Sunday, August 16, 2009

The Krugman Konfusion

As per usual, Paul Krugman posts to his blog a comment that puts him in the mode of deceptive hustler, or seriously confused. He starts with this chart:

He then moves on to tell us:

Net federal saving is, roughly, the budget surplus (so it’s negative if there’s a deficit.) It turns out that there’s a strong correlation between budget deficits and interest rates — namely, when deficits are high, interest rates are low.

On reflection, it’s obvious why: a weak economy both drives up deficits and drives down the demand for funds, while a strong economy does the reverse. Thus the surpluses of the late Clinton years were associated with high interest rates, while the current recession has depressed both rates and revenues.

And what about the bounce in interest rates over the past few months?

It reflects a gradual reduction in the end-of-the-world discount: interest rates have risen along with stock prices as investors have gradually become convinced that we’re avoiding a second Great Depression.

He gets it about half right. Deficits do climb when the economy is in recession. What he forgets is that this is a period when the Fed is pushing down interest rates aggressively. Earth to Krugman, do you honestly believe that interest rates would be at their current low levels if the Fed wasn't maintaining a near zero interest rate on Fed Funds?

During the upside of the Fed manipulated business cycle, the Fed tends to fight inflation, so while the deficit is down, the Fed is raising rates. All this said, if the Fed maintains low rates for an extended period of time, inflation will kick in, and if the deficit continues to soar because of expansive government, rates will most assuredly rise, whatever part of the business cycle we are in.

Krugman is trying to force a corollary between interest rates and the deficit, which only exists under very specific conditions. He subtle about it but what he wants is to sell the fact that you don't have to worry about deficits, as a general rule. It's really the same hustle that was worked on sub-prime securities buyers.

Mortgage default rate data was used by the hustlers of syndicated sub-prime securities. What they used was very specific default rate data, i.e. data that applied only when the banks held the sub-primes and didn't syndicate them out. When banks held the loans in their portfolios, they were concerned about default rates and didn't make dumb loans. Once they started syndicating out the loans and weren't exposed to defaults, and realized the syndicate buyers didn't understand a good loan from a dumb loan, they sold them tons of dumb loans (Since they were easier to write). Of course, the dumb loans changed the default rates dramatically, and the dumb buyers got stuck with the dumb loans

It's the same with interest rates and the deficit. If interest rates are primarily impacted by the business cycle, they will tend to start climbing during the boom phase and decline when the Fed is pushing rates down during a recession. But, if you have hustlers/clueless like Krugman implying that this is a hardcore general rule as opposed to a rule for specific conditions, and you have a government that buys into this hustle and goes whole hog issuing debt, then you will have climbing rates all the time, during all phases of the business cycle---and, eventually, when this becomes obvious to everyone, rates really start to soar. Of course, by that time Krugman will be hustling some other big government solution that will make things even worse.

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