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Listen to the Vampire Squid

By Matthew Yglesias on July 7, 2010 at 11:27 am

"Listen to the Vampire Squid"

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From Goldman Sachs’ latest analysis of the economic situation:

The weak labor market implies not only a great deal of hardship for workers, but also a growing risk of deflation. Although the last couple of core CPI/PCE releases were a bit higher than those earlier in 2010, the trend still seems to be downward and other measures such as wage growth and inflation expectations have been declining. In particular, the 5-year 5-year forward breakeven inflation rate in the TIPS market has fallen 75bp since April and now stands at 2% for on-the-run securities, the lowest level since mid-2009.

Our recently released Global Economics Paper No. 200 entitled “No Rush for the Exit” argues that policymakers should react to the combination of a sluggish recovery and declining inflation with additional policy easing, either via a return to unconventional monetary policy or via further fiscal stimulus. The obvious counterargument is that monetary and fiscal easing carries long-term costs in the form of, respectively, a risk of a renewed asset bubble and a higher public debt burden. But our study shows that these costs look far from prohibitive at present. On the monetary side, US financial markets are nowhere close to bubble territory. On the fiscal side, it is difficult to argue that the US government has reached the limits of its debt capacity when long-term bond yields are low and falling, and when federal interest payments stand at just 1½% of GDP. When compared with the risk of a renewed economic downturn and/or a descent into deflation, the cost of additional stimulus seems to be well worth paying.

I also note that some of the thinking on bubble risks seems a little confused to me. I think it’s bad when regulators decide that a bubble by definition cannot exist and therefore misunderstand the situation. But from a macroeconomic stabilization point of view to say that the problem with a given approach to recovery is that eventually it will lead to a new recession just isn’t saying very much. Every expansion is followed by a recession and every recession is followed by an expansion.

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