Some Perspective on the Debt Ceiling Debate

John Taylor on Evaluating Stimulus

I continue to see counterfactuals on the stimulus package that are generated from structural models of the U.S. economy. These counterfactuals, however, are not useful for ex post policy analysis because they provide the same predictions ex ante. John Taylor makes this point using a simple example:

• Consider two models relating the size of the stimulus package (symbolized by S) to GDP (symbolized by Y). Model A is Y= αS + Z and Model B is Y = Z, where Z is an unobservable shock and α is a coefficient which we set to 1.5.
• Suppose that a stimulus is enacted with S = 2, but Y falls to -1. Then the shock implied by Model A is Z = – 4 while the shock implied by model B is Z= -1.
• Now consider policy evaluation of the stimulus based on a counterfactual where there is no stimulus so S=0.
• Economists using Model A would say:

  Just as we predicted, the stimulus package worked. Without it, Y would have fallen to -4 rather than -1. The decline in output would have been 4 times as deep, a Great Depression 2.0.

• Economists using Model B would simply say:

  Just as we predicted the stimulus package didn’t work.

• The best way to way to deal with this problem is to look empirically at the direct effect of the stimulus using actual data, but without imposing a specific model structure like Model A or Model B.

Taylor’s own empirical estimates suggest the stimulus failed.

Quote of the Day

Cameron is a fan of the Swedish center-right government, and would like to move the UK in that direction. But he will probably fail. British voters have no stomach for the savage inequalities of Swedish-style laissez-faire.

That’s Scott Sumner, who is blogging again.

Debt Ceiling Expectations

Why does the Treasury market seems substantially less concerned than David Brooks? The last I checked, the yield on 10-year Treasuries was about 3.04%. Assuming that a “default” has been priced in with non-zero probability, it seems that yields should be significantly higher than they are presently.

I think that there are two potential scenarios that explain why bond yields haven’t moved substantially in the midst of the debt ceiling debate. First, it is possible that bondholders have significantly underestimated the probability of “default.” As such, a failure to raise the debt ceiling would result in significantly higher yields. Second, the market is unconcerned about what is only a technical default. If an agreement cannot be met on raising the debt ceiling, it is possible that the Treasury could prioritize spending to pay bondholders first. In other words, they could withhold spending allocated for other uses and use the proceeds to make interest payments on the debt. In this latter case, bondholders are unconcerned about the debt ceiling because they assume that they will still get paid. In addition, a failure to raise the debt ceiling might send a signal to the markets that the U.S. is actually serious about reducing debt.

Admittedly, I do not know which, if either, scenario is correct. I also remain skeptical that purported experts know which scenario is correct.