In Britain and the US, Grim Expectations

Friday, 14 December 2012 09:55 By Paul Krugman, Krugman & Co. | Op-Ed
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Denmark.(CartoonArts International / The New York Times Syndicate)There's an interesting mix of contrast and similarity between the policy debates in Britain and the United States right now. In both countries — as in every country that retains its own currency and has debts denominated in that national currency — interest rates are near record lows.

However, Very Serious People tell very different stories about the two nations. In the United States, we supposedly have low borrowing costs despite our budget deficit — and if we don't implement the Bowles-Simpson plan immediately, the bond vigilantes will attack. Really! This time we mean it!

Meanwhile, in Britain, the official line is that the low rates are a reward for all that fiscal austerity— and Very Serious People get upset and abusive if someone well-informed points out that a much better explanation is that investors expect the economy to remain weak, and hence for short-term rates to remain very low for a long time.

Chart.(The New York Times)Let's unpack this a bit. It's very hard to come up with any reason why either the United States or Britain might default, since they can simply print money if they need cash. And given the absence of real default risk, long-term interest rates should be more or less equal to an average of expected future short-term rates (not exactly, because of maturity risk, but that's a fairly minor detail). So if people expect the American and British economies to be depressed for a long time, with the central banks keeping rates low, long rates will be low too — end of story. But won't that money printing cause inflation? Not as long as the economy remains depressed. Budget deficits could lead people to expect higher inflation down the road, once the slump finally ends — but that would be a good thing for the economy in the short run, discouraging people from sitting on cash and weakening the exchange rate, thereby making exports more competitive.

Graph.(The New York Times)The point, then, is that the whole "credibility" argument is incoherent. Twenties Tales The 1920s — when several of the victorious Allies emerged from World War I with large debts in their own currencies — offer in some ways the nearest parallel to the debt concerns dominating recent debate. And it occurred to me that it would be useful to do a side-by-side comparison of Britain and France.

The two countries dealt with their debts very differently. Britain was a model of orthodoxy, returning to the gold standard and running huge primary surpluses to pay its debts; France, which had a weaker political system, ended up inflating away much of its debt and accepting a big devaluation of the franc. So how did the two economies fare? We shouldn't start the clock in 1918, because France was in part a battlefield, and could be expected to have some bounce as the war damage was fixed. So see real gross domestic product from 1913 on, from the Maddison Database, on the first chart on this page. And debt, from the International Monetary Fund's debt database, on the second chart. So virtue was not rewarded, and French political weakness actually led to a better economic performance.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008. Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including "The Return of Depression Economics" (2008) and "The Conscience of a Liberal" (2007).
Copyright 2014 The New York Times.

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