By Jove, Krugman was right!
Even if that assessment springs from lips of Paul Krugman himself, we have to say the evidence increasingly seems to confirm it.
Krugman’s point was always that inflationistas, aka austerity enthusiasts — such as noted nemesis Professor Niall Ferguson — neglected the importance of “liquidity preference” when considering government deficits and stimulus spending plans.
After all, it’s all very well for the Fed to set a target rate, but it’s quite another for policymakers to implement it.
And herein lies the problem.
As Krugman stated on Tuesday:
This was never a question of simply forecasting what was going to happen to rates. It was about what would drive rates.
And that is the situation we find ourselves in. The whole shape of the curve is being dictated not by realistic interest-rate expectations but by “liquidity preference” — as Krugman has always suggested it would.
To explain, let’s hop back to Krugman’s prescient blog posting of May 2, 2009, where he explains as much.
As he noted back then (our emphasis):
So what determines the level of GDP, and hence also ties down the interest rate? The answer is that you need to add “liquidity preference”, the supply and demand for money.
In the modern world, we often take a shortcut and just assume that the central bank adjusts the money supply so as to achieve a target interest rate, in effect choosing a point on the IS curve.
Which brings us to the current state of affairs. Right now the interest rate that the Fed can choose is essentially zero, but that’s not enough to achieve full employment. As shown above, the interest rate the Fed would like to have is negative. That’s not just what I say, by the way: the FT reports that the Fed’s own economists estimate the desired Fed funds rate at -5 percent.
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In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.
So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.
So as long as a savings glut persists (which will be the case for as long as the world and his wife keep their money on the sidelines) the scramble to achieve a relative risk-free return will ensure bond yields stay suppressed.
In fact, only a negative interest rate might incentivise the money to flow into riskier assets — since the persistence of a savings glut/bank hoarding at zero per cent suggests market forces are quite content with the risk/return balance achieved at that rate.
Government borrowing, as Krugman suggests, would actually be essential for giving some of that excess savings money a place to go.
In fact, without it, investors might have to get contend with a ‘liquidity premium’ on quality collateral for some time yet. Or even increasingly negative returns, anyway.
Related links:
Tips are the best – FT Alphaville
Euribor has been vaporised – FT Alphaville
‘General collateral remains puzzlingly inverted to fed funds’ – FT Alphaville
The secured lending boom (through gold-tinted glasses) – FT Alphaville