Liquidity Preference, Loanable Funds, and Erskine Bowles
Here’s Erskine Bowles in March 2011:
[T]his is a problem we’re going to have to face up to. It may be two years, you know, maybe a little less, maybe a little more. But if our bankers over there in Asia begin to believe that we’re not going to be solid on our debt, that we’re not going to be able to meet our obligations, just stop and think for a minute what happens if they just stop buying our debt.
Strange to say, however, neither Bowles nor anyone else of similar views has, as far as I can tell, actually done what he urged: “stop and think for a minute what happens if they just stop buying our debt.” They just assume that it would be catastrophic, without laying out any kind of model of how that would work.
I, on the other hand, have worked out two models, one ad hoc and the other a more buttoned-down New Keynesian-type model — and they just don’t support Bowles’s worries.
Some commenters here have declared it obvious that a cutoff of Chinese funds would drive up interest rates, saying that it’s just supply and demand. That struck me, because it’s exactly what George Will said when I tried to argue, back in 2009, that budget deficits need not lead to high interest rates when the economy is depressed. And in fact the argument that foreigners will reduce their lending to us, sending rates higher, and shrinking the economy even though we have our own currency and monetary policy is, when you think about it, more or less isomorphic to the famously wrong argument that fiscal expansion is contractionary, because it will drive up interest rates.
I am, by the way, grateful to those commenters — thinking about the equivalence of the China-debt and deficit-interest fallacies nudged me into a better, simpler formulation of my NK model, which I’ll say more about in a few days. And my model-building has, in turn, given me a new way to talk about what’s going on.
So, here we go. Start from the observation that the balance of payments always balances:
Capital account + Current account = 0
where the capital account is our sales of assets to foreigners minus our purchases of assets from foreigners, and the current account is our sales of goods and services (including the services of factors of production) minus our purchases of goods and services. So in the hypothetical case in which foreigners lose confidence and stop buying our assets, they’re pushing our capital account down; as a matter of accounting, then, our current account balance must rise.
But what’s the mechanism? (Remember the fallacy of immaculate causation.) The answer is, it depends on the currency regime.
If you’re Greece, the way it works is indeed that interest rates soar, depressing demand and compressing imports until the current account has risen enough; unfortunately, demand for domestic goods falls too, so you have a nasty slump.
**But if you’re America or Britain, the central bank sets interest rates, and under current conditions that means holding them at zero. So what happens instead is that your currency depreciates, making exporters and import-competing industries more competitive. The effect on the economy as a whole is therefore expansionary, not contractionary.
Things might be different if the private sector had large debts in foreign currency, as was true in Asia in the 90s. But it doesn’t.**So the conventional wisdom about how we have to fear a Chinese bond-buying strike just doesn’t make sense — and in fact it falls down in exactly the same way as fallacious arguments about the harm done by fiscal deficits in a depressed economy; basically, Erskine Bowles is making the same error as whatshisname.
You may find it hard to believe that so many important and influential people could be dead wrong about the basic economics of our situation. But as far as I can tell, this is simply something “everyone knows”, and none of them have ever thought it through