Monday, July 9, 2012

What's a Good Indicator of the Stance of Fiscal Policy? (part 1)

Scott Sumner makes a big deal over the idea that neither the size of the monetary base nor the nominal/ real interest rate are good indicators of the stance of monetary policy. Lately I was thinking if a corrollary might not be true of fiscal policy; is it possible that focusing on the flow of deficits or the stock of debt might not be misleading as to the stance of fiscal policy?

This has been bothering me for several years as the Federal deficit and debt (and future projections of each) continually expand, will at every turn interest rates on that debt fall instead of rising. Its something of a pastime for conservatives to claim that rates are about the spike (we're the next Greece! Also my ass is on fire! plus zombies!) as they proceed to fall.

For backgroud, lets see why the Federal deficit is supposed to negatively affect the economy anyways. When the Federal government runs a deficit, it sells bonds that are purchased by private savers (both foreign and domestic). As the supply of bonds in the bond market increases, their price falls and their interest rate rise accordingly. At higher market interest rates, less investment projects are profitable private capital accumulation slows. The key here is that the MECHANISM through which the deficit affects the broader economy is tremendously important; it has to raise the real interest rate to have an effect.

So how have rates fared in relation to the real interest rate on the debt? Lets see, since 2008. We see the deficit rises as rates plunge. This complicates the economic narrative considerably, as we'll see subsequently.

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