The following comes from the testimony of James Galbraith on June 30 appeared before the US Commission on Deficit Reduction and is the section of that testimony that had the above title, with which i completely concur:
Markets are not calling for Deficit Reduction; now or later
Let me turn next to a larger economic question. Do deficit projections matter? Are they important? Was the President well-advised to frame the mandate of the Commission as he did?
What, in short, are the economic consequences of a high public deficit and a rising debt-to-GDP ratio, and what (if any) benefits are to be expected from creating an expectation that deficits will come down and that the debt-to-GDP ratio will fall?
The idea that US economic policy should aim for a path of reduced deficits in the future, is shared by liberals and conservatives, and it is, from a political standpoint, a very powerful idea. The Commission’s charter takes for granted that this goal is desirable. It specifies that your objective is to achieve a balanced “primary budget” — net of interest payments, by 2015.
Yet your charter does not say why this is an appropriate goal. It cites no study to which one might refer. It does not explain why 2015 is the right target date, as opposed to (say) 2025 or even 2050. It does not spell out the economic consequences — if any — of failing to meet the stated objective.
Does the requirement make economic sense? I shall tackle that question in two parts. The first accepts the view most people hold of the fiscal and financial world. The second reflects, from an operational standpoint, how that world actually works in practice.
Most informed laymen believe that the Federal government must borrow in order to spend. They believe that the interest rate on Treasury securities is set in a market for government bonds. The markets impose discipline on the government. Thus their idea is that “fiscal responsibility” will produce low long-term interest rates and tolerable borrowing conditions for the federal government, while “irresponsibility” will be punished by higher, and eventually intolerable, debt service costs.
Accepting this view for the moment, what does the present level of long-term interest rates tell us? As I write, thirty year Treasury bonds are yielding just over four percent — or just a little more than half their yield a decade back. On the argument just given,this must be an extraordinary success of virtuous policy. It seems that Wall Street has made a strong vote of confidence in the fiscal probity of our current policies. This vote is unqualified, backed by money, contingent on nothing. It therefore represents a categorical rejection, by Wall Street itself, of the CBO’s doomsday scenarios and all other deficit-scare stories.
On this theory, it follows that the mandate to reduce the primary deficit to zero by 2015 is unnecessary. Such an action can hardly reduce interest rates — neither short nor long-term — which are already historically low.
But wait a minute, some may say. Yes interest rates are low at the moment. But bond markets are fickle, they can turn on a dime. And what then?
Yes, it is possible that interest rates could rise. But the problem with this argument is that it takes us away from the premise of rationality. If bond markets are fickle and arbitrary, who is to say what they will do in response to any particular policy? In the face of irrational markets, the sensible policy is to borrow heavily for so long as they are offering a good deal. One may say that all good things end, and perhaps they will. But if markets are irrational, then by construction you cannot prevent this by “good behavior.”
The conclusion from this section is that one cannot logically argue that markets insist on deficit reduction. Either the markets are rationally unworried about deficits, or they are acting irrationally right now, in which case they can hardly “insist” on anything.
In Reality, the US Government Spends First & Borrows Later; Public Spending Creates a Demand for Treasuries in the Private Sector.
As noted, the above argument is based on the common belief that the government must borrow in order to spend, and thus that the government faces "funding risks" in private markets. Such risks exist, of course, for private individuals, for companies, for state and local governments, and for national governments such as Greece that have ceded monetary sovereignty to a central bank. But the situation of the United States government is quite different.
The U.S. government spends (and the Federal Reserve lends) in a very simple way. It does so by writing checks -- in fact simply by marking up numbers in a computer. Those numbers then appear in the bank accounts of the payees, who may be government employees, private contractors, or the recipients of federal transfer programs.
The effect of government check-writing is to create a deposit in the banking system. This is a "free reserve." Banks of course prefer to earn interest on their reserves. Thus they demand a US Treasury bond, which pays more interest without incurring any form of credit or default risk. (This is like moving a deposit from a checking to a savings account.) The Treasury can meet that demand, or not, at its option -- it can permit, or not permit, the stock of US Treasury bonds in circulation to increase.
So long as U.S. banks are required to accept U.S. government checks -- which is to say so long as the Republic exists -- then the government can and does spend without borrowing, if it chooses to do so. And if it chooses to issue Treasuries to meet the demand, it can do that as well. There is never a shortfall of demand for Treasury bonds; Treasury auctions do not fail.
In the real world, the government creates demand for bonds by spending above the level drained by taxation from the system. The extent to which those bonds are held locally, or abroad (another common source of worry) depends on the US current account deficit. This also has nothing to do with approval or disapproval by foreign bankers, central bankers, or their governments of American deficit policy. A foreign country cannot acquire a US Treasury bond unless someone outside the United States has acquired dollars to pay for them, which is generally done by running a trade surplus with the United States. And when foreigners do acquire those dollars, then like domestic banks they prefer to earn interest, which is why they buy Treasury bonds.
Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system. The actual risks in this system are (to a minor degree) inflation, and to a larger degree, depreciation of the dollar. However at the moment there is wide agreement that a lower dollar would be a good thing -- against the Chinese RMB and now also the euro. So it is difficult to believe that the goal of deficit reduction per se serves any coherent, or presently desirable, economic objective.
We can conclude that there is actually no economic justification for the target of reducing the primary deficit to zero by 2015 or any other date. The right economic objectives are to meet real problems, not those conjured from thin air by economists. Bringing about a rapid end to unemployment, caring properly for an aging population, cleaning up the Gulf of Mexico, coping with our energy insecurity and with climate change are all far more important objectives than reducing a projection of future budget deficits.
Quite so. All comment to the contrary is, I am afraid, based on ignorance.
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From you own mouth: “Market mis-price: fact”
http://www.taxresearch.org.uk/Blog/2010/06/27/if-evidence-were-needed-that-markets-misprice-now-you-have-it/
It would be easier for people to support you (as I do on this particular issue) if there were consistency between your various posts.
@Jason
Consistency is only possible when facts are identical
When they’re not consistency is horribly over-rated because it shows:
a) inability to re-appraise data
b) erroneous judgement
c) a closed mind
None are attractive
I refer you to John Kay in Obliquity – where he suggests consistency the most horribly over-rated virtue
Except of course he does not see it as a virtue at all
He sees it as a falsehood spread by economists with little or no understanding of the real world.
I leave it to you to decide if you fall into that category, or not
Richard, tha ability to re-appraise one’s judgement on the base of new facts or evidence is surely commendable.
But I think that for purpose of the present argument it would be important that you explain why you think that markets are “correct” in setting interest rates at such low levels.
For it it is after all the same financial markets that mis-priced sub-prime mortgage risk, and led the global equity markets to vastly over-inflated levels.
The markets were obviously “wong” then. What makes you think that they are “right” now?
@Jason
Sub prime was mispriced because of the supply of deliberate misinformation
Current rates are being set on the basis of open disclosure of information on likely outcomes of current economic activity
Fundamentally different
“Sub prime was mispriced because of the supply of deliberate misinformation”
Which at the time was thought to be correct information.
“Current rates are being set on the basis of open disclosure of information on likely outcomes of current economic activity”
At this time this is thought to be correct information.
@John Scrivens
As usual untrue
Some of us worked out sub prime was mispriced
Asymmetry of data is not hard to identify and some of us did so
There is none now
If you’re saying that attaches a premium to wit, I buy it
But that’s another issue
And my argument remains intact. It’ yours that falls apart
There’s a quite simple way for lenders to assess the true capital value of property, above which they should never lend. That is the capitalised rental value. All else is speculative froth which they should skim off. Just shows how ignorant these super-rewarded bankers really are.
Carol Wilcox: “There’s a quite simple way for lenders to assess the true capital value of property, above which they should never lend. That is the capitalised rental value. All else is speculative froth which they should skim off. Just shows how ignorant these super-rewarded bankers really are.”
I’d be interested to know how you’d calculate that.
In principle, the capital value should equate to the NPV of future rents. In order to calculate that, you’d have to make assumptions about the likely levels of future rents, which is in itself a speculative exercise.
Richard, what was your moral standpoint when you worked out that sub-prime was mispriced? I presume you wouldn’t take a short position, due to your belief that shorting is morally wrong? However do you not think that such a situation is why short selling should be allowed?
@Greg
I oppose opacity because it produces abuse
Subprime used opacity
Abuse followed
@Paul Lockett
The fact of the matter is that rental values are fairly stable, varying with GDP and local investment. It should have been quite obvious that when capital values were jumping 20-30% pa the underlying rental stream was not. But lenders were happy to take the excessive rent (via interest) and leave the speculators to take the capital gain. Greedy and reckless.
Carol Wilcox: “The fact of the matter is that rental values are fairly stable, varying with GDP and local investment. It should have been quite obvious that when capital values were jumping 20-30% pa the underlying rental stream was not.”
Rental values certainly tend to be more stable than capital values. Land values, as you imply, tend to track GDP, with local investment having an impact on individual locations and those are things which tend to move relatively slowly.
That said, I still don’t see how anybody could calculate, with a high degree of certainty, the NPV of future rental values for a given location. In order to know those rental values, you’d have to know the inputs into them, such as the future GDP, future infrastructure investment, etc. and any schedule of those figures would, by their very nature, be speculative.
I think that part of the problem was that people did believe that the rental stream would grow to the extent that the capital values implied. People started believing that high, uninterrupted GDP growth, cheap credit and government interventions to keep land prices well inflated (shared equity schemes, etc.) were guaranteed.
“But lenders were happy to take the excessive rent (via interest)”
There was no excessive rent: lenders borrow from the wholesale market and loan to individuals at a margin. The intense competition drove those margins down, not up. Thinner margins meant more pressure to drive deal volume to make up the numbers, which is what we saw in increasingly exotic products and new markets.
“and leave the speculators to take the capital gain. Greedy and reckless.”
When there’s an apparent lending bubble, to refuse to lend means (in effect) you must shut up shop, close down your entire mortgage department and send everyone home. Because you cannot compete with the reckless lenders, and cannot do no business waiting for the market to correct while retaining high fixed operational costs: it can take years for a market to correct – it was apparent in 2003 that a bubble was underway yet here we are 7 years later and we are still in bubble territory.
You have a stark choice: shut down your business or compete with the rest of the herd. The very human pressures on any manager in a financial institution are to follow the herd (just look at what happened to Tony “Dr. Doom” Dyer who refused to engage in the internet bubble). Before we write this all off as “greed” we should be a little more open minded as to the environment in which people operate.
@John Scrivens
With regard to mortgages, the underlying market failure is in land, not buildings. Two solutions to market failure are regulation and taxation. The simplest way to correct the land market is to collect all land rent for public benefit. There would then be nothing to speculate on and land would be allocated to best use. Since policymakers seem blind to this option (perhaps because vested interests have removed their spectacles) the alternative is regulation of lenders so they are forced to use a capitalised rental basis for lending on property. The taxation option is far simpler and has many other benefits, including a welcome revenue stream.