September 20, 2004

The Economists' Voice: Stiglitz

Joe Stiglitz brings back the Keynesian view on deficit spending with a vengeance: "Run a deficit when there is insufficient demand; try to get the biggest bang for the buck...; try to spend the money in ways which enhance long term growth." Right, then. The second and third tenets should be non-controversial. As for the first… well, see 1993. But wait! Stiglitz did see 1993. And here's what he has to say:
The official argument was that deficit reduction allowed lower interest rates; lower interest rates led to more investment; and the increased investment spurred the recovery. But that is unconvincing—largely because it implies a false connection between deficit reduction and lower interest rates. ... As the last few years have shown, Greenspan had considerable room to lower interest rates with or without deficit reduction. So while lower interest rates may have spurred the recovery, deficit reduction did not.
Wait a minute, we say. What about long-term interest rates? How does the Fed keep those down if its running deficits? To which Stiglitz replies: "Presumably, the Fed could have intervened more directly, by buying up long term government bonds, rather than just buying Treasury bills, as it customarily does."

Some context first. The usual supply-and-demand argument has it that when the government runs deficits, it issues more bonds. More bonds equal lower bond prices, which means higher bond yields and hence higher interest rates. Stiglitz is saying that the Fed (or someone else) can intervene by buying back those bonds directly, and bond traders will never know we're running a deficit.

In part, that's what happened over the last few years, according to a recent Fed study. (Although the Fed study uses "no arbitrage" finance models rather than classical supply-and-demand arguments**.) Japan came through for us big, purchasing Treasury bonds in high volume, and knocking down yields 50-100 basis points. Long-term yields also fell because the Fed went on a wild bond buyback when it was carrying a short term surplus between 2000-2001, and reduced bond issues in the late '90s. But hey! That means the Clinton surpluses were partly responsible for the Fed's ability to run low interest rates during the Bush recession.

But that's only part of the story. As the Fed Study above notes, Greenspan was also able to hold long term interest rates down simply by saying so. Brad DeLong called this "open-mouth operations," meaning that Greenspan has so much credibility as an inflation hawk, that when he says "I'm keeping interest rates down," investors truly believe he won't let things get out of hand (by "things get out of hand", I mean inflation and rapid rate increases).

So the last four years have been a relatively special case. Greenspan could do what he did because a) he's a rock star on Wall Street, b) central banks in Japan and China are willing to take on a shitty investment for strategic reasons, and c) the Fed went on a quick 'n' dirty bond buyback, announced in 1999, thanks to the Clinton surplus. I don't think we can always count on this perfect storm appearing to keep interest rates low even as we steep the country in red ink.

**The Fed study is massively interesting, and I wish I could understand more of it. It basically looks at the Fed's approach interest rates from a finance (rather than an economics) perspective. Daniel Davies wrote an essay on this topic a while back—showing how to factor in expectations when figuring out the bond market. I'm not very good at that sort of thing. I wish I was, but I'm not.
-- Brad Plumer 7:38 PM || ||