Thought du Jour

Harvard economist Martin Feldstein worries that a shift from 1% deflation to 1% inflation in Japan will produce soaring deficits and increased debt, even if real interest rates do not change:

[D]espite the large government deficit and the enormous government debt – now close to 200% of GDP – the interest rate on 10-year Japanese government bonds is just 1%, the lowest such rate in the world.

But what of the future? While the current situation could continue for a number of years, there is a risk that rising interest rates and reductions in net business saving will bring Japan’s current-account surplus to an end.

One reason for a rise in the interest rate would be a shift from low deflation to low inflation. Prices in Japan have been falling at about 1% a year. If that swung by two percentage points – as the government and the central bank want – to a positive 1% inflation rate, the interest rate would also increase by about two percentage points. With a debt-to-GDP ratio of 200%, the higher interest rate would eventually raise the government’s interest bill by about 4% of GDP. And that would push a 7%-of-GDP fiscal deficit to 11%.

Higher deficits, moreover, would cause the ratio of debt to GDP to rise from its already high level, which implies greater debt-service costs and, therefore, even larger deficits.

Martin Feldstein, “Japan’s Savings Crisis”, Project Syndicate, 24 September 2010.

Professor Feldstein is wrong. He suffers from “money illusion”, a tendency to think of debt and interest rates in nominal, rather than real, terms. Economists regard money illusion as a sign of irrationality. In fact, money illusion separates the Keynesians (who believe that people suffer from it) from the New Classical economists (who assume that everyone is rational). Professor Feldstein has an extraordinary cv. He was Chairman of President Ronald Reagan’s Council of Economic Advisors, and is former President of the prestigious National Bureau for Economic Research. It is thus remarkable that he suffers from money illusion.

A rise of two percentage points in inflation and nominal interest rates would increase nominal interest payments on Japan’s public debt, but not real (inflation adjusted) interest payments. If the government actually paid the higher nominal costs of debt service, the real value of its debt would fall. Debt service costs in real terms would also fall.

Yale economist Irving Fisher (1867-1947), along with John Maynard Keynes (1883-1946), believed that people are afflicted in varying degrees by “money illusion”. In 1928 Fisher wrote an important book on the subject, appropriately titled Money Illusion. Years ago I read the book, which was then out-of-print and difficult to locate. The book has since been reprinted as an inexpensive paperback. It is a short book – 236 pages plus index – an easy read. I recommend it highly.  Fisher was the first economist to distinguish clearly between real and nominal interest rates. The resulting equation is known as the Fisher equation in his honour.

A digitized edition of Fisher’s longer and more difficult work, The Theory of Interest (1930) is available online (ungated). A scan of the first chapter can be viewed here. Although Fisher was a mathematical economist, he wrote clearly, expressing ideas with words rather than symbols.

Update: I posted a short comment at Project Syndicate, with a link to this post. The comment was accepted, but has since been removed. Very strange. Fortunately, I have my own blog and can voice my concerns here.

Max Corden has given considerable thought to the world economy’s recent heart attack, an economy’s “heart and arteries being the financial sector”. He has written a concise essay about fiscal stimulus – “about the ambulance that has been called upon all over the world, from China and Japan, to the US and Germany, and about all those hostile arguments that have been thrown at it as it hurtled past”. Here is a short excerpt from the essay:

In this crisis we have seen a major case of worldwide market failure. That can hardly be questioned. But can governments be trusted? It is too early to judge and compare government reactions. Here is important scope for research. But on the broad issue, let me refer to The Master.

Keynes was certainly critical of governments. He was definitely not naïve. In his view governments did the wrong thing after the First World War, at the Versailles Treaty negotiations – so he wrote The Economic Consequences of the Peace. The British government did the wrong thing in 1925 when it returned sterling to the gold standard at an overvalued parity – so that he wrote The Economic Consequences of Mr Churchill. And the American, British and other governments failed, of course, during the Great Depression, especially by adhering too long to the gold standard, and by being preoccupied with budget balancing. But he did believe that governments can get it right, and he believed in his ability, and indeed duty, to persuade.

The other underlying issue is the relative weight one places on the danger of another Great Depression relative to a revival of inflation. I think that older people (like myself), are likely to weigh heavily the danger of another depression. There is also the issue of how much one knows about the Great Depression – a matter of knowing history. I find the concern about inflation in present circumstances surprising, though one has to accept that it is reasonable to focus on the ‘exit’ from the crisis, so as not to lay the foundation for another inflationary or bubble period.

W. Max Corden, “Ambulance economics: The pros and cons of fiscal stimuli”, CEPR Policy Insight No. 43 (January 2010), p. 6.

University of Melbourne economist Warner Max Corden (1927-) emigrated from Nazi Germany to Australia in 1939. His numerous publications include The Theory of Protection (Oxford University Press, 1971) and Too Sensational: On the Choice of Exchange Rate Regimes (MIT Press, 2002). I purchased the first book and read it from cover to cover when I was in graduate school in the early 1970s. Professor Corden’s writing is as lucid and didactic today as it was four decades ago. We are very fortunate to have him with us during the current financial crisis.

Columbia University macroeconomist Edmund Phelps thinks that economic fallacies abound because spokesmen on each side of the “theory wars” ignore past economic thought. “The ‘Keynesians’ seem not to have studied Keynes and the neoclassicals misread or do not read Hayek.”

These fallacies lull analysts into the false sense that, one way or another, a full recovery lies ahead – thanks to government spending or to self-correcting market forces. As I see it, the poor state of balance sheets in households, banks and many companies augurs a “structural slump” of long duration. Employment will recover, quickly or slowly, only as far as investment demand will carry it. It is highly uncertain whether government spending on infrastructure would help, after taking into account the employment effects of the higher tax rates to pay for it. ….

The lesson the [financial] crisis teaches, though it is not yet grasped, is that there is no magic in the market: the expectations underlying asset prices cannot be “rational” relative to some known and agreed model since there is no such model.

Edmund Phelps, “A fruitless clash of economic opposites”, Financial Times, 3 November 2009.

Professor Phelps has long been concerned with workers who suffer in economic recessions yet do not participate fully in periods of economic growth. To address this concern, he proposes – most elaborately in Rewarding Work: How to Restore Participation and Self-Support to Free Enterprise (Harvard University Press, 1997) – a system of public subsidies to increase the wages of low-skilled workers. In 2006 he received the Nobel Prize in Economics, concluding his Nobel Prize Lecture with the words “a morally acceptable economy must have enough dynamism to make work amply engaging and rewarding; and have enough justice, if dynamism alone cannot do the job, to secure ample inclusion.”