by Ben Cohen
Paul Krugman dispels the myth that government spending during a recession causes inflation:
It turns out that there’s a strong correlation between budget
deficits and interest rates — namely, when deficits are high, interest
rates are low.
On reflection, it’s obvious why: a weak economy both drives up
deficits and drives down the demand for funds, while a strong economy
does the reverse. Thus the surpluses of the late Clinton years were
associated with high interest rates, while the current recession has
depressed both rates and revenues.
And what about the bounce in interest rates over the past few
months? It reflects a gradual reduction in the end-of-the-world
discount: interest rates have risen along with stock prices as
investors have gradually become convinced that we’re avoiding a second
This is another slap in the face to free market doctrine that states the market will always figure out what is best. Writes Brad DeLong:
A government deficit means that the government is printing and issuing
a lot of bonds at exactly the same moment that private investors are
looking for a safe asset to hold. As these bonds hit the market, people
who otherwise would have socked their money away in cash--thus
diminishing monetary velocity and slowing spending--buy the bonds
instead. A large and timely government deficit thus short-circuits the
adjustment mechanism, and avoids the collapse in monetary velocity that
was the source of all the trouble.
In other words, when the economy collapses, markets behave extremely irrationally and the government must step in to prevent total catastrophe. If left to its own devices, the market does the following in a recession: Investors stop investing, people stop buying, and companies start firing. While Republicans claim government spending increases inflation and makes a bad situation worse, the inverse is true. The data to prove it: