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koganbotMy understanding of economics is so poor that statements that are immediately obvious to some people still contain unbridgeable ellipses for me. But here's a passage from Paul Krugman's End This Depression Now that I think, if I were to reread it five or six times, I may end up understanding. At least I'll post it here for reference. I know this is no substitute for understanding IS-LM curves (on the long-term lol to-do list), but at least it may give me some idea why government borrowing when we're in a liquidity trap doesn't drive up interest rates. (The block quote in the Krugman excerpt is from a May 2009 blog post of his in which he does bring up IS-LM curves.)
Recall from chapter 2 that a liquidity trap happens when even at a zero interest rate the world's residents are collectively unwilling to buy as much stuff as they are willing to produce. Equivalently, the amount people want to save — that is, the income they don't want to spend on current consumption — is more than the amount businesses are willing to invest.
Reacting to Ferguson's remarks a couple of days later, I tried to explain this point:
Where did the money to finance all this borrowing come from? From the U.S. private sector, which reacted to the financial crisis by saving more and investing less; the financial balance of the private sector, the difference between saving and government spending, went from –$200 billion a year before the crisis to +$1 trillion a year now.
You may ask, what would have happened if the private sector hadn't decided to save more and invest less? But the answer is, in that case the economy wouldn't have been depressed — and the government wouldn't have been running such big deficits. In short, it was just as those who understood the logic of the liquidity trap had predicted: in a depressed economy, budget deficits don't compete with the private sector for funds, and hence don't lead to soaring interest rates. The government is simply finding a use for the private sector's excess savings, that is, the excess of what it wants to save over what it is willing to invest. And it was in fact crucial that the government play this role, since without those public deficits the private sector's attempt to spend less than it earned would have caused a deep depression.
—Paul Krugman, End This Depression Now, pp 136–137
(Context of this is Niall Ferguson apparently assuming that if the government borrowed there'd be no buyers/lenders, so the Fed would have to do the buying itself, which would drive down the price of government bonds and drive up interest rates by the law of supply and demand, too many bonds and not enough buyers — if I'm understanding the Ferguson passage right [quoted by Krugman on p. 135], which I may not be.)
Recall from chapter 2 that a liquidity trap happens when even at a zero interest rate the world's residents are collectively unwilling to buy as much stuff as they are willing to produce. Equivalently, the amount people want to save — that is, the income they don't want to spend on current consumption — is more than the amount businesses are willing to invest.
Reacting to Ferguson's remarks a couple of days later, I tried to explain this point:
In effect, we have an incipient excess supply of savings even at a zero interest rate. And that's our problem.The federal government has borrowed arount $4 trillion since I wrote that, and interest rates have actually dropped.
So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.
Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems; some countries, such as Ireland, are being forced into fiscal contraction even in the face of severe recession. But the fact remains that our current problem is, in effect, a problem of excess worldwide savings, looking for someplace to go.
Where did the money to finance all this borrowing come from? From the U.S. private sector, which reacted to the financial crisis by saving more and investing less; the financial balance of the private sector, the difference between saving and government spending, went from –$200 billion a year before the crisis to +$1 trillion a year now.
You may ask, what would have happened if the private sector hadn't decided to save more and invest less? But the answer is, in that case the economy wouldn't have been depressed — and the government wouldn't have been running such big deficits. In short, it was just as those who understood the logic of the liquidity trap had predicted: in a depressed economy, budget deficits don't compete with the private sector for funds, and hence don't lead to soaring interest rates. The government is simply finding a use for the private sector's excess savings, that is, the excess of what it wants to save over what it is willing to invest. And it was in fact crucial that the government play this role, since without those public deficits the private sector's attempt to spend less than it earned would have caused a deep depression.
—Paul Krugman, End This Depression Now, pp 136–137
(Context of this is Niall Ferguson apparently assuming that if the government borrowed there'd be no buyers/lenders, so the Fed would have to do the buying itself, which would drive down the price of government bonds and drive up interest rates by the law of supply and demand, too many bonds and not enough buyers — if I'm understanding the Ferguson passage right [quoted by Krugman on p. 135], which I may not be.)
