Jonathon Portes on macroeconomics and the deficit:
As we all know, since then both the US and UK have had deficits running at historically extremely high levels, and long-term interest rates at historic lows: as Krugman has repeatedly pointed out, the (IS-LM) textbook has been spot on. Empirically (and theoretically) well-founded? Definitely. As Simon Wren-Lewis points out here. Recent developments have in many ways been a vindication of the basic Keynesian model that lies at the heart of any undergraduate macro course.
The policy implications are of course not unambiguous – the conclusion isn’t “borrow as much as possible” – but the implication that, when you have excess (desired) private saving, government borrowing won’t push up long-term interest rates is obviously important. So score one for macro 101. Of course, there were economists, not just people like Ferguson, arguing the contrary in public; but generally not on the basis of a different analytical framework, with the result that their analysis was confused at best. See for example my debate with David Smith here, where David begins by explaining that low interest rates reflect “market confidence”, and ends up by saying that they reflect the “fragility of the banking system.”
Of course, some countries – all, not coincidentally, members of the eurozone – that have high deficits have indeed seen interest rates soar. So a second, and equally policy-relevant, example is “what drives the possibility of a sovereign debt crisis?”. Here the economic theory was set out very clearly by Paul De Grauwe, of the University of Leeuwen, for example here (and versions of this paper were circulating as far back as mid-2010):
This separation of decisions [in a monetary union] – debt issuance on the one hand and monetary control on the other – creates a critical vulnerability; a loss of market confidence can unleash a self-fulfilling spiral that drives the country into default. Suppose that investors begin to fear a default by, say, Spain. They sell Spanish government bonds and this raises the interest rate. If this goes far enough, the Spanish government will experience a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates…
It doesn’t work like this for countries capable of issuing debt in their own currency. To see this, re-run the Spanish example for the UK. If investors began to fear that the UK government might default on its debt, they would sell their UK government bonds and this would drive up the interest rate. After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign-exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets.
The economic theory underlying this verbal explanation is clear and convincing. And so is the empirical evidence. Not only have Japan, the US and the UK all failed to experience self-fulfilling liquidity crises resulting from their very large deficits, so has every other developed country that issues debt in its own currency.
This contrasts, of course, with the eurozone experience; and it is precisely what theory predicts. It is quite rare that an economic theory – macroeconomic or microeconomic – is so clearly and comprehensively vindicated so quickly. Again, the policy implications are not that we (or the US) can or should expand our fiscal deficit without limit. But they are very clear that we should ignore the ratings agencies, and that anybody who is still arguing that the current path of fiscal consolidation – and the economic damage it has done – was necessary to preserve “market confidence” has chosen to ignore the evidence.