When trying to determine how economists failed to predict and address the financial crisis, Paul Krugman offered an extensive critique of "fresh water economists" associated with the University of Chicago, whom he describes as "neoclassical purists." We associate these economists with the efficient markets hypothesis (EMH), the theory that markets reflect the best information that ran into some hard empirical ground in 2008.Many economists on the left share Krugman's concerns about Chicago economists, but now Scott Sumner seems to have caught them in a double-step: One key argument in favor of continued, short-term deficit spending is that we're not seeing rising interest rates or inflation, which would indicate that markets are worried about the United States' ability to repay its debt and forecast potential "crowding out" of private investment (Krugman made that argument yesterday). But that assumes that the market is 'right' in its expectations about the U.S. economy, ala EMH.
Kevin Drum highlights a key rejoinder from economist Brad Delong: Whether or not we think these are the "right" interest rates, the fact that money is available so cheaply for government means the cost of additional stimulus is low relative to the benefits of increased demand, regardless of the market's accuracy in pricing -- at this price, how can you say no?
But more than that, I think that when stimulus proponents cite these market indicators, it is less an attempt to promote their strategy than to undercut the arguments of deficit hawks. Every time interest rates have bumped up at all, breathless fear-mongering ensues, but challenging those claims by pointing out the trending historic rate lows (and deflation) isn't so much an endorsement of the indicators as a challenge to deficit hawks: Come up with serious arguments to justify your calls for austerity, since the human price we pay for waiting is too high for arguments that don't even work in your own model.
-- Tim Fernholz
