Monday 23 January 2012

David Smith finds me puzzling..[updated 24 January]

[updated to reflect David's response, below]

David Smith ties himself in all sorts of knots in yesterday's Sunday Times (£).   He quotes me as saying: “Our historically very low level of interest rates is — just as in Japan — a sign of economic failure, not success. ” David says: " I find this puzzling...We should celebrate the fact that borrowing costs are so low. "
Apparently my views reflect the fact that I've taken NIESR back to its "Keynesian roots".  But of course my view on this has absolutely nothing to do with Keynes; it simply reflects the standard neo-classical view (normally credited to Irving Fisher) that, as the Bank of England puts it in its handy beginners guide to monetary policy, "long-term interest rates are influenced by an average of current and expected future short-term rates".  
In other words, the low level of long-term interest rates in the UK reflects (just as it does in Japan) low expected future short-term rates; and low expected future short-term rates in turn reflect (just as they do in Japan) low expected economic growth; indeed, Mervyn King has made it abundantly clear on numerous occasions that as soon as recovery is clearly firmly established, he wants to waste no time in "normalising" short-term rates. By that he means raising them back to the 4-5 percent range, in line with "normal" nominal GDP growth.
It therefore follows that the current level of long-term interest rates reflects market expectations that this isn't going to happen any time soon; when it does (and eventually it will), long-term rates will rise.
Note that this has nothing in particular to do with the correct stance of fiscal policy; it is simply a statement of the standard theory of interest rate determination.  If David has come up with an alternative theory, under which long-term interest rates of 2% (the current level) are consistent with a) healthy expected future growth and b) a central bank credibly committed to an inflation target of 2%, he should really explain it, because I don't think it's in any standard textbook.
Of course David is entirely correct that low interest rates benefit the government's finances; but it is perfectly consistent to welcome this collateral benefit at the same time as to say that it is the consequence of protracted economic weakness.  But "celebrating" is going too far: it will be time for celebration when that weakness passes, and not before, even though the consequent rise in interest rates (both short and long-term) will not be welcome for many.  Again, this is pretty much exactly what Mervyn King has said.  
David's point, I think, is that low long-term interest rates also reflect "market confidence" in the UK's fiscal solvency, that is, unlike some eurozone countries, they do not incorporate any default premium. That is entirely correct. But here again he seems confused both by my views and the policy implications. He says  "Somehow, though the critics will not have it, the government has fiscal credibility."   
If  he means me - and no-one else is mentioned - he just hasn't been paying attention.  In my original blog, the sentence immediately preceding the one he quotes above reads: "The UK will not default, no-one with a brain seriously thinks it will, and the opinion of the rating agencies is irrelevant.  We have nothing to worry about on that score."   This is not the only time and place I've said this - see here and here.  
In fact, David seems to have got my argument, and that of other critics, completely backward. If I thought that the UK lacked fiscal credibility, I would not be arguing for a temporary, short-term fiscal stimulus to boost output and employment.  It is precisely because we have fiscal credibility, and are in no danger of losing it, that such a policy could yield significant benefits with little or no downside. David is quite correct that "the verdict of the markets is more important than that of the rating agencies".  And what are the markets actually telling us?   As Martin Wolf puts it "They are saying: borrow and spend, please."

Update 24 January, 10 am.  David responds here.  And it's revealing.  In his original post, he said "low gilt yields, currently around 2% for the benchmark 10-year bond, are testimony to market confidence.  In his second, he agrees that low gilt yields reflect the fact that the markets "expect Bank rate to stay low."   But he then argues "I'm not at all sure this is a sign of economic failure, merely a reflection of banking and financial conditions. Sir Mervyn King has made clear that a key factor keeping rates low is the health (or lack of it) of the banking system."

So it's not "market confidence" keeping rates low after all.  In David's view, it's because Mervyn King thinks our banking system is so fragile it needs effectively zero interest rates. And note that, to the extent this is true, Mervyn is worried about the banking system's health solely because of its potential negative impact on the wider economy (he doesn't care about their profits). So David is simply conceding the original point here.  

To me the lesson of this is that even when sensible commentators try to make the argument that low interest rates reflect confidence, they end up engaging in odd intellectual contortions, ending up, as here, in contradiction.   There is a perfectly respectable argument against fiscal stimulus ( I won't respond to David's points on this, since I think I've covered them at length, here for example).  But this isn't it. 

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