Paul Krugman Puzzles Greg Mankiw

When I read the latest from Greg Mankiw, my initial reaction was to think he was being argumentative:

I often disagree with Paul Krugman, but I usually understand him. Lately, however, I have been puzzled about his view of the bond market. In a recent post, he takes President Obama to task for believing that the failure to deal with our long-term fiscal imbalance might cause a spike in interest rates

Greg contrasts Paul’s latest on this topic to something Paul wrote back in 2003 when Paul was worried that financial markets might quickly lose faith that the U.S. government would ever be serious about addressing its long-term fiscal balance:

I am having trouble reconciling these points of views. Has Paul changed his mind since 2003 about how the bond market works? Or are circumstances different now? If anything, I would have thought that the fiscal situation is more dire now and so the logic from 2003 would apply with more force. I am puzzled.

Paul has addressed his 2003 post before and I’ll invite him to remind Greg of what he has said about that. But yes – the circumstances now are clearly different from what they were as of March 11, 2003. First of all – we are currently further below full employment to the point where the Federal Reserve has clearly announced it would not initiate monetary restraint until the labor market significantly improves. Does Greg remember that the Federal Reserve started raising interest rates a little over a year after Paul wrote his piece back in 2003? But I guess the key portion of Paul’s 2003 post that troubled Greg was this:

How will the train wreck play itself out? Maybe a future administration will use butterfly ballots to disenfranchise retirees, making it possible to slash Social Security and Medicare. Or maybe a repentant Rush Limbaugh will lead the drive to raise taxes on the rich. But my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.

Greg is emphasizing the fact that the debt/GDP ratio is higher than it was 9 years ago and the deficit is also quite high. But let me protest by arguing that the long-run fiscal situation depends more on what markets expect future fiscal policy will be. Paul was likely worried that the Grover Norquist pledge imposed on most Republicans never to raise taxes combined with their willingness to load up defense spending (after all – Paul wrote on the eve of the Iraq invasion) would tell financial markets that our fiscal folly was doomed to continue forever. Note, however, that the Obama Administration is much more willing to both raise taxes and cut spending than the Administration that Greg served in. Then again – the Grover Norquist crowd still has a strangle hold over Congress so maybe Greg is right to be puzzled.