30 Nov 2011

Heads Krugman Wins, Tails Hard Money Loses

Economics, Federal Reserve, Krugman No Comments

I really am swamped with my “day job” for the next month or so, meaning blogging will be sparse. But at this point, I think someone needs to write Portrait of the Artist as a Keynesian Man. In this post, Krugman shows just how many degrees of freedom he has to work with:

Some readers have asked why, given my scornful discussions of the “confidence fairy” story about fiscal austerity (will that be my lasting contribution to economic discourse?), I’m willing to take seriously the idea that ECB rate hikes had a huge impact via expectations.

That’s a good question, but I do have answers.

[Krugman then talks about two differences, which you can read if you’re interested.–RPM]

Finally, the whole euro situation is fraught with multiple equilibria and the risk of self-fulfilling panics — which means that there can sometimes be disproportionate responses in a way that doesn’t make sense when we’re talking about budget cuts.

You see, Krugman is allowed to invoke “multiple equilibrium” and “self-fulfilling panics” when spinning his yarns. With a clever guy like Krugman, he therefore can always “see” his predictions coming to fruition, day in and day out.

I’ve already pointed out a great example, when Krugman first cited Italy as proof that large debt loads wouldn’t invite the bond vigilantes, and then when Krugman cited Italy as proof that the ECB needed to print more to stave off the bond vigilantes (who had suddenly lost their invisibility cloak).

Today, I’ll point out a similar story–or should I say stories–with Germany. To wit, in a Nov. 21 post memorably titled “Real Austrian Economics,” Krugman used Germany’s status as a safe haven to underscore his theme about the folly of austerity:

Austria is, by most comparisons, a very successful economy, with low unemployment and a current account surplus. Its fiscal outlook is slightly better than Germany’s, according to IMF projections…

Yet Austria has had almost exactly the same interest rate experience as France. In June, both Austria and France had 10-year rates of 3.43%, 44 basis points above Germany’s 2.89. As of today, German rates were down to 1.91, but French rates were up to 3.47 — and Austrian rates up to 3.44. Both countries, in other words, have seen their spreads more than triple.

What exactly is going on here? Is the market worried about bank exposure? Is it pricing in a possible euro breakup? Lots to chew on here. But one thing is clear: fiscal rectitude — which the Austrians have displayed even more than the Germans — is no protection.

Now look carefully at those numbers. Krugman is here trying to conclude that the Austrian government isn’t earning brownie points from bond investors, even though they said “adieu, adieu” to high deficits. And Krugman’s evidence is that the yield on Austrian 10-year bond rates rose a whopping 1 basis point since June, as the European debt crisis really heated up.

Oh wait, that’s not fair to Krugman. It wasn’t actually the absolute move (again, of 1 basis point) in Austria’s bond yield that he was citing, but rather the spread between Austrian and German yields. So really what is happening here, is that when investors got really worried and rushed into German bonds (pushing down their yields), Krugman said, “Aha! Told you! Fiscal responsibility, i.e. a relatively tame debt-to-GDP ratio, is a sham.”

Then, three days later, in a post titled “The Apocalypse Trade,” Krugman wrote:

I really wasn’t planning on blogging on Thanksgiving Day. But what’s going on in Europe deserves a mention.

So, the big story: German bonds are now being priced as a risky asset — what the FT calls the “apocalypse trade“. The interest rate on bunds, at 2.21% as I write this, is still very low by historical standards. But it’s above the rate on UK bonds (2.17%) and way above the rate on US bonds (1.88%).

The way to see this is that the market is in effect pricing in a real possibility of eurozone collapse.

In particular, market expectations seem to assume that the ECB will remain utterly indifferent to its responsibilities. The German breakeven rate, an implicit forecast of inflation over the next 5 years, is just 1 percent. That’s a disaster level, implying severe deflation in the debtor nations — or, more likely, a euro breakup.

Awesome all around.

Do you see the artist at work? Remember, on November 21, the fact that investors had been fleeing into German bonds (and thus driving down their yields, relative to Austrian bonds) was cited as evidence in favor of Krugman’s views on deficit spending. Then, a mere three days later, the fact that investors were fleeing out of German bonds (and thus driving up their yields, presumably relative to Austrian bonds but I didn’t bother checking), was cited as evidence in favor of Krugman’s views on money printing.

Awesome all around.

One last clarification: It’s possible to have a view on economic policy, that is invariant to the observed data. For example, if it rains tomorrow, I will say, “Bernanke should tighten.” If it doesn’t rain tomorrow, I will say, “Bernanke should tighten.” There’s nothing weird about that.

What would be weird is if it rains tomorrow and I say, “See what I mean? Bernanke should tighten. And get yourself some galoshes.” And then if it doesn’t rain, I also say, “Gosh sometimes I amaze even myself. I told you idiots, Bernanke should tighten. I hope you folks stocked up on water bottles, cuz we’re in for a drought.”

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