No one can deny that Paul Krugman is a gifted expositor of economic ideas. His column today, "Death by Hawkery," constitutes a fine example of this skill in action.

What I found most interesting in this column is something that would have almost surely escaped his average reader. In particular, I noticed that in telling his basic story, he appealed to a mathematically explicit model of credit cycles written by Nobu Kiyotaki and John Moore (JPE 1997).

Why do I find this interesting?

Well, first of all, I notice that at the time, Kiyotaki was affiliated with that great "freshwater macro" department at the University of Minnesota. You will also notice that the arch-devil Ed Prescott is thanked (among others) for his "thoughtful comments and help" on the paper.

I mention this because I think that Krugman has in the past overemphasized the disagreement that exists among the newer cohorts of macroeconomists (one could make the case that disagreement was much greater in the past); see, for example, here: Disagreement Among Economists. On this matter, I side with Steve Williamson, who I think has rightly taken Krugman to task on this issue; see here and here.

Secondly, I find it interesting that the mechanism highlighted by Kiyotaki and Moore in no way relies on nominal or real price rigidities. It is, in fact, a real business cycle model. Yes, you heard me correctly: Paul Krugman is appealing to an RBC model to help him account for recent events. (Granted, it is an RBC model that incorporates limited commitment, a friction that plays a prominent role in all modern macro theory; see my post here: Asset Shortages and Price Bubbles: A New Monetarist Perspective).

I think this constitutes evidence that the great macroeconomic divide is not as great as it is sometimes portrayed. Most of the disagreement I am aware of is of the gentlemanly "let us agree to disagree" type. But there is no fundamental disagreement in basic macroeconomic methodology among most academic macroeconomists. (There are, of course, healthy and welcome challenges from the fringes of the profession.)

Now for some comments on the economic ideas.

As you may have gathered from my previous post, I am generally sympathetic to the idea of expanding the supply of U.S. treasury debt at this time (with a commitment to unwind in the future, if and when economic conditions improve). Of course, a big question is what to do with the funds acquired in this manner. I'm with Krugman in that heck, we may as well use it to build physical capital (public infrastructure). Financing a corporate tax cut to stimulate domestic private capital spending might be a good idea too (not so politically popular though).

These provisional policy recommendations suggest themselves to me by way of a class of "new monetarist" models that I like to use to organize my thinking about things. But I should say, however, that I'm still not sure just how seriously to take these models (at least, their current incarnations). I'm still a little sketchy about how one might plausibly generate negative real rates of interest in these models; that is, models that take seriously the intertemporal production capabilities of actual economies (you will note that Krugman abstracts from physical capital in telling his little story).

I can't help but note that this same class of models might be used instead to support "conservative" policies. In particular, one force that can potentially drive the expected marginal product of capital (real interest rate) lower is the rational (or irrational) expectation of a future regulatory/tax burden paid for by capital accumulators of all types (including human capital).

If (and I emphasize the if) this is the (or a significant part of the) fundamental problem (and how do we really know that it is not?), then it is hard to see how treasury debt expansion and/or inflationary policy is going to solve it. Fixing the problem in this case means providing an environment that rewards private investment. Death by Dovery is also a possibility. 

One way to measure the ability to service debt is to compute a debt-to-income ratio. Suppose, for example, that your income is $50K per year, that your home is worth $200K, and that you have a $150K mortgage. Then your debt-to-income ratio is 150/50 = 3; or 300%.

Similarly, one way to measure the ability of a country to service its national debt is to compute debt-to-GDP (a measure of domestic income) ratio. The ratio of U.S. federal debt to GDP is currently close to 100%.

Of course, what has a lot of people worried is not the level, but the trajectory, of this ratio. Clearly, the debt-to-GDP ratio cannot rise forever.

No, but on the other hand, there is some evidence to suggest that it can feasibly go much higher. (Whether it should be permitted to do so is a different question, of course.)

Before I go on, I want to clear up a misguided analogy that I frequently hear repeated. The misguided analogy is the idea of the government behaving like a household running up a massive amount of credit card debt.

If this is the way you like to think about things, let me ask you this: Which of your credit cards charge you 0% interest? I ask because that is the interest rate creditors around the world are willing to lend to the U.S. federal government. And what sort of credit card company starts to reduce the interest it charges on your debt as you become progressively more indebted (see the figure above)?

In fact, the terms are even much better than 0%. The real cost of borrowing is measured by the real (inflation adjusted) interest rate. As the figure above shows, the real cost of borrowing has plummeted over the last decade for the U.S. government. As the following figure shows, the U.S. government can now borrow funds for 10 years at close to zero real interest. It can borrow funds for 5 years at a negative real interest.


Now, a negative real rate of interest is a pretty cool deal. Imagine importing 100 bottles of beer from China today, and having to return only 99 bottles next year. If the interest rate remains unchanged one year from now, you can rollover your debt and make a profit. For example, you could borrow another 100 bottles of beer from China, use 99 of these bottles to pay off your maturing obligation, and then drink the remaining beer for free. (Of course, domestic beer brewers would become upset at the lack of demand for their own product, but maybe they can be bribed with free Chinese beer?)

Before we get too carried away, however, I explain here why these very low real rates constitute bad news.

Why are real rates so low?

My own view is that this phenomenon, at its root, has little to do with Federal Reserve or Treasury policy. I believe that the decline in real rates on U.S. treasuries reflects a steady change in how agents and agencies around the world want to structure their wealth portfolios. There has been a massive substitution away from many asset classes into U.S. treasuries; and it is this fundamental market force that is driving real interest rates lower.

The phenomenon began in the early 1990s, with the collapse of the Japanese stock market. Then Mexico in 1994, the Asian crisis 1997-98, Russia in 1998, and Brazil in 1999; see Bernanke (2005). Investors became rationally pessimistic about the returns to investing in these countries, as well as similar countries that had not yet experienced crisis. The natural effect of this would be capital outflows from these countries into relative safe havens, like the United States.

The basic thesis here is very much related to what Ricardo Caballero calls a "global asset shortage." See his discussion here and here; and my own discussion here and here.

The global investment collapse associated with the recent recession has pushed already low real rates lower still. There has been a flight to U.S. treasuries not only by foreigners, but this time by Americans too. Evidently, the perceived return to domestic capital spending remains low. (Some basic theory available here.)

Policy 

Given this pessimistic outlook, it seems unclear what monetary policy can do (the Fed is largely limited to swapping low interest currency for low interest treasuries).

I do, however, believe that there may be a role for the U.S. treasury (in principle, at least). In particular, given the huge worldwide appetite for U.S. treasury debt (as reflected by absurdly low yields), this is the time to start accommodating this demand. Failure to do so at this time will only drive real rates lower. For a world economy that is reasonably expected to grow, negative real interest rates imply a dynamic inefficiency. In short, this is the time to start raising real rates, not lowering them (real rates theoretically rise when new debt crowds out private capital, but note that new debt can also be used to finance corporate tax cuts to stimulate investment, if so desired).

Of course, what theory also tells us is that the government should also be prepared to reverse this recommended debt expansion (assuming that tax rates remain unchanged) once the domestic and world economy return to normal. One may legitimately question whether the government can be expected to make these cuts at the appropriate time. If the government lacks credibility along this dimension (or if future governments cannot be expected to abide by policies put in place by previous governments), then political forces may emerge to block an otherwise socially desirable debt expansion. Perhaps this is one way to interpret recent events.