The Great Debt Scare

It might not seem that Europe’s sovereign-debt crisis and growing concern about the United States’ debt position should shake basic economic confidence. But they apparently have. And loss of confidence, by discouraging consumption and investment, can be a self-fulfilling prophecy, causing the economic weakness that is feared. Significant drops in consumer-confidence indices in Europe and North America already reflect this perverse dynamic.

We now have a daily index for the US, the Gallup Economic Confidence Index, so we can pinpoint changes in confidence over time. The Gallup Index dropped sharply between the first week of July and the first week of August – the period when US political leaders worried everyone that they would be unable to raise the federal government’s debt ceiling and prevent the US from defaulting on August 2. The story played out in the news media every day. August 2 came and went, with no default, but, three days later, a Friday, Standard & Poor’s lowered its rating on long-term US debt from AAA to AA+. The following Monday, the S&P 500 dropped almost 7%.

Apparently, the specter of government deadlock causing a humiliating default suddenly made the US resemble the European countries that really are teetering on the brink. Europe’s story became America’s story.

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Irving Fisher, Debt Deflation and Crises

It is the 100th anniversary of Irving Fisher’s 1911 book The Purchasing Power of Money. But, more important than that, it is a good time, during the current financial turmoil, to reconsider some of his theories again, in light of current events. And I think that some of his theories about variations in the purchasing power of money are very important today, have been underappreciated, and are worthy of considering anew.

In that 1911 book he described a theory of financial crises that tied them to over-borrowing during the expansion phase that preceded the crisis, and to the changes in the purchasing power of money that this expansion causes, then to the collapse in credit and the drop in the price level.

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Taxing and Spending, in Balance

THE fight over the debt ceiling has deflected attention from the serious problems of fixing the economy and finding jobs for the 14 million unemployed. Worse, it has created strong negative feelings about fiscal policy, just when other policy measures seem incapable of restoring economic health.

The very term “fiscal stimulus” has become tainted. John Boehner, the House speaker, refers to a “misguided ‘stimulus’ spending binge.” It’s a label that reflects how many people have come to think of government expenditures to stimulate the economy — as a binge, maybe like an overdose of amphetamines. For amphetamines, the aftereffects are mental fatigue and depression. For fiscal stimulus, it is the headache of national debt — or at least that is the all-too-common view.

Fiscal stimulus is actually very useful and appropriate in the current circumstances. But rather than despair, we should at least consider what more we should be doing to deal with the pressing issue of unemployment. Let’s never give up proposing sensible economic policies.

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Debt and Delusion

NEW HAVEN – Economists like to talk about thresholds that, if crossed, spell trouble. Usually there is an element of truth in what they say. But the public often overreacts to such talk.

Consider, for example, the debt-to-GDP ratio, much in the news nowadays in Europe and the United States. It is sometimes said, almost in the same breath, that Greece’s debt equals 153% of its annual GDP, and that Greece is insolvent. Couple these statements with recent television footage of Greeks rioting in the street. Now, what does that look like?

Here in the US, it might seem like an image of our future, as public debt comes perilously close to 100% of annual GDP and continues to rise. But maybe this image is just a bit too vivid in our imaginations. Could it be that people think that a country becomes insolvent when its debt exceeds 100% of GDP?

That would clearly be nonsense. After all, debt (which is measured in currency units) and GDP (which is measured in currency units per unit of time) yields a ratio in units of pure time. There is nothing special about using a year as that unit. A year is the time that it takes for the earth to orbit the sun, which, except for seasonal industries like agriculture, has no particular economic significance.

We should remember this from high school science: always pay attention to units of measurement. Get the units wrong and you are totally befuddled.

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