The old verities of economics, outstripped by events, are revealed as impostures. Perhaps the most basic imposture is that of supposing economics a science capable of the precision and predictability of the physical sciences. Upon this sandy foundation were erected numerous structures of modeling and forecast, great gleaming houses of impressive design and craftsmanship; but, like the old Sunday School song, when the rain came down and the floods came up, the houses on the sand went SPLAT!
There is, to begin with, the elaborate infrastructure of probabilistic modeling that forms the basis of all fixed-income assets; which assets form the basis of virtually all portfolio management, thus establishing the framework of world capital markets. The vast majority of bonds, whether simple and ancient (corporate debt) or new and exotic (credit derivatives), are priced by comparing their interest yield to “risk-free” government bonds. It is not too much to say that this fact precludes the possibility of a balanced US government budget. The private economy, especially at the highest level of importance, entirely depends on the government running a deficit. Without the regular issuance of US Treasury bonds, capital markets would be thrown into chaos. Investors would lack the indispensible underpinning for classical economics: the pricing mechanism.
It is important to recognize that this feature of modern capitalism was not a consequence of government meddling but of spontaneous order of a Hayekian variety. It was a natural development of private actors operating in a cooperative capacity for mutual benefit. The price mechanism is no trivial matter. As securities markets matured from an insular preserve of cigar-chomping magnates into the conduit for credit formation (matching borrowers with lenders as private enterprise demanded much larger sums of capital for its operations), with new instruments being developed all the time, a stable method of pricing was more than a felt need. It was an absolute prerequisite. As a friend puts it, “There's just a term in all of the equations where you have to plug in a risk-free interest rate from some specific point on the yield curve. US govt debt prices happen to be the best real-world proxy for that theoretical value.” Government bonds generally being the most staid and predictable investment instrument, it was natural that they would form the basis for this price.
But there’s a problem. US Treasury debt is not, in fact, risk-free. That is to say, even the nearest approximation of the theoretical value remains but an approximation. And it remains an approximation in large part because non-linear factors like human psychology impinge upon it. A mathematical structure depends, in the end, on unpredictable human things like sentiment and intuition. The scientific precision of economics is an illusion. This is why I strongly prefer the term “political economy.” As John Medaille notes in his excellent book Toward a Truly Free Market, the decision to drop the modifier (for “political economy” is in fact the oldest term) was a deliberate one designed to emulate hard science precision and thus gain its prestige. An ancillary design was to abstract out the persistent philosophical questions of distribution, justice, fairness, etc. If economics could become a hard science, with all the clinical objectivity of physics or chemistry, why, then we could have done with all this messy business human motives and human ends and human duties. We could talk merely about the world as it is and leave to the philosophers those thorny and interminable disputes about the way it ought to be.
So the “old verities” of economics are not verities at all but rather approximations. Politics and philosophy cannot be abstracted from the student of economics. Government bonds are not always risk-free. Easy money does not always produce inflation. Human psychology intrudes in disruptive ways. We have all witnessed in recent years the consequences of overestimating the exactitude of our economic science.