While Brad DeLong provides a nice summary of the debate through yesterday, Kash has been very busy this morning. I shared a question over at David Altig’s blog that simply queries what would Rip van Winkle think if he woke up from a nap that began in 1985. In 1985, the debate centered on the “Twin Deficits” – the fiscal irresponsibility during Reagan’s first term and the large current account deficit caused in part by a massive dollar appreciation. Rip might be happy to have learned that Reagan’s second term saw a strong recovery even as the dollar devalued and reversed the slide of the current account. Rip might next ask what is different in 2005 versus the situation 20 years ago. I’ll toss a few items and simply solicit comments.
The first item comes from the fact that the reasons for the current account deficit now are quite different from the reasons for the current account deficit during Clinton’s second term. By definition, the current account deficit is the difference between investment and national savings. During Clinton’s second term, national savings was higher than the pitifully low levels we have been witnessing since 2001. During Clinton’s second term, we were enjoying an investment-led boom but we suffered an investment-led slump that started just as George W. Bush was taking office.
Interest rates were quite high in 1985 and are low today. Of course, one would expect low interest rate during a period of weak investment demand. As investment demand is picking up, the Federal Reserve is reversing its easy monetary policy.
Much of the hard landing camp is noting that much of today’s current account deficit is being financed by Asian Central Bank mercantilism. The old Mundell premises about floating exchange rates may be good macroeconomics for the 1980’s, but we may indeed have entered Bretton Woods II. If these Asian Central Banks abandon their current form of mercantilism, an analysis of the effects would have to go beyond these particular Mundell premises.
However, I still hold to some of the critiques of Reagan fiscal irresponsibility from Thomas Sargent that Rip likely read before his nap. Sargent held out the possibility that policymakers in the 1980’s were not insanely devoted to spend and borrow but were rather playing a transitional game of chicken as to how to restore fiscal sanity – as in slashing spending versus raising taxes. Fiscal sanity in fact was restored in the 1990’s with a combination of tax increases and defense spending reductions. If markets are forward-looking, what are they expecting future fiscal policy will be given that the ruling party has the courage to neither slash spending nor raise taxes. If private agents 20 years ago held hope for fiscal sanity, but private agents today have no such hope, how does this affect our analysis as to the soft v. hard landing debate?