Thursday, March 17, 2011

Arnold Kling is Not the First Economist to be Confused About the Reagan Deficits and Interest Rates

Arnold Kling confused nominal versus real interest rates here:

Many people predicted that the Reagan deficits would produce soaring interest rates. The deficits appeared, but the 10-year interest rate peaked before the Reagan tax cuts took effect and plummeted in the latter half of 1982, in spite of then-record deficits.

Paul Krugman responds:

The Reagan years were marked by two things: large budget deficits — although much smaller as a percentage of GDP than we’re seeing now — and a huge disinflation, engineered by Paul Volcker. So we need to look at real, not nominal interest rates — and real rates were in fact very high by historical standards during the Reagan years. 10-year bond rates ranged between 8 and 9 percent in the later Reagan years, while inflation generally ran under 4 percent. And may I say, I thought that this was part of what every economist knows — the story of the tight-money loose-fiscal mix of the Reagan era is, literally, a textbook case that’s in just about every undergrad macro book.

Not much to add except to note a couple of other economic papers that fell into Kling’s muddled thinking including something the American Economic Review published in March 1985 by Paul Evans entitled: “"Do Large Deficits Produce High Interest Rates?". His conclusion was no with part of his evidence being the same Reagan years. Alan Reynolds noted this paper and its Barro-Ricardian Equivalence explanation in defense of the Bush43 tax cuts. Reynolds goes onto to assert:

Confronted with this evidence, some began to say that it was not nominal interest rates that were driven up by deficits but real interest rates. But the only way deficits could raise real rates without raising nominal rates would be if deficits caused inflation to fall, which does not make sense.

I guess that since the Volcker tight money policy coincided with the Reagan fiscal stimulus, one could abuse the term “cause” to say deficits caused inflation to fall. I prefer to suggest that Reynolds was just being silly with this paragraph. Let’s also note the reason Barro-Ricardian Equivalence is supposed to make fiscal stimulus something that is not going to impact interest rates even in a full employment economy. The proposition is that households will fully save and not consume their tax cuts if they are not accompanied with at least some expectation of future spending cuts. But we should recall that U.S. consumption did jump after the Reagan tax cuts even though we never saw appreciable spending cuts. In a words – national savings fell, which in the full employment classical world that Robert Barro, Paul Evans, and Alan Reynolds live in means an increase in real interest rates. Which is exactly what we saw during the 1980’s.


Jazzbumpa said...

The proposition is that households will fully save and not consume their tax cuts if they are not accompanied with at least some expectation of future spending cuts.

Where does a proposition like this come from? Do economists ever pay attention to the real world? Does anyone seriously believe actual people with kids in sports and dance lessons, miserable commutes to jobs they hate, overbearing bosses, and peptic ulcers sit around pondering some abstract notion of future spending before deciding to buy a big-screen TV?

If they think about finances at all, it's at the level of - can I make the monthly payment on this thing and still afford to feed my cat?!

This is why I have simply given up on economics as a serious mental discipline.

Ralph Musgrave said...

I fully agree with Jazzbumpa: the economics profession is full of time wasters, parasites, hangers on and people counting the number of angles on a pinhead. Kling is one of these. But these undesirable will always be with us. So, Jazzbumpa: don’t give up.

Re Jazzbumpa’s intuition based attack on Ricardianism, this intuition is actually backed by evidence. That is there is plenty of evidence that households spend a fair proportion of tax rebates and other windfalls within short time of receiving them. See:

Jazzbumpa said...

Musgrave -

I'd say more real-world-observation than intuition based. Which makes it anecdotal, I guess.

But anecdotes that correspond to reality are more valuable than beautifully quantifiable theories that do not.

Maybe there is a baby in the bathwater somewhere, but I'm afraid it's either stillborn or drowned.

The problem is that policy decisions are made based on the theories.

Kling defends himself at econbrowser.


ProGrowthLiberal said...

Jazz - I saw Arnold's attempt to word smith his way out of embarrassment. I would trust he knows that the reason Keynes talked about liquidity traps aka a flat LM curve was to introduce a case where fiscal stimulus sine monetary accomodation does not lead to even partial crowding out. And we were not in a liquidity trap in the early 1980's. If Kling does not understand these concepts, he is not qualified to write on macroeconomic issues. If he does understand these issues, he is being less than honest.

Robin said...

I did a critical reveiw of all the studies on deficits and interest rates in a presentation at the U.S. Treasury in 2004. If anyone finds fault with the logic or evidence, that is fine. To dismiss it as silly is, well, silly.

Unknown said...

I did an analysis of your analysis just far enough to see that you insist that FIAT money has some sort of intrinsic value. It is a trap into which the Keynesians also fall. Deficits need not create debt. That deficits create debt this is the underlying assumption (religious principle) of current econ idiotologies. It is a testimonial to the conservatism being practiced on both sides of the deficits debates. The only thing that gives fiat money any value is the reclamation of that money via taxation. Yet, it is not necessary to reclaim all of the money spent to "promote the general welfare" if in fact, the spending does "promote the general welfare".

Both Keynes and RE camps ASSUME that fiat money is a commodity of the private sector. It isn't.