billy blog Wed 2010-09-29 10:15 EDT

Budget deficits do not cause higher interest rates

Bill Mitchell

...An often-cited paper outlining the ways in which budget deficits allegedly push up interest rates is -- Government Debt -- by Elmendorf and Mankiw (1998 -- subsequently published in a book in 1999). This paper was somewhat influential in perpetuating the mainstream myths about government debt and interest rates...Their depiction of...Ricardian equivalence...alleges that: ``the choice between debt and tax finance of government expenditure is irrelevant...[because]...a budget deficit today...[requires]...higher taxes in the future...'' ...I have dealt with this view extensively...Ignoring the fact that the description of a government raising taxes to pay back a deficit is nonsensical when applied to a fiat currency issuing government, the Ricardian Equivalence models rest [on] several key and extreme assumptions about behaviour and knowledge. Should any of these assumptions fail to hold (at any point in time), then the predictions of the models are meaningless. The other point is that the models have failed badly to predict or explain key policy changes in the past. That is no surprise given the assumptions they make about human behaviour. There are no Ricardian economies. It was always an intellectual ploy without any credibility to bolster the anti-government case that was being fought then (late 1970s, early 1980s) just as hard as it is being fought now...So where do the mainstream economists go wrong? At the heart of this conception is the [pre-Keynesian] theory of loanable funds...where perfectly flexible prices delivered self-adjusting, market-clearing aggregate markets at all times...Mankiw claims that this ``market works much like other markets in the economy''...[assuming] that savings are finite and the government spending is financially constrained which means it has to seek ``funding'' in order to progress their fiscal plans. The result competition for the ``finite'' saving pool drives interest rates up and damages private spending. This is what is taught under the heading ``financial crowding out''...Virtually none of the assumptions that underpin the key mainstream models relating to the conduct of government and the monetary system hold in the real world...When confronted with increasing empirical failures, the mainstream economists introduce these ad hoc amendments to the specifications to make them more realistic...The Australian Treasury Paper [used advanced econometric analysis to find that] domestic budget deficits do not drive up interest rates. The long-run effect...is virtually zero. The short-run effect is zero!...toss out your Mankiw textbooks...

Billy Blog; budgets deficit; caused higher Interest rate.

naked capitalism Wed 2010-09-08 17:27 EDT

Economic consequences of speculative side bets -- The case of naked CDS

Yeon-Koo Che and Rajiv Sethi

...We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice...the existence of zero-sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic about the future revenues of borrowers, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic about the borrower's prospects, and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns...

Case; economic consequences; naked capitalism; Naked CDS; speculative side bets.

Mon 2010-08-16 13:54 EDT

Could The US Become Another Ireland? >> The Baseline Scenario

Peter Boone and Simon Johnson

As Greece acts in an intransigent manner, refusing to act decisively despite deep fiscal difficulties, the financial markets look on Ireland all the more favorably. Ireland is seen as the poster child for prudent fiscal adjustment among the weaker eurozone countries...Ireland's perceived ``success'' is partly due to its draconian fiscal cuts...Ireland's difficulties arose because of a massive property boom financed by cheap credit from Irish banks...Today roughly 1/3 of the loans on the balance sheets of banks are non-performing or ``under surveillance''...The government...guaranteed all the liabilities of banks and then began injecting government funds...it is planning to buy the most worthless assets from banks and pay them government bonds in return. Ministers have also promised to recapitalize banks than need more capital. The ultimate result of this exercise is obvious: one way or another, the government will have converted the liabilities of private banks into debts of the sovereign (i.e., Irish taxpayers)...The government is gambling that GDP growth will recover to over 4% per year starting 2012 -- and they still plan further major expenditure cutting and revenue increasing measures each year until 2013...The latest round of bank bailouts (swapping bad debts for government bonds) dramatically exacerbates the fiscal problem...

Baseline Scenario; Becomes; Ireland.

Jesse's Café Américain Sun 2010-07-25 09:33 EDT

China: The US Is "Insolvent and Faces Bankruptcy"

Jesse

The common thought amongst even reasonably educated and economically literate Americans is that China is 'stuck with US Treasuries' and has no choice, so it must perform within the status quo and do as the US wishes, or face a ruinous decline in their reserve holdings of US Treasuries...Guan Jianzhong, chairman of Dagong Global Credit Rating, told the Financial Times...``The US is insolvent and faces bankruptcy as a pure debtor nation but the rating agencies still give it high rankings'' Mr Guan said. ``Actually, the huge military expenditure of the US is not created by themselves but comes from borrowed money, which is not sustainable.''

China; faces bankruptcy; insolvent; Jesse's Café Américain.

Mon 2010-04-05 15:16 EDT

Eleven lessons from Iceland

Thorvaldur Gylfason

Iceland's economic crisis has destroyed wealth equivalent to about seven times its GDP. The damage inflicted on foreign creditors, investors, and depositors amounts to about five times its GDP, while the asset losses thrust upon Icelandic residents account for the rest. These figures do not include the cost of Iceland's increased indebtedness. Iceland's gross public debt, domestic and foreign, is estimated to increase by more than 100% of GDP as a result of the collapse of the banks, or from 29% of GDP at the end of 2007 to 136% by the end of 2010. In 2009, the government spent almost as much on interest payments as on healthcare and social insurance, the single largest public expenditure item. The damage due to Iceland's tarnished reputation is harder to assess...the absence of checks and balances that had led to an unbalanced division of power between the strong executive branch and the much weaker legislative and judicial branches came to haunt the country when unscrupulous politicians put the new banks in the hands of reckless owners who then found themselves in a position to expand their balance sheets as if there were no tomorrow -- and no supervision. Politicians who privatise banks by delivering them on a silver plate to their friends are not very likely to subject the banks to stringent supervision or other such inconveniences...What can be done to reduce the likelihood of a repeat performance -- in Iceland and elsewhere?

Iceland; Lessons.

Wed 2009-04-01 00:00 EDT

Calculated Risk: Business Cycle: Temporal Order

residential investment and personal consumption expenditure lead economy out of recession

business cycle; Calculated Risk; Temporal Order.

Thu 2008-01-24 00:00 EST

Tomgram: Chalmers Johnson, How to Sink America

"Military Keynesianism"; "morally obscene", "fiscally unsustainable" US military expenditures

Chalmers Johnson; Sink America; Tomgram.