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The Confidence Fairy and Gnome, Debunked

Paul Krugman: Count me in as someone who believes that macroeconomics – at least of the Keynesian variety – has actually worked pretty well these past five years.

It’s kind of sad, but I suspect that the confidence fairy is the main thing people will remember me for — if they remember anything — half a century from now. So maybe I can somewhat package my attempts to debunk the Hellenization of our discourse by pointing out that the scare stories seem to involve invoking a related set of characters, the confidence gnomes.

The popular story — put out by everyone from the former chairman of the Federal Reserve, Alan Greenspan, to Erskine Bowles, the co-chairman of President Obama’s debt commission — runs like this:

1. Loss of investor confidence

2. ??????

3. Greece!

What I keep asking is for someone to explain step 2 in a way that’s consistent with the fact that America, Britain and Japan — unlike Greece — have their own currencies, and central banks that control short-term interest rates. Are they saying that central banks will raise these rates, and if so, why? Are they saying that long rates will become delinked from short rates? Why, and why can’t central banks prevent this just by buying long-term debt?

So far, nobody has answered this challenge clearly. They simply assert that this is how it will happen, or they switch arguments in midstream, suddenly bringing in the specter of bank collapse or something else. Just tell me what’s supposed to be happening to monetary policy! And don’t tell me that this is what experience shows. There simply aren’t historical precedents for the claims — a debt crisis in a country that has its own currency and borrows in that currency. France in the 1920s comes closest, but it didn’t play out anything like modern Greece.

Japan right now is, in effect, an example of a country benefiting by reducing confidence in the future real value of its debt. (Before commenting on these assertions, read the draft my new paper). What’s more, we have a clear recent example of just how important it is to think these things through. Remember that people like Mr. Greenspan insisted that budget deficits would lead to soaring rates and inflation. But they never explained how this was supposed to happen in a depressed economy with short-term interest rates at zero.

Again, their logic was more or less:

1. Deficits

2. ??????

3. Zimbabwe!

Meanwhile, those of us who tried to think it through concluded that nothing of the sort would happen — and it didn’t. Count me in as someone who believes that macroeconomics — at least of the Keynesian variety — has actually worked pretty well these past five years. The problem is that so few economists have been willing to use their own models, and also that so few influential people have understood that gut feelings are no way to deal with a once-in-three-generations economic crisis.

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