One confusion I often run into is the belief that there’s some contradiction between times when I and others argue that markets are wrong — as I did when diagnosing a housing bubble, and now in questioning the market’s optimistic beliefs about inflation — and my point that low interest rates undermine the argument for immediate fiscal austerity.

What people don’t get is that in all cases I’m starting from the fundamentals. It’s the austerity types who are appealing to market psychology to reject those fundamentals — and the point then is that this market psychology is all in their imagination.

The key argument against fiscal austerity now is that it’s bad economics: it would depress the economy, while doing very little to improve the long run budget position (and might even make that long-run position worse.) I’ve done the math repeatedly on this blog.

But the austerians argue that the numbers don’t matter — we have to cut now now now or the bond vigilantes will attack.

And then the question is, where are those vigilantes? I guess they’re suckering us in by lending to the US government at negative real interest rates.

So the point isn’t that market are always right; it’s that if you’re going to claim that appeasing the markets trumps rational economic analysis, you really should have some evidence that the markets care at all about what you’re demanding.

I haven’t written at all about HAMP — the administration’s disastrously failed home mortgage modification program, which was supposed to be the modern version of FDR’s Home Owners Loan Corporation. My excuse, such as it is, is that I don’t presume to know the legal ins and outs well enough to devise an alternative.

But still: this is a case where the administration had (and still has) the money, $50 billion from TARP. That should be enough to dangle some pretty big carrots in front of lenders. And it could have had sticks, too: it could have advocated cramdown, it could have taken advantage of the popular anger to put pressure on the banks at any time — and especially as the foreclosure scandal has broken.

And HAMP’s failure isn’t news: it has been obvious for more than a year that the thing wasn’t working. I mean, the money wasn’t even being spent, which is a scandal in itself at a time when the economy so desperately needed help. And tales of the Kafkaesque process have been spreading for many months; read David Dayen’s series at Firedoglake.

But there has been nothing; no significant changes, no major rethinks, just excuses.

I really don’t understand the passivity here.

The 5-year TIPS spread

Financial markets seem convinced that quantitative easing will be highly effective at solving at least one problem: inflation running well below the Fed’s 2-percent-or-so target. The chart above shows the difference between interest rates on 5-year inflation-protected bonds (which are now negative) and rates on unprotected bonds; implicitly, the market forecast of inflation over the next five years has risen half a point.

But I really don’t understand this. Granted that QE2 will probably have some positive effect, hopefully bigger than analysis based on the debt-maturity equivalence suggests. Still, the prospect remains that we’ll face multiple years of high unemployment — or, if you prefer, a protracted large output gap (PLOG). And history is clear on what that means: declining inflation:

My guess, then, is that the markets are overreacting; they’re thinking, “The Fed is printing money!”, while forgetting that this ultimately matters, even for inflation, only to the extent that it seriously reduces unemployment.

A new memo from Goldman Sachs (no link) looks at quantitative easing by treating it as equivalent to a shortening of the maturity of federal debt; among other things, the memo answers the question of where I got it from: work by Jim Hamilton and Cynthia Wu.

So, what GS estimates is that a trillion dollars of QE amounts to a one-year reduction in the average maturity of federal debt. How many people think that would be enough to have a transformative effect on the economy?

I’m finding the foreclosure issue difficult to write about; it’s clear that there has been massive malfeasance on the part of the banks (again), but it’s less easy to say what should be done. One thing is clear, however: the main argument being made for turning a blind eye to the situation, and avoiding anything like a temporary freeze on foreclosures, is wrong.

I’m referring to the argument that we need to let foreclosures proceed, never mind the doubts, because it’s important to get those properties seized and sold, so that we clean up the mess. That’s the argument you’ve been hearing from administration officials — and it sounds reasonable if you don’t look at what actually happens to foreclosed homes.

For the fact is that a startling number of those homes aren’t being sold: there’s a huge “shadow inventory” of homes that have been seized, but not yet put on the market.

If servicers really wanted to get homes sold and the issue resolved, they’d be doing short sales: letting the current owners sell the homes for whatever they can get, hand the proceeds over, and call it quits. And there are a lot of short sales out there — but there are also many cases in which short sales are being refused, and foreclosures take place instead.

The official reason for aversion to short sales is the potential for fraud: the homeowner sells the house cheap to his cousin, or whatever. But how hard is it to police that fraud, at least sufficiently to avoid gross abuses? Remember, a house sold somewhat too cheaply is still a better deal for the lender than a house not sold at all.

An alternative explanation for the preference for foreclosure and the willingness to sit on foreclosed homes for long periods of time is that it’s a game of extend and pretend: a short sale means that lenders have to acknowledge their losses, while an empty foreclosed home can be kept on the books at an unrealistic value.

If this is the right way to look at the situation, then the paperwork crisis presents an opportunity to help fix a major market failure — an opportunity to prod lenders into either short sales or workouts with homeowners, and to stop the socially harmful buildup of shadow inventory.

And it’s an opportunity that is, as usual, going to waste.

Wow. I guess I lead an intellectually sheltered life. Until I followed a link from Yves Smith, I had been blissfully unaware that the investment airwaves were full of people yelling that Bernanke is debasing the dollar because the dollar has fallen modestly in recent weeks.

Is it really possible that the CNBC-watching crowd doesn’t understand that right now a weak dollar is good for America? Have the usual suspects turned their backs not only on the insights of Keynes, but on basic monetary economics as well? Is goldbuggism triumphant?

Guess so. Just for reminders: in the 1930s, the French were the diehard defenders of the gold standard. Here’s what they got:

Industrial production, 1929=100

One of the common arguments against fiscal policy in the current situation – one that sounds sensible – is that debt is the problem, so how can debt be the solution? Households borrowed too much; now you want the government to borrow even more?

What’s wrong with that argument? It assumes, implicitly, that debt is debt – that it doesn’t matter who owes the money. Yet that can’t be right; if it were, we wouldn’t have a problem in the first place. After all, to a first approximation debt is money we owe to ourselves – yes, the US has debt to China etc., but that’s not at the heart of the problem. Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

It follows that the level of debt matters only if the distribution of net worth matters, if highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past.

To see my point, imagine first a world in which there are only two kinds of people: Spendthrift Sams and Judicious Janets. (Sam and Janet who? If you’d grown up in my place and time, you’d know the answer: Sam and Janet evening / You will see a stranger … But actually, I’m thinking of the two kinds of agent in the Kiyotaki-Moore model.)

Read more…

A brief further note on the equivalence of quantitative easing and shifts in the maturity composition of federal debt, raised here.

Some people have quarreled with my statement of this equivalence. It’s true, they say, that monetary base and Treasury bills both yield near-zero interest rates. But monetary base is money — it provides liquidity in a way that T-bills, no matter how negotiable, don’t. To which the answer is yes, but no — and right now it’s no.

The point is that we’re now in a liquidity trap. What does that mean? It means that the Fed has pushed short rates down to zero, so that at the margin T-bills are no better than cash — and correspondingly, that means that at at the margin people and banks are holding some of their cash purely as a store of value. Liquidity is now free, and as a result the market’s demand for liquidity is satiated; adding more potentially liquid assets makes no difference. So issuing short-term debt and printing monetary base are equivalent.

But, you say, it won’t always be thus: at some point the economy will recover to the point where the zero lower bound is no longer binding; and at that point monetary base and short-term debt will no longer be the same thing. Indeed. But at that point the Fed will be seeking to reduce the monetary base — by definition: it’s only once the Fed is trying to curb the size of the base that the zero lower bound ceases to be binding.

And how will the Fed reduce the monetary base? Through open market operations — that is, by selling T-bills.

And what that means is that as soon as monetary base and short-term debt start to become non-equivalent, the Fed will start swapping base for short-term debt. In the end, then, by increasing the monetary base the Fed was in effect selling short-term debt.

So QE really is just like a shift in the maturity of federal debt.

I’m tempted to end with a Greenspanism: if you think you understood all that, you weren’t reading carefully.

I’ve been getting a lot of correspondence lately that runs something like this:

You’re an idiot. Give me one example in all of history of a country that spent its way out of a depressed economy

Ahem. There’s this country — people may not have heard of it — called the United States of America:

The blue line is total debt, public plus private, in billions of dollars; the red line debt as a percentage of GDP (both on left scale).

But that was different, you say — it was a war! To which I reply, you think it’s better if we spend all that money on useless things?

Sigh.

Wolfgang Munchau marvels at the European obsession with a revived and strengthened stability pact — that is, with tougher constraints on budget deficits.

The real irony is that the pact, in whatever form, is not even relevant to the eurozone’s future. This may be a shocking statement. But look at the evidence. Contrary to popular narrative, fiscal profligacy played only a minor role in the eurozone’s sovereign debt crisis.

…

As for Spain and Ireland, they did not breach the rules ever, and would thus never have been subject to sanctions, automatic or otherwise.

What Munchau doesn’t say, but I suspect he understands, is that this is in large part an extension of the case of the boy with a hammer, for whom everything is a nail. Bankers and economists love, just love, being fiscal scolds; deficits are something they understand, plus denouncing deficits is an easy way to sound all moral and responsible. Rather than facing up to the complexities of our current problems — how do you get out of a liquidity trap? how do you rein in shadow banking? — many Very Serious People would much rather lecture governments on the evils of red ink.

One thing that was very obvious from where I sit was the sheer joy the Greek crisis created for the VSPs. Here, at last, was their kind of issue. And this was one main reason they were so eager to Hellenize everything in sight. There has, I can assure you, been much disappointment over the failure of US interest rates to spike.

And so the great and good of Europe are obsessing over the stability pact. It’s a whole lot more pleasant for them than wondering how to actually make the euro work.

A thought: it has occurred to me that we could use an economics equivalent of Keith Olbermann’s “Worst Person in the World” award. KO does not, of course, mean that the person he goes after on any given night really is the worst person in the world; he just uses the title to highlight some especially awful action or statement.

I’d encourage others to enter this game — and yes, I know that various paid trolls and others will award me the title five times a day if they can. But here’s what caught my eye: the WSJ’s Real Time Economics explaining (or rather, “explaining”) the risks from competitive devaluation:

When one country devalues its currency, others tend to follow suit. As a result, nobody achieves trade gains. Instead, the devaluations put upward pressure on the prices of commodities such as oil. Higher commodity prices, in turn, can cut into global economic output. In one ominous sign, the price of oil is up 8.7% since August 27.

Urk.

Why do dollar commodity prices tend to rise when the dollar falls? Because other countries buy commodities too, so that a constant dollar price would mean a fall in terms of other currencies. To a first approximation, in fact, you’d expect commodity prices to remain constant, other things equal, in terms of a GDP-weighted basket of currencies around the world.

So yes, a fall in the dollar tends to raise the price of oil in dollars — but it also tends to reduce the price of oil in euros. A fall in the euro tends to raise the price of oil in euros, but raise reduce it in dollars. [whoops!] So what would devaluations that raise commodity prices in terms of all currencies look like? I have no idea.

There is, I think, a tendency to think of devaluations as reductions in the value of currencies relative to something external and eternal — and hence as making us all poorer. But the reality is that my depreciation is your appreciation, and vice versa; we can’t all devalue at the same time.

But competitive devaluation is one of those things people just know is bad, and so critical thinking has a tendency to go out the window.

Still on the run, so no long posts. But with all the talk about further quantitative easing by the Fed — QE2, for quantitative easing, the sequel — I think it’s worth sharing one way of thinking about what’s on the table — and why you shouldn’t be too optimistic about its effects. This isn’t original, although I don’t know who deserves the credit.

So, here it is: in effect, QE2 amounts to a decision by the US government to shorten the maturity of its outstanding debt, paying off long-term bonds while borrowing short-term. This should drive down long-term interest rates. But how much?

How do we get to this view? Think first of the Fed’s balance sheet. The Fed’s liabilities are the monetary base — currency in circulation, plus bank reserves. Those bank reserves are essentially short-term borrowing: the Fed pays a small interest rate on them, which is comparable to the interest rate on Treasury bills. More broadly, in a near-zero-rate world, cash — an official liability that pays no interest — is essentially equivalent to T-bills — another official liability that pays more or less no interest.

What happens when the Fed buys long-term government securities? If we consider the Fed and Treasury as a consolidated entity — which, for fiscal purposes, they are — then what happens is that some long-term federal debt is taken off the market, and paid for by issuing more short-term debt in the form of monetary base. It’s just as if Treasury sold 3-month T-bills and used the proceeds to buy back 10-year bonds.

So the question to ask is, how much do we think federal management of its maturity structure matters for the real economy? I think if you put it that way, most people wouldn’t be terribly optimistic.

Anyway, my jet-lagged thought for the day.

On my way to Berlin and beyond. Posting will be erratic.

As if to illustrate my point about the non-equivalence of the United States and China: China raises interest rates.

So, the United States is pursuing an expansionary domestic monetary policy, which increases overall world demand; however, a side consequence of this policy is a weaker dollar. China is pursuing a weak-yuan policy; to counter the inflationary domestic effects of that policy, it’s pursuing a contractionary domestic monetary policy, reducing overall world demand.

We’re doing the right thing; they’re making the world as a whole worse off.

Mark Thoma points us to a paper by Mary Daly of the San Francisco Fed, which contains this remarkable chart of core inflation in two episodes:

From Seven Samurai to The Magnificent Seven, this time in economics.