On DeLong V Krugman

Brad DeLong and Paul Krugman are having a mini debate on whether Brad et al (that means the Clinton administration) had good reason to fear bond vigilantes in the 90s. Krugman wrote tht they did not.*

Krugman phrases Brad’s argument as high deficits cause high inflation which causes tight money.   He notes that the inflation implies high nominal interest rates and low real interest rates so it should cause high demand now and writes “It’s not at all easy to tell a coherent story in which the effect of future expected deficits on today’s interest rates is contractionary “ I’m not going to let a challenge like that get by me.  On the spot, without using pen or paper I try 2

1) Very political economy  and trying to read Greenspan’s mind of the time.   Greenspan would have punished Congress and Clinton for disobeying his command to cut the deficit with high interest rates.  Note I make no reference to inflation.  In fact, in my model, I assume there is no inflation.  Monetary authorities using tight money to punish elected officials for violating Austerian doctrine strikes me as totally obviously what regularly happens (note your discussion of episodes of alleged expansionary austerity, in any case deficit reduction followed by high growth and speculate as to why Alesina claims that spending cuts work better than tax increases).

Basically the story that we have to do what Greenspan says or he will make US workers suffer makes a whole lot of sense to me.

2) Hmm I will assume that productive capital depreciates very quickly (and so is just a material input reall) so long term interest rates matter only for home construction (this is just an unrealistically for exposition strong version of something you wrote here) .  I will assume that the home equity loan (heloc) market is not developed and people think of taking a second mortgage as a desperate last resort (I think this was true in 1993). Finally assume extreme nominal wage rigidity.  Really assume that medium income economic agents assume extreme nominal wage rigidity so inflation implies low real wages.   In fact, assume nominal wages are permanently fixed so inflation is high prices for while but is eventually followed by deflation to get real wages back to normal.  A couple with low financial wealth considers buying a house.  The relevant real interest rate is the nominal rate corrected for wage inflation.  Oh that’s the nominal rate.

Yes someone has to have financial wealth.  I assume people accumulate it after paying off their mortgage.  These people would face a negative real interest rate.  There would be the effect of the change in real interest rates on their consumption.  I assert that the effect of real interest rates on consumption  is negligible.  This can be modeled assuming those with financial wealth are rentiers without labor income and that they have logarithmic utility.  But I assert that it is clear from the data and that any discussion of important effects of real interest rates on consumption and saving is proof of detachment from reality.

Here the story really is that what  depends on interest rates is housing and that the housing market depends on the ratio of a monthly mortgage payment (notably nominal) and current wages.  It does require sophisticated investors in the bond market and unsophisticated home buyers (given the other assumptions that’s just to rule out the heloc borrow from Peter to pay Paul strategy).

I think this second story is the truth, nothing but the truth, and the only truths that are relevant to the debate which I call for Brad.

* update: Preceding sentence revised and one sentence deleted.

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