid. In the long-term, that means investments in infrastructure and education and research and development. Instead, at a moment of record-low borrowing costs, we're letting cash-strapped California gut the UC system. That's a one-two punch: We lose jobs now, and we lose educated workers later.

As an economic strategy, it's baffling. We have an opportunity here. We should use it. And we should combine it with the sort of long-term policies that will reassure the market about our future trajectory. But refusing to let the market be irrational in our favor is, at the end of the day, to be irrational ourselves.

Update: I ran into Greenspan later, and we talked a bit more about this. He explained that he doesn't think the market is irrational. Rather, he believes that the rational short-term behavior, which includes very low rates on US debt, will eventually give way to rational long-term behavior, and we'd be wise to address the problem rather than risk the panic of the market's correction.

By Ezra Klein  |  July 9, 2010; 5:08 PM ET
Categories:  Economy  
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Comments

not bad, but this is pithier http://krugman.blogs.nytimes.com/2010/07/06/lincoln-mcclellan-and-stimulus/

Posted by: bdballard | July 9, 2010 5:29 PM | Report abuse

Very nearly shrill, Ezra.

Funny how just having to consider hooey from Ayn Greenspan can set one off....

Posted by: Dollared | July 9, 2010 5:42 PM | Report abuse

why is alan greenspan speaking at a "festival of ideas" conference?


it was his wisdom that helped to get us into this mess in the first place.

Posted by: jkaren | July 9, 2010 5:48 PM | Report abuse

Austerity is a great idea!

Quick, let's do quantitative easing to the tune of 2 trillion! The interest payments alone will save us tens of billions a year!

Oh wait, it's only austerity if it hurts poor people...

Posted by: theamazingjex | July 9, 2010 5:49 PM | Report abuse

"Here's an old economics joke: Two economists are walking down the street. One says: "Hey, there's a dollar bill on the floor." The other says: "Impossible. If it were real, someone would have picked it up by now." The austerity take is even weirder: They counsel that we should pick it up, and then hand it over to the police to track down whoever dropped it and make sure they don't do so in the future. Oh, and we should do all this despite a warrant out for our arrest."

But we know the guy who dropped the $5. He's a notorious drug dealer, and isn't shy about killing people who cross him. We could hold onto the $5 and buy something fun, but we risk running into him before we have another $5 on hand. If we return it, it won't be fun but the risk of getting beaten to death by the drug dealer isn't worth it.

"And we should combine it with the sort of long-term policies that will reassure the market about our future trajectory."

But it's a lot easier for the market to trust us if we start now, than if we kick the can down the road.

"Quick, let's do quantitative easing to the tune of 2 trillion! The interest payments alone will save us tens of billions a year!"

This depends on the relative strength of the inflation effect vs. the demand/ability to return interest payments to the treasury. If inflation shoots up to 6%, $2 trillion of quantitative easing might cost us if interest rates go up to, say, 9% (and if we try buying those too, then, well...).

That all said I'm in favor of more monetary stimulus. Have the Fed target a 5% NGDP growth path, using 2007Q4 as the start of the path, and after we have caught up to the growth path, lower the growth path gradually to 3% to keep inflation in the 0.0%-0.5% range.

Posted by: justin84 | July 9, 2010 6:00 PM | Report abuse

If we've got a limited period in which our borrowing costs are low because the rest of the world is in terrible shape, then it would make sense to use this period to frontload the investments we need to make to get short- and long-term economic growth on track. In the short-term, that means things like unemployment insurance and state and local aid. In the long-term, that means investments in infrastructure and education and research and development.

Hey Ezra I have been making this point for months in the comments. I'm glad you agree.

Posted by: srw3 | July 9, 2010 6:30 PM | Report abuse

The alternative punch line goes, "don't pick it up yet, if we continue deflating it'll be worth $2!"

Posted by: bdballard | July 9, 2010 6:53 PM | Report abuse

Why is it that nobody is at least speculating on the possibility of tax increases on at least a few areas where they can be levied without dumping the economy or hurting the middle class.

The most obvious tax, announced as a purely revenue tax, to be removed once it has had its effect, would be an immediate increase of 10% on imports from all countries. (I'd actually like to leave Canada out but revenue is revenue.)

Since thyere is something fishy about the way the world economy works, in that no amount of balance of payments deficits to any country we trade with seems to improve our exports to that country, and when ever their is an adjustment in the foreign exchange rate the Dollar always seems to some how get stronger, that much extra in taxes will probably have no effect in balance or absolute amounts of trade. Even when our trading partners raise their tariffs to match, it just gives them revenue to sort out their economies.

It might even lead to a bit of economic recovery.

Then we can put taxes on all securities transactions except basic financial transactions like checking and savings accounts. Discourage the attitude of the securities industry that it exists to transfer money from investors to CEOs.

Just two possible ways to help balance the budget.

It CAN'T be worse than GWB's "Budget Balancing Program"

Posted by: ceflynline | July 9, 2010 7:17 PM | Report abuse

@ceflynline:would be an immediate increase of 10% on imports from all countries.

I believe that this is not allowed under WTO rules, and these kind of tariffs just depress the entire world economy as they did during the great depression.

Lets raise money by having a financial transactions tax focused on hyper fast computer arbitrage, and a derivatives tax that focuses on naked derivatives trades. Plenty of deficit reducing money there...

Posted by: srw3 | July 9, 2010 7:30 PM | Report abuse

Love the column but totally disagree with the premise. The reason the markets are favoring the US by loaning us money at crazy low interest is that the US looks better and better in the near and long term. The greatest threat to that is the austerity measures that the recently born again financial conservatives preach are our salvation.

Posted by: EarlyBird1 | July 9, 2010 8:02 PM | Report abuse

Gotta love the way when the evidence doesn't support Greenspan's theory about how the market reacts to the deficits, instead of revising his theory, he declares the market irrational. Isn't it just possible that the evidence supports Krugman, et al, who believe this is not the right time to be worried about conquering the deficit?

Posted by: adagio847 | July 9, 2010 10:42 PM | Report abuse

It is sad that in this country we cannot prosecute Alan Greenspan for all the damage he has done to America over years.

At minimum the guy is the hack worth not all to listen. He is the same guy who basically sold 'Bush Tax cuts' and where is that promised land due to those cuts? Further, he failed to regulate market and became the 'pimp' for Wall Street.

He is utter garbage.

Posted by: umesh409 | July 9, 2010 11:40 PM | Report abuse

EarlyBird1, for the win. The U.S. has a flexible highly skilled labor force, lots of ideas and freedom of speech. The comparative advantage of other countries is in raw materials and cheap labor, and that hurts different U.S. sectors in successive waves, but the final U.S. advantage is Best Culture for Creativity. This is going to be a tough advantage for the others to beat because it also comes from mixing all races and cultures under a unique though sometimes frustrating political system. You can piss and moan all you want, but we got game.

Posted by: Lee_A_Arnold | July 10, 2010 12:28 AM | Report abuse

EarlyBird1 understands it better than Greenspan. or rather, Greenspan may understand, but his bias has always been against ordinary workers and for the wealthy. Read anything by William Greider.

Posted by: Mimikatz | July 10, 2010 12:27 PM | Report abuse

Greenspan's clarification is bogus and you should say so explicitly. How is it possible for the market to make a "rational short-term bet" on a 10- or 30-year T-bill? You have to go back to 1958 to find 10-year rates as low as today's.

Posted by: McWatt | July 10, 2010 11:32 PM | Report abuse

All of these pro-deficit arguments ignore that paying the debt back in the future will make us poorer in the future. It's the last grasp of the baby boomers for whatever wealth this country has left- stealing it from the future.

Greenspan is right, Treasuries are where a lot of money is getting parked now- but it's a part of the big bank scam, where we give them free money to lend to the government at interest.
http://www.zerohedge.com/article/guest-post-fed-funding-treasury-through-banks

This is how QE is getting done now. Have to sneak it past China.

Posted by: staticvars | July 11, 2010 1:52 AM | Report abuse

Question two for huge deficit lovers- do you think increasing government borrowing increases or decreases systemic risk?

Posted by: staticvars | July 11, 2010 1:59 AM | Report abuse

William Kristol spearheads the case for invading Iraq, selects Sarah Palin for John McCain and the Republican party, and he's lionized by the right and more and more people listen to him and give him platforms on TV to continue to theorize.

Alan Greenspan champions Randian economic shell games that eventually crash and burn the economy worse than anything in decades, the second worst in our history perhaps, and he's given speaking slots at conferences where important people and columnists continue to listen to his words of wisdom.

We've got a serious problem in this country, and we don't even know what it is.

It's like a city has been destroyed by rampaging carloads of evil clowns, and while we run around trying to put out the fires and clear the rubble to rebuild, we're still asking the clowns for advice on how to do it. They honk their horns and gleefully tell us to just let them back at it, and everything will be alright.

We're seriously, seriously screwed.

Posted by: BillEPilgrim | July 11, 2010 3:39 AM | Report abuse

staticvars:It depends on what part of the economic cycle the deficits are created. Having deficit spending now will ultimately grow the economy by stimulating the demand side of the economy, which is very depressed right now. Stimulating it during boom times like Bush did with the no millionaire left behind tax cuts exploded the deficit when we should have been building up a surplus for this downturn, again engineered by the economic geniuses in the bush admin ( actually it has worked out well for the top 1%, which is the republican financial and political base. I remember Bush referring to a room of millionaires and saying just that...You are my base!

Posted by: srw3 | July 11, 2010 10:37 AM | Report abuse

@staticvars : to answer your question, a double dip recession/depression caused by lack of demand is far worse for our systemic economic stability than creating larger short term deficits to stimulate demand and rebuild infrastructure right now.

Posted by: srw3 | July 11, 2010 10:42 AM | Report abuse

"Greenspan's clarification is bogus and you should say so explicitly. How is it possible for the market to make a "rational short-term bet" on a 10- or 30-year T-bill? You have to go back to 1958 to find 10-year rates as low as today's."

Treasuries are very liquid. If you expect a budget crisis 10 years from now, but low inflation / deflation next year, you buy the long duration bonds, take your capital gains and then redeploy in something you like better in advance of the expected crisis. Lots of people thought junk bond yields were ridiculously low in 2006 and 2007, but invested nonetheless, as the yield was better than alternatives and the thought was you could get out before the credit cycle turned.

There are various investment theses out there too. Some investors have Krugman's perspective, think there won't be enough stimulus and we'll fall into an inflationary double dip, which is good for long duration bonds, at least for awhile. Some investors have an Austrian perspective and think the deflation is inevitable. A sovereign investor like China might think that it will have sufficient political influence over the U.S. in that it can force austerity if needed. The Fed has bought treasuries as well, and it has other things in mind rather than return. Banks can fund at low levels and enjoy great capital treatment for treasuries, but short duration notes don't provide enough yield. Corporations have been increasing their cash balances, most likely via mutual funds which invest in treasury bills.

Posted by: justin84 | July 11, 2010 2:13 PM | Report abuse

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