By Arnold Kling
Right now, the Mankiw indicator is -8.5 — core inflation at about 1, unemployment at 9.5. As you can see, that implies a majorly negative interest rate; what we actually get is zero.
He suggests that the low interest rate on long-term bonds is consistent with the CBO forecast of prolonged low inflation and high unemployment. On the other hand, look at stock prices, about which James Hamilton writes:
Despite the recent correction in stock prices, stocks still cost more today relative to the earnings you’re buying than they did over most of the previous century and a half. We’d still need about another 17% decline in stock prices to get back to the historical average valuation multiple.
My guess is that if you were to plug in the CBO forecast, the case that stocks are overvalued would be strengthened. And of course, gold remains high. I still would like to figure out how to bet against gold and bonds simultaneously. I cannot imagine an economic scenario in which gold investors and bond investors both hold their own over the next five years.
Another thing about the CBO forecast: if nothing changes, by 2030 we will have reached a point where a sovereign debt default becomes likely. At some point, that risk will find its way into the interest rate on bonds. Actually, the moment a significant default risk gets built into the price, it becomes a self-fulfilling prophecy–at a high enough interest rate, we will have to default. (I take monetizing the debt as a form of default.)
Finally, I am still pondering Tyler Cowen’s post:
Let’s say that housing and equity values fall and suddenly people realize they are less wealthy for the foreseeable future. The downward shift of demand will bundle together a few factors: 1. A general decline in spending…2. A disproportionate and permanent demand decline for the more income- and wealth-elastic goods…3. A disproportionate and temporary demand decline for consumer durables, which will largely be reversed
One of the weirdest things about macro is the notion that the economy decides to forego output. In the classic “real business cycle” models, a bunch of folks decide to take time off and enjoy leisure. I’ve cited Franco Modigliani’s retort–was the Great Depression a mass outbreak of laziness?
But the Keynesian story is not much better. Instead of the representative agent deciding not to produce a typical year’s output, the representative agent decides not to buy a typical year’s output. You get a mass outbreak of abnegation.
I know, I know. People try to save all at once. Paradox of thrift. Liquidity trap. But there are still $20 bills being left on the sidewalk. An entrepreneur could hire an unemployed worker at a low wage and produce something that people would want to hold as wealth. Trying to explain why those $20 bills are left on the sidewalk is what leads one in the direction of Zero Marginal Product and the Recalculation Story.