Jun 6 2009, 9:58AM
Paul Krugman and Niall Ferguson: The Great Inflation Smackdown
How afraid should we be about inflation? Via a nice post from Ezra Klein, I see Daniel Gross has a Slate column parsing the arguments between Paul Krugman and Niall Ferguson. Krugman wrote a column last week suggesting the inflation scare was in part a Republican conspiracy, and Ferguson devoted an FT column to settling a debate he had with Krugman on a panel in New York. (Yikes.) What's the controversy? From Gross:
In a nutshell, Ferguson and his allies believe that the rising bond yields prove that markets are worried about the inflation that will inevitably result from the fiscal policies of the Obama administration and the Fed. Given the large deficits and rising concerns about the viability of Social Security and Medicare, Ferguson writes, "It is hardly surprising, then, that the bond market is quailing." [...]
Krugman and his fellow travelers couldn't disagree more. Far from being a sign of failure and impending disaster, they say, the rising bond yields actually signal success and impending improvement. Government bonds were so low last December because the world's investors were totally freaked out about risk. They sold everything--U.S. stocks, emerging market government bonds, corporate bonds in Europe, Indian stocks--and parked their cash in the safest, most liquid investment around: U.S. government bonds. In the months since then, as the stimulus and bailouts have helped stabilize the economy, investors have started to relax. [...] This line of argument makes sense, especially when you look at a very long-term chart of the 30-year bonds, which shows just how much of an aberration the December 2008 lows were.
Here is the chart Gross has in mind:
(The current yield does look less worrying in context, though a Fergusonian [?] would respond by saying it's the rate of increase and not the level that has them worried.)But a related question is whether this is all political: Are inflation Cassandras parsing the bond-market in search of reasons to criticize Obama and the Fed? Dan Gross says yes. But since I haven't yet developed the ability to see into Niall Ferguson's brain, I'll just say zthat I've been thinking a lot about this penultimate paragraph from Gross:
Finally, the notion that the market is telling us something -- anything -- ultimately rests on the erroneous assumption that financial markets represent the collective wisdom of rational actors processing information efficiently. There are plenty of cool-minded forward-thinking investors in the markets. But there are also a lot of lunatics, fools, sharks, widows and orphans, government actors with ulterior motives, algorithmic traders, greedy speculators, and whack jobs. The markets resemble the Star Wars bar scene more than they do the economics faculty lounge at Princeton.So here's a question for the weekend: Why should we care if the bond market is rational? Of crucial importance for predicting inflation are present inflationary expectations: If there is a widespread fear of future inflation, workers in the present should demand higher wages in their contracts, which in turn will lead to higher prices, which in turn will lead to ... inflation. (James Kwak had a good explanation of inflationary expectations a while back, and the Federal Reserve Bank of San Fransisco has a good explanation of how this is measured through the bond market here.)
But I don't think the Fed cares why anyone has these expectations. You can fill the bond market with all the goofy people in the world. If the goofy people think long-term inflation is coming, it'll affect long-term inflation. Paul Krugman says we have nothing to fear but the fear of inflation. But isn't the fear of inflation, er, worth fearing?
A final question, of course, is why we should believe the faculty lounge at Princeon doesn't resemble the Star Wars bar scene.
Photo of violence in the Princeton faculty lounge from Wikimedia.
So the inflation scare is a Republican conspiracy? China and Germany have both been vocal lately about their fear of USA inflation. Are they part of the conspiracy?
Krugman is obsessed with politics, his view of the world is distorted by his intense partisanship. If Bush II were president rather than Obama (but had spent the same amount of money as Obama), people would be just as worried about future inflation. Only the true believers and naive think US politicians have the political will to pay off the debt that has been incurred. The logical consequence will be eroding the debt via inflation.
Krugman points to unused capacity precluding inflation. He may be living in the past. Yeah, our car manufacturing is way under utilized (for example) but there is a very good structural reason for this: Detroit can not compete effectively in the auto business. This is not going to change anytime soon.
There are a lot of workers unemployed but a lot of them are unemployed because they don't have the skills to get a job unless the economy is red hot. We've seen the internet bubble, the easy money bubble, and the housing bubble. Just how well can we expect our economy to perform when there isn't a bubble?
Nowadays there is a global economy which means global competition for workers and companies. If you can't compete, then there is going to be underused capacity. It is possible to have a stagnant economy and still suffer from inflation.
Back in the days of Jimmy Carter we had stagflation, a combination of a stagnant economy combined with inflation. It was horrible. Obama reminds people of Carter (except less idealistic, as one would expect of a Chicago machine politician).
Oh gosh, no, I don't think it's a Republican conspiracy ... I mean, you don't need to look further than Krugman's princeton colleague Alan Blinder (a loyal Democratic economist) to see that's not the case:
http://www.ritholtz.com/blog/2009/05/blinder-sees-rising-inflationary-expectations-in-bond-market/
Here I think Blinder is basically making the same argument that Ferguson is making --- you can see inflationary expectations in the bond market.
Conor,
It appears that I have committed internet friendly fire (I was aiming at Krugman, not you).
My impression is that Bernanke's response (dropping loads of money into the economy to fight deflation) was correct. My problem has been with the stimulus package and the bailouts. The problem of fighting deflation in the short run and inflation in the longer run is inherently tricky.
BTW, it is possible to make money in inflationary times. During the late 70's real estate tended to be a good investment (at least in Austin, Texas). The real estate value tends to keep up with inflation and the loan is paid back with depreciated dollars.
On the topic of recovery (which we were not discussing), doesn't it seem obvious that we ought to reduce the burden on corporations so that it is easier for them to hire and fire? For example, why should corporations have any responsibility to provide social security payments, unemployment, medical benefits, pensions, i.e. anything but a job with a good salary? By making it cheaper for corporations to hire (and fire) people, corporations will hire more people, reducing unemployment.
I would advise not even taxing corporations as long as the profit is reinvested in the USA.
To make up for the increased governmental expenses and lost tax revenue, I suggest instituting a progressive VAT (i.e. exempt the basics like food and medicine from taxation and tax expensive goods like fancy cars more than cheap goods).
I'm actually surprised rates are so low.
Anyone who is at all cautious (or cynical) knows the deficit will not come down as fast as Obama (or even CBO) are predicting. They know that a new health care plan is an unpredictable expense, along with CO2 legislation, energy legislation, etc. They know Social Security and Medicare are huge problems. And they know this recession is not over, and that recovery will not be quick or strong.
They also know that if rates go up, the U.S. budget picture deteriorates even further. Mortgages get more expensive, the recession gets deeper, and the interest to be paid gets larger.
So given how unstable the situation is, and given the huge amounts we need to borrow for decades under any realistic scenario, how in the world is anyone prepared to lend us money for 30 years at 5%?
I really think the stage is set for some kind of panic. If the U.S. does the wrong thing (or continues to spend as if there's no tomorrow), at some point, someone is going to edge towards the exits, and the rush will start.
I'm wondering if California's budget will be a tipping point. If the state simply will not live within its means, will not raise taxes, and cannot borrow any more money, what happens? If the Federal government steps into guarantee the state's loans, I think that is another strong signal that we just aren't serious about managing our budget at any level. I expect there will be a reaction to that.
We'll know in a few weeks.
Conor,
We care about rational agents in the bond market for two reasons. 1. if they are highly irrational, it is more likely there will be more mean reversion in prices/rates. We overreact today, so we overreact tomorrow. Feeling terrible about that, we underreact the day after. etc. This is important because, imho, we are going from a dangerous deflationary spiral of 6 months ago to the normal level of inflation of 1 1/2 years ago (see how the TIPS charts look). This is good, but if the bond market is nutso it could overshoot.
As you note, overreactions can feed into themselves, where I am overreacting against you and you me, and the rational smart arbitrageurs have all gone bankrupt because we've pushed prices so far away from fundamentals that they've been wiped out on their leverage. That doesn't worry me so much.
2. The big issue here is that there are two issues - 'Green Shoots' + 'Inflation' = Increased Yield on 10 Years. Both increase yields on the 10 years. So you have one value to solve two unknowns. It's tough to tell which consumers are feeling which just looking at that chart. We use the TIPS spread as another equation, where TIPS is 'Inflation' = 'Increased Yield on 10 Year' to solve out the Green Shoots part. I've been neck deep in a work project Conor so I haven't followed this closely on the non-financial blog side - is everyone watching TIPS spreads? I think that graph is even more striking in terms of a "return to normal" chart.
3. This is fantastic, and accurate inho. Even Kudlow looks embarrassed at his co-host:
http://zerohedge.blogspot.com/2009/06/melissa-francis-takes-on-deutsche-chief.html
4. To be a lefty about this, but the idea that labor is in some position to argue their salaries with Captial in the way they were in 1970s is so wrong in my book. Back then it was contractual, wages adjusted for inflation. There needs to be a credible threat of work shutdowns or quits, and with U6 and union numbers and health insurance what they are the part where labor credibly demands more wages to spin the inflation cycle around 360 isn't there. Labor didn't get wage increases during the 2001-2007 boom years, how can they pull off getting them now!?!?
5. For whatever it is worth, every bond trader I know is piling into the high-yields. (Not trading advice for anyone!) They are certainly making their beds as if green shoots are starting to show....I'll try and post on this more...
Keep up the good work!
Conor:
All I can say is that the bond market predicted the recession (remember those low rates as the stock market soared?). So I am a believer in the bond market, no matter its compositon!
Roger
I think I'll make myself a persona as resident Krugman apologist commenter.
I think Krugman's point on inflation as Republican conspiracy is that the reason we're hearing about it all the time is not because Niall Ferguson is a Republican shill as much as actual Republican shills are blasting Ferguson's concerns to the media who are reporting on it without good context and writing columns about an impending inflation disaster without understanding the opposite view which he represents. It's not much less hacky or self-aggrandizing but it is a lot more sensible.
In his blog he's taken on the what he would characterize as the myths of the fear-inflation crowd:
Here on stagflation:
http://krugman.blogs.nytimes.com/2009/06/03/the-stagflation-myth/
Here on borrowing:
http://krugman.blogs.nytimes.com/2009/06/06/wheres-the-money-coming-from/
I'm not an economist, so these arugments seem sensible to me, but what do I know? I do know I was worred about deflation, for the short term I am not worried about inflation until a better case than Ferguson's comes along, or at least until that Treasury yield chart starts to spike up to 8 or so instead of finally climbing back to 5.
In a service economy, I don't see how current levels of unemployment can make me worry about inflation - so much of what we spend is based on the cost of labor the salaries of people doing the work that even commodity cost increases may well drive people to consume services more and hard goods less (since they'll be relatively cheaper) and we have a LOT of room to consume services before wages really start driving up.
Can't help addressing first poster's (Republican conspiracy) comments. He illustrates perfectly why it is a new party line for the Right to beat the inflation drum (along with trying to fan hysteria about how opening Medicare/Medicaid to anyone who wants to sign up is the Road to Serfdom).
Way back in the antediluvian early '90s, while a mere lad, I overheard two overfed traders in New York (and not very successful ones, by the by) opining that, with the election of Bill Clinton, it was time to get out of bonds as "now we have a Democrat, so we're getting deficits and inflation. You know, like Carter." I hope they stuck to that plan, since that would have had them fired pretty quickly, and they were too dumb to be managing anybody's money.
This kind of 'thinking' is endemic to conservatives: since they idolize (and idealize) the past (or is that just live in the past?), every liberal policy, every deficit or rise in government spending is for them a retread of recent history, especially when that (now not so recent) past coincides with the crack-up of a liberal era and their rise to power.
The last poster above makes one of many necessary points on how much has changed in the national and global economy since the '70s (when we were terrified of the Germans and Japanese, who were complaining about the weak dollar and irresponsible America and were about to take over what was left of the U.S. economy according to mass media--anyone remember this?) If labor has zero pricing power, the savings rate continues to rise, and consumption stagnates or barely rises, even a highly expansionary monetary policy is not so inflationary.
Krugman and others have pointed out that declining velocity of money can cancel out any increase in its supply (i.e. if you and I get a tax cut and save it for one year, spending it only after I get my tax refund the following year, the effect on inflation is nearly or truly nil--especially if the bank I put the bucks in is rebuilding its capital and won't lend--or if in fact I buy gold with my extra money; whereas during the Bush binge I spent every dollar of my cut and it then recycled through the economy twelve times during the year as it was earned, spent, earned, spent by various economic actors).
China, Russia, some EU observers and others are worried about the value of the dollar, and if most of the excess dollars being 'printed' by the Fed leak overseas that could cause the dollar to weaken even if there is little or no U.S. inflation. So, even with no U.S inflation, dollar reserve holders lose big. Or we successfully 'export' the inflationary effect, if it happens, because our economy stagnates (lucky us)--the extra money sloshes into economies abroad that are growing faster.
This is exactly what happened as the Bank of Japan tried without success to end the Japanese (contained, low unemployment) depression throughout the 90s--inflation spiked in many Asian countries, until they imploded in financial crisis. Since the Japanese banks remained largely bust and didn't meaningfully expand lending, their economy remained deflationary even with zero interest rates and huge expansion of the money supply (although that money helped feed our stock market bubble). Another thing we've forgotten about, since the Chinese surpassed them and financed all our Bush era deficits in recent years.
As for manufacturing and capacity utilization, without being any kind of professional dismal scientist, since we still produce more than 80% of what we consume (what is trade now--15% of GDP? 12%) they still matter. Giant deficits in a growing economy will eventually have inflationary effects. But then, growth should cut deficits as tax revenues recover--and increasing taxes may be an excellent way to mop up any inflationary effect (the Bush cuts expire in 2011, remember?). This is the worst nightmare of the Friedmanites--Obama succeeds in reviving the economy, inflation is tamed, and tax increases make Wall Street cheer and revive the financial markets--which would be Clinton all over again.
But then, things don't repeat themselves exactly the same way ever...and we should be so lucky as to have the inflationary problem, as opposed to the Japanese situation, but with 10% unemployment instead of 4%. In general, I think everyone should agree that this huge increase in the national debt is terrible, but less terrible than the remaining options (slash spending? raise taxes now, on everybody? thank you, but no, Mr. Hoover....) I would worry more about a Chicken Little "inflation-is-coming!" hysteria causing interest rates to spike so much that 'green shoots' become dead weeds by year's end and we go into Nippon-style economic catatonia.
Full disclosure: as I still make a living (or try to) selling Real Estate, I have a personal interest in not facing 8% mortgages in six months to a year. The pain that would inflict goes far beyond me, however. And vis-a-vis the supposed boost inflation will give Real Estate, yes, if the '70s return and we are all wearing cardigans & bell bottoms and listening to Donna Summer, I will be selling tax shelter-partnerships, Florida time-shares and houses will appreciate rapidly and...do I have to grow a mustache, though?