Originally published at The Benfell Blog. Please leave any comments there.
Imagine that you are a bond trader.
Remember that you are in the financial industry. You believe in capitalism and are more than likely to the right of political and economic center. Even if you accept that John Maynard Keynes had a point–Paul Krugman calls it textbook economics–in suggesting that government should incur debt to encourage economic recovery, you have been alarmed that government has gone deeper in debt even in prosperous times rather than, as Keynes recommended, paying it off.
Now, imagine that you, a bond trader, have read a story in the Washington Post in which “the co-chairmen of President Obama’s debt and deficit commission” declare that “we can’t grow our way out of” a rapidly growing debt.
Now, recall that Krugman has pointed out numerous times that “investors don’t seem at all worried about the solvency of the U.S. government; the interest rates on federal bonds are near historic lows.” But you have the O.E.C.D., the I.M.F., the G.A.O. and our putatively spendthrift socialist president’s own debt and deficit commission warning of a crisis unless fiscal policies are tightened:
[Commission on Fiscal Responsibility and Reform Co-chairman Erskine] Bowles said that unlike the current economic crisis, which was largely unforeseen before it hit in fall 2008, the coming fiscal calamity is staring the country in the face. “This one is as clear as a bell,” he said. “This debt is like a cancer.”
I’m thinking that if you’re a bond trader, you’re getting a little more nervous about federal debt. After all, all these very prestigious organizations staffed with experts are pushing the panic button.
This is what is known as a self-fulfilling prophesy. And the logic isn’t principally based on immediate necessity. As Robert Reich puts it,
Many Americans borrowed too much during the boom years before the Great Depression, and now they’re paying the price. So they naturally analogize their own plight to that of the federal government and the economy as a whole. The government is too deep in debt, they reason. Logically, that means the only way out of the nation’s economic doldrums is for the government to mend its ways. The government has to reduce its budget deficit just like American families have to reduce theirs.
This analogy is faulty, of course. If John Maynard Keynes taught us anything, it’s that a federal budget is not at all like a family budget. In fact, it’s precisely because families have to pull in their belts that the federal government has to let its belt out. When consumers and businesses aren’t buying much of anything, the government has to fill the gap. That’s the only way to get jobs and get the economy moving again. Once the economy is percolating, the government can pull back. By then, tax revenues will soar, and the long-term deficit will shrink. (And yes, entitlement reform is probably necessary in the long term. But here again, it’s vitally important to separate the long term from the now.)
But the powers that be are all chanting a mantra that deficit reduction must come first despite horrendous unemployment. This is not the result of logic but of ideology.
And this is the part that Krugman and Reich fail to answer. Because at some point, when you trust your economic system to the market, what really matters, whether the markets are collectively right, wrong, prudent, or bat shit crazy, is what the markets believe. Theories, analysis, and statistics may at any point, entirely subject to the vagaries of fickle human nature, cease to matter.
Even if it has yet to appear in market behavior, virtually all the capitalists I’ve been reading are united in their fear of expanding federal debt. To the extent they concede that unemployment inhibits economic recovery, they seem to see it as a necessary price. “There are no good answers,” I remember John Mauldin writing.
So I imagine that as a bond trader, you’re probably going to start insisting on a little higher yield on government debt any day now. That will, of course, make the deficit worse because now a larger portion of government revenue will have to be diverted to service the debt. And of course, as Reich and Krugman point out, prolonged unemployment–which on the advice of all your experts the government will do absolutely nothing about–depresses those revenues.
So, as a bond trader, you’ll insist on a still higher return. After all, you have your own interests to look out for, and a capitalist mantra is that the universal pursuit of individual self-gain will benefit society the greatest. You’re pushing the economy on a tailspin, but you’re just doing what you’re supposed to do, and counting on the rest to work itself out somehow.
I guess I’m the crazy one for not believing you.