Monday, August 08, 2011

The Debt Downgrade Blame Game

Here's something that the nation's politicians should think about before pointing their fingers at the other party and saying, "This is your fault!" By making that accusation you're admitting that the debt downgrade is appropriate - and that our nation's debt is a riskier investment than S&P triple-A rated French debt. (Let's ignore the fact that it's French debt that's taking it on the chin after the downgrade, not U.S. debt.)

 I heard Tyler Cowen on the radio this morning arguing a position that, to me, sounded like "This is a good editorial statement for S&P to make to the U.S. government." That is, he seemed less concerned with the accuracy of the S&P debt as a rating of the risks of U.S. debt, as opposed to agreeing with the implicit political statement that the U.S. needs to start working toward a balanced budget involving both tax increases and entitlement cuts. Cowen explained his reaction, in advance, on his blog. Consistent with his support for tax hikes and entitlement cuts, he argues that the Republicans should have worked with the President toward the "grand bargain" that Obama proposed during the debt ceiling debate.  Cowen is correct that, at least if we want this country to be what we claim it is, a land of opportunity, an example to the world, a leader in technology and innovation, and all that, we will need tax increases to balance the budget.

Cowen also argues that "Democrats need to choose on entitlements", which apparently means that they need to support entitlement cuts. There are unquestionably some Democrats who are taking a "no cuts now, no cuts ever" stance toward Social Security and Medicare, and it's fair for Cowan to criticize that. But it's farcical to pretend that entitlement cuts don't occur because only the Dems are blocking them. I'm not attributing this whine to Cowen, but those who complain that it was the Democrats who magically stopped the Republicans from partially privatizing Social Security under Bush consistently ignore the fact that Bush couldn't get majority support for his plan from his own party, nor could he get them to back a different plan.

Had Bush backed away from privatization and proposed the type of tweaking that has been approved in the past, odds are that he would have succeeded with his reform. Similarly, it was Bush who advanced and signed into law Medicare Part D, the unfunded prescription drug benefit. It was the Republicans who screeched about "death panels" and "Medicare cuts" during the debate of healthcare reform. It was again the Republicans who howled that President Obama was offering to cut Social Security and Medicare after the recent debt ceiling debate.

 Don't get me wrong - I'm not suggesting that the Republican Party wants to preserve either Social Security or Medicare. But there is no question that they will preserve and even expand those programs if they perceive that doing so will help them win reelection. And there's no question that they will engage in demagoguery against the Democrats that makes it difficult for them to subsequently implement the cuts that they actually support. Their dream is for the Democrats to propose and pass the cuts or reforms that undermine the social safety net, such that they benefit both from the implementation of their policy preferences and have the opportunity to angrily accuse the Democrats of harming seniors. The difficulty is, you really can't have it both ways. (Hence David Frum's crying into his coffee about how, prior to Joe Lieberman's last minute sabotage, the Affordable Care Act threatened the future of the Republican Party.)

 Cowen suggests that the lesson history will draw from the economic downturn will not be "we should have had a much bigger stimulus" but will be "We needed a big dose of inflation, promptly, right after the downturn. Repeat and rinse as necessary." Cowen argues that didn't happen because "voters hate inflation and, collectively, we proved to be cowards." But do voters actually hate inflation? Would voters have hated seeing their long-term investments show a rate of return that reflected inflation, as opposed to flatlining? Yes, voters were upset by skyrocketing energy prices and gas prices contributed to the collapse of the auto industry and probably contributed to the timing of the bursting of the housing bubble. But for some reason we were supposed to view inflation in energy prices and in housing costs as a "good thing". We were supposed to view housing inflation as turning our houses into giant piggy banks from which we could withdraw tens or hundreds of thousands of dollars with no concern for the future. There are some forms of inflation that the U.S. public can be convinced are good, and a subset of those can actually be good for average citizens.

When inflation is tied to market realities and people aren't cashing every cent of equity out of their homes, it's actually a good thing for there to be some level of inflation. It's not a horrible thing, either, for there to be a reasonable return of interest on passbook savings accounts. Spikes in food prices, on the other hand, would be unpopular. I don't see much point in speculating as to which theoretical future we will ultimately wish we had chosen. But I disagree with Cowen's suggestion that it was fear of voter reaction that led to a policy decision to pursue a stimulus instead of imposing "a big dose of inflation". I suspect that the financial interests that we had just bailed out would have been apoplectic if the government took away the all-but-free money they've been enjoying since the bail-out, and instead imposed a policy that would require that they share the burden of the recovery by across-the-board inflation that had the effect of wiping out homeowners' negative equity. If the financial industry had wanted inflation, we would have had inflation. It wanted interest rates near 0%, so that's what we got instead.

If somebody was making the case for "a big dose of inflation" during the debate over the stimulus, they did a good job of keeping it a secret. One of the loudest voices in support of a larger stimulus was Paul Krugman. But I am recalling that he has also spoken about how higher inflation could help consumers, while repeatedly pointing out that the government spending that his political critics proclaimed would result in inflation has not done anything of the sort.

 Cowen argues against the biased sample, suggesting that it is unfair to point to S&P's poor track record on other matters when questioning its present rating of U.S. debt. The problem is, Cowen does not actually present evidence that the sample is biased - he asks us to take it on faith that S&P is good at rating government securities. I was thinking of Krugman's criticism of bond raters in general; but I see that Krugman has also responded to the criticism raised by Cowen:
Notice that what’s happening in the case of S&P is precisely that many people are giving them credence because of where they sit; it’s therefore highly relevant to point out that they may be a prestigious organization for some reason, but their track record is ludicrously bad.
It's unfair to pick out a few errors from an otherwise good track record to argue, "You should never take that guy seriously," but sometimes it actually is fair to point out, "You're asking that we follow the advice of the village idiot." If Cowen wants to establish that S&P has sound methodology and a good track record, the ball appears to be in his court.

 Will this be the wake-up call that Cowen hopes it will be? Something that "years from now today may well be seen as a turning point of significance"? I doubt it. If nothing happens - as appears to be the case - it could be worse than doing nothing. The boy who cried "wolf". Being able to say "I told you so", five, ten or twenty years from now? Worthless, even if you can make the after-the-fact case that this (of all things) should have been what woke our nation's leaders up to the need for real change.

Update: Yesterday I wrote,
If the financial industry had wanted inflation, we would have had inflation. It wanted interest rates near 0%, so that's what we got instead.

The U.S. Federal Reserve on Tuesday took the unprecedented step of promising to keep interest rates near zero for at least two more years and said it would consider further steps to help growth, sparking a rebound in stocks. 
The Fed painted a gloomy picture, saying that U.S. economic growth was proving considerably weaker than expected, inflation should remain contained for the foreseeable and unemployment, currently at 9.1 percent, would come down only gradually.

Whatever voters may think of inflation, we're suppressing inflation due to the financial industry and markets, not because of consumer sentiment.


  1. Cowen's argument about Medicare and Social Security reminds me of Thomas Friedman's recent column, lamenting that we didn't have a Republican President like Bush whose moderate politics would result in his party's implementing President Obama's policies (and thus that we need some sort of moderate third party that agrees with Friedman about everything).

  2. Cowen writes, "Instead, Ken Rogoff and Scott Sumner are likely to go down as the prophets of our times. We needed a big dose of inflation, promptly, right after the downturn", linking to an article in which Ken Rogoff writes, "I argued that the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years."

    Cowen argues for high inflation over the short-term, repeated as necessary. Rogoff argues for moderate, sustained inflation over a period of years - no shocks to the system. I haven't found a statement by Sumner calling for Cowen's approach to inflation.