Do I Disagree with Paul Krugman about the Policy Relevance of Risk Premia ?

As always, I seek an economic issue on which I disagree with Paul Krugman. I think I might only partially agree with his recent tweet storm. I certainly think that Twitter is not the best medium for discussion of economic theory.

update: The man can be irritating. His op-ed (too short but better than a tweet) discusses the issue very clearly and convincingly without any jargon.

The point is Krugman (and I) believe in Keynesian aggregate demand effects of government spending, but they are not central to the current debate.

So why not borrow money at these low, low rates and do some much-needed repair and renovation? This would be eminently worth doing even if it wouldn’t also create jobs, but it would do that too.

end update

Kenneth Rogoff argued that persistently extremely low safe interest rates are not proof of secular stagnation and do not necessarily imply that increased deficit financed public investment would be good policy.

Low real interest rates mask an elevated credit surface … What about the very low value of real interest rates? Low rates are often taken as prima facie by secular stagnation proponents, who argue that only a chronic demand deficiency could be responsible for steadily driving down the global real interest rate. The steady decline of real interest rates is certainly a puzzle, but there are a host of factors.

This puzzled Brad DeLong. I wrote rude things about Rogoff. Brad took the debate to twitter. Krugman wrote a brief (this is twitter) argument defending Keynesian stimulus.

Paul Krugman ‏@paulkrugman 13h
The Policy Irrelevance of the Risk Premium: 1/ Brad DeLong (@delong) has a multi-part discussion of the question of whether the very, very

2/ low interest rates on government debt, short- and long-term, are a good indicator of overall credit conditions. Obviously private agents

3/ can’t borrow as cheaply as the US and German governments. Much less clear whether this risk premium has gone up. But the real point

4/ surely is that from a policy point of view *it doesn’t matter*. Low short-term rates make conventional monetary policy ineffective;

5/ low long-term rates make government borrowing attractive. So it’s the low government borrowing costs that make the case for fiscal

6/ expansion, whatever is going on with risk premiums — unless you have some way to sharply reduce those premiums, which you don’t

The point (if any) of this post, is that I discussed the policy relevance of of risk premia here

I realize that I can’t summarize my post by cutting and pasting a comprehensible bit (I define notation and stuff) nor can I really recommend clicking the link and reading it. The contrast with Krugman’s tweet storm reminds me of his extraordiary ability to discuss technical topics briefly and clearly and cut to the policy relevant point.

But I do want to understand why I seem to disagree with the claim that risk premia are policy irrelevant. I think it is really very simple. Krugman is (as usual) discussing an economy in the liquidity trap. He doesn’t state this because Twitter. This means he assumes that increased Government investment doesn’t crowd out private investment. I discussed an economy with full employment. I really was thinking of an economy in which the unemployment rate is at the target chosen by the monetary authority (the level which they believe — perhaps incorrectly — is the maximum consistent with non accelerating inflation).

I think my assumption is the one relevant to the current policy debate. Although the Federal Funds rate is very low, the FOMC is considering increasing it. The target (0.25-0.5%) isn’t the lowest ever (0.0-0.25%). This tiny difference in interest rates has huge implications for the response of monetary policy to fiscal policy.

In any case, extremely low safe interest rates don’t have to be zero — my discussion of fiscal policy with positive safe interest rates below the growth rate of the economy might have some trace of policy relevance.

In this case, public investment crowds out private investment. I presented a model in which this is definitely a good thing as the very low safe real interest rate implies that private investment is Pareto inefficiently high (there is dynamic inconsistency). I also present an alternative model in which the crowding out causes a transfer to current owners of capital at the expence of future generations. This means there is a model in which public investments with a social return higher than the safe rate and lower than the risky rate are bad policy.

The reason I think Krugman’s tweet storm is not the last words on the topic is that monetary policy will not always be at the lower bound. The question of what fiscal authorities should do when safe interest rates are very low but not zero may be of some policy relevance.

Of course real world fiscal authorities will ignore the discussion entirely, so it is purely academic and not worth your time.