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How many economists does it take to start a flamewar?
Posted on June 10, 2009 by Richard Beddard
Filed Under Markets |
In theory:
It takes two, baby
Of all the bad jokes about economists my favourite doesn’t involve changing light bulbs:
- Q: Why did God create economists?
- A: To make weather forecasters look good.
Although our understanding of the economy, and the atmosphere, is sophisticated it doesn’t mean we can predict how they will behave, mostly because of the bewildering number of inputs, and the fact that each one influences the others.
But, I don’t remember a spat between two weather forecasters as intense as the one currently raging between Paul Krugman, Nobel Prize winner and professor of economics at Princeton University and Niall Ferguson, who’s professorship, in truth, is in history, not economics.
Krugman is a reconstructed Keynesian, so I feel I should support him as free markets are so obviously not self regulating. But Ferguson is a British exile, and presenter of the Channel 4 programme ‘The Ascent of Money’. Given their gladiatorial one-upmanship, sometimes I feel I should support him even though he seems to be an unreconstructed Monetarist.
They disagree about what rising bond yields tell us in the US, but also by inference in other highly indebted countries like the UK. It sounds incredibly dull, but actually, it seems, that everything depends on bond yields.
The disagreement started in the flesh at a symposium organised by the New York Review of Books last April, and they’ve pursued it in columns, letters pages, and blogs in the weeks since.
Ferguson is worried about government debt. He says that when governments borrow money to spend their way out of recession, as John Maynard Keynes prescribed, they neutralise the monetary medicine they’re also administering, in the form of lower interest rates. That’s because, when you raise finance by flooding the market with bonds, prices fall, and yields, or interest rates rise. Meanwhile, by borrowing so much to achieve so little, nations put their own creditworthiness and economies at risk, so bond yields rise to compensate investors.
Krugman says there is no contradiction, because the monetary medicine isn’t enough to put upward pressure on interest rates. For that to happen, demand for investment, and therefore borrowing, must be restored. But people in countries like the US and UK are over indebted so they are saving instead. That saving ought to be translated into investment but there’s nowhere for the money to go. Property markets are “flat on their backs” and businesses don’t want to invest because we’re not spending.
In normal times, cutting interest rates and printing money by buying debt and crediting bank reserves is inflationary, but these aren’t normal times. Banks aren’t lending those reserves.
When the private sector won’t lend and borrow, the government must step in says Krugman.
So why are bond yields rising? Economist and FT columnist Martin Wolf explains bond yields are ‘normalising’. They’re rising because back in March, when it felt like large sections of capitalism might collapse, they were exceptionally low. Then, the only investments that looked safe were those backed by the government, so prices rose, and yields fell. Now government borrowing has filled the gap, and the economy seems to be recovering, bond yields are rising to normal levels and not because investors fear inflation.
The disagreement hinges on ‘normalisation’. Two weeks ago Russell Napier told me that’s what economists would say about bond yields, until, almost unnoticed, they creep above normal levels, into the danger zone, at around 6%. Then stockmarkets crash as businesses labour under high interest rates and inflation, and investors switch out of equities and into high yielding government bonds.
It seems that policy-makers face the Butler-Miller paradox, named after the two economists who identified it, where the authorities stimulate the economy when inflation is falling to compensate for increased saving . When that store of saving is released, as people start spending again, policy makers must hike interest rates, restrict the supply of money and cut spending to restrict the double stimulus. It’s either that or unleash runaway inflation.
The question is will politicians, central bankers and their advisers have the skill and courage to do it?
Napier’s argument, and I suspect Ferguson’s, is they won’t, until it’s too late.
One thing’s for sure, economics is interesting again. My ‘A’ level teacher presented the big economic ideas as a battle between Keynesian and Monetarist schools. Thirty years of free market ideology sidelined the Keynesians, but now, after the havoc caused by bubbles in unrestrained markets, they sense their opportunity.
The extreme scenarios, the kind of stagflation that Ferguson and Napier see ahead, and the deflationary depression that Krugman and Wolf think we must avoid, would be terrible for the stockmarket. The choice is between the ruinous ‘70’s and Japan’s lost decade in the ‘90’s.
Somehow we must walk the tightrope between the two, which probably means it’s a good thing that economists and historians are slugging it out, however dogmatic they appear.
Here’s a blow-by-blow account:
- Round 1. Krugman and Ferguson head to head at the Metropolitan Museum of Art. Also in various corners: Nouriel Roubini and George Soros.
- Round 2. In his blog, Krugman says Ferguson is living in a Dark Age of macroeconomics, in which hard-won knowledge has been forgotten.
- Round 3. Ferguson warns Krugman that he’s in thrall to the long dead Keynes. Borrowing and spending will lead to insolvency or inflation.
- Round 4. Ferguson writes to the FT, accusing Wolf, who’s in Krugman’s corner, of ‘insouciance’.
- Round 5. Krugman produces a chart to show Ferguson that rising government borrowing is only offsetting falling private borrowing.
And, in an aside, Krugman notes that of the major European countries Britain, whose reaction to the crisis has been most aggressive, is expanding again (very weakly), while France, Germany, Italy, and Spain are still contracting.
Like rising bond yields, Krugman, who praised Gordon Brown for defining “the character of the worldwide rescue effort”, sees this is a good sign, but are we storing up more trouble?
Listening to Tory promises to cut spending, and Labour promises to keep investing during Prime Minister’s Questions today, it seems that politics is getting interesting again too.
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2 Responses to “How many economists does it take to start a flamewar?”
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Great post. They both seem right, just disagreeing over where the danger point is. And given that can’t be “predicted” at all, capping your exposure to interest rate rises (e.g. on your mortgage) seems a good idea right now.
Yet so many mortgage products are now uncapped trackers at several percentage points above base rate (rather than discounts to base rates people got used to during the boom times), it seems a lot of people could be caught out by even a small rise in rates… Hence the tips on a W-shaped recession?
Thanks Pragmatist,
I agree with you. I find it incredible that people who wouldn’t ‘gamble’ in the stock market under any circumstances are happy to speculate wildly on variable rate, short-term, interest only mortgages. The prevalent belief seems to be that when its time to refinance, conditions will be the same or better than before! But with such a large debt people should think about how they would cope if they aren’t.
It doesn’t even matter what shape the recession will be, all people need to know is that things could be worse than they are now at some point in the lifetime of their mortgage, and plan accordingly.
I wrote that people’s inability to think this way was the cause of the credit crisis: http://blog.iii.co.uk/why-didnt-we-see-the-credit-crunch-coming/ and it will probably be the reason why it will happen again!