Something I’ve been meaning to write: there are two different stories about why deficits might drive up interest rates. They’re not at all the same — although members of the pain caucus have deliberately blurred the distinction. And for policy purposes it’s quite crucial to understand what we’re talking about.
The first story is good old crowding out: the government is borrowing, that competes with private borrowers, and that drives rates up. That’s what Niall Ferguson was arguing back when, it’s what Morgan Stanley was arguing when it predicted soaring rates in 2010. To be fair, it’s a reasonable story when the economy is near full employment. But it’s all wrong when the economy is depressed, and especially if it’s in a liquidity trap. And it also involves a fundamental misunderstanding of economics to argue, as Ferguson did, that crowding out can actually deepen a slump.
The other story involves fears about a government’s solvency. The key point to understand here is that one year’s deficit, in practice, can’t matter very much in determining a government’s solvency, which depends on the present discounted value of revenues and obligations over many years. So the deficit matters in that case only to the extent that it represents a signal about government determination, or, possibly, to the extent that it pushes debt over some psychologically important threshold.
It’s worth noting that the current attack on Italy was not triggered by news about the deficit; it was triggered by worries about economic growth. And this makes one wonder whether austerity can really restore confidence.
Anyway, two different stories. A number of deficit hawks switched stories in midstream, without admitting it — they were crowding-out types, but seized on solvency as crowding out failed to materialize while the Greek crisis did. But that was cheating.