Last week Alan Greenspan handed the Democrats a new weapon in their election-year efforts to discredit President Bush’s booming economy: the Fed chairman hinted broadly that today’s historically low interest rates are about to move higher.
But rising rates are a tricky weapon for the Democrats to use, as Paul Krugman — America’s most dangerous liberal pundit — is learning. In a New York Times column last week Krugman forecasted that 10-year Treasury bond yields will soar to 7 percent from their current 4.4 percent, and warned that “many American families and businesses will be in big trouble if interest rates really do go as high as I’m suggesting.”
At the same time, though, the Democrats can’t evade the reality that rising rates are strong evidence of the economic boom they’ve tried to deny and discredit. Even Krugman admitted (between clenched teeth) that rates will rise “If the economy fully recovers — or even if investors just think it will.”
Krugman seems to find himself in the rather difficult position of arguing that “American families and businesses will be in big trouble” when “the economy fully recovers.”
Fortunately for the Democrats, there’s another way to spin rising interest rates: as the product of Bush’s tax cuts and the present federal budget deficit. This gives Democrats the opportunity to retell their nostalgic myth about the prosperity of the late 1990s, kindled by the low interest rates that the Clinton administration made possible when it brought “long-term budget deficits under control through a mixture of tax increases for upper-income families and spending restraint.”
Krugman, an economics professor at Princeton, cites academic arguments in order to convert myth into fact:
… there’s no argument among serious, nonideological economists. For example, a textbook by Gregory Mankiw, now the president’s chief economist, declares — in italics — that “when the government reduces national saving by running a budget deficit, the interest rate rises.”
Yes, it’s true that Mankiw’s textbook, Principles of Macroeconomics, does say that. It’s even true that it says it in italics. But (with due respect to Mankiw) the myth is just a myth. The historical evidence simply doesn’t bear out any such relationship between deficits and interest rates — indeed, the data prove the opposite. When annual changes in debt are regressed against annual changes in interest rates, the result is a negative correlation — precisely the reverse of what Krugman’s politics (and Mankiw’s theory) would dictate.
For those interested in the truth, the chart below makes all this crystal clear. Between the years 1958 and 1974, rates rose while debt plummeted. Between 1974 and 1982, rates soared while debt barely changed at all. Between 1982 and 1993, rates collapsed while debt soared. After 1993, during the Clinton years, while debt fell sharply — and again, since the Bush years began in 2001, a period of climbing federal debt — interest rates continued lower, moving in the same direction they’d been moving since 1982.
How could Krugman and Mankiw be so wrong? In Krugman’s case, that’s an easy one: He’s just trying to score partisan political points, and the difference between right and wrong doesn’t enter into his considerations. In Mankiw’s case the answer is a bit more subtle: He’s dealing in the realm of abstract theory, in which propositions like the relationship between rates and debt can be considered in splendid isolation, without any of the complicating influences that inevitably interfere in the real world.
One such influence is taxes — especially taxes on savings, like the capital-gains tax. The epoch of falling interest rates that began in 1982 coincided with a time of generally falling tax rates, starting with the Reagan revolution (and including a large cut in the capital-gains rate forced on Clinton by a Republican Congress in 1997). Krugman, of course, would never mention it, but Mankiw’s book also says — and also in italics — that “if a change in the tax laws encouraged greater saving, the result would be lower interest rates.”
Inflation is another influence on interest rates. Since 1958 inflation and interest rates have moved hand-in-hand — the two are positively correlated to the same degree that rates and debt are negatively correlated. Krugman mentioned rising inflationary trends in his column last week. But until then he had been wringing his hands about just the opposite — deflation (as ex officio Krugman Truth Squad member Brian Briody reminded me). Krugman wrote in his Times column in late 2002 that “the threat of deflation is worse now than it was a year ago. In fact, by some measures deflation is already here … Will it be all over the newspapers a year from now?” The risk of falling into what he called the “black hole” of deflation was exacerbated (you guessed it) by “the Bush administration … playing politics with fiscal policy.”
For the record, around the same time I wrote in my SmartMoney.com column that “deflation is dead.” As Krugman now implicitly confesses in last week’s piece, I was right and he was wrong. But no matter: For Krugman, it’s another day, another black hole — and another chance to blame Bush.
– Donald Luskin is chief investment officer of Trend Macrolytics LLC, an independent economics and investment-research firm. He welcomes your comments at don@trendmacro.com.