Krugman Ignores His Own Theory and Misses An Important Piece of European History

This whole “what danger is there for a country issuing its own currency?” argument is really slippery. First of all, what these people really mean is, “What danger is there for a country issuing its own currency and in which most of its debts are denominated in this currency?” I.e., even on their own terms, it’s not enough for a country to issue its own currency. I believe this extra hoop is how they rule out things like Russia defaulting on its bonds and causing a bit of a ruckus, as you may recall.

When you think about it, there are only a handful of countries for which this concept even applies, and even then it only really works from 1971 onward. But anyway, let’s put aside that objection and consider Krugman’s latest:

What [a critic of the fiscal scaremongers] doesn’t note, however, is that the problem with bond vigilante scare tactics runs even deeper than that — because it’s actually quite hard to tell a story in which a loss of confidence in U.S. bonds hurts the real economy. Why wouldn’t it just drive down the dollar, and thereby have an expansionaryeffect?

Yes, I know, Greece — but Greece doesn’t have its own currency. What’s the model under which a country that does have its own currency and borrows in that currency can experience a slump due to an attack by bond vigilantes? Or failing that, where are the historical examples?

This is really amazing. Krugman is acting like it’s not even theoretically possible to imagine this kind of thing. But sure it is. Here’s a theory of it:

So suppose that we eventually go back to a situation in which interest rates are positive….with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.

So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So? …

Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation…

At this point I have to say that I DON’T EXPECT THIS TO HAPPEN — America is a very long way from losing access to bond markets, and in any case we’re still in liquidity trap territory and likely to stay there for a while. But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.

So there you have Paul Krugman himself, explaining how a bond strike on Treasuries would either force the government to balance its budget, or risk hyperinflation itself. If Krugman is now admitting that he can’t even come up for a theoretical basis for his objections to the MMT guys (that was the context of the above quotation), then he should send an apology to James Galbraith.

But let’s go back to Krugman’s recent post. It gets better:

The closest I can come to anything resembling the danger supposedly lurking for America is the tale of France in the 1920s, which emerged from World War I burdened by large debt, and which did in fact face an attack by speculators as a result. Yet the French story does not, if you look at it closely, offer any support to the deficit scare talk we keep hearing.

So Krugman walks through, and shows how France followed Krugmanian advice and let the franc depreciate, inflating away the real value of its post-war debt. Krugman claims that everything was great, and points to a table showing French unemployment. Only thing is, in 1927 it jumps up to 11 percent. Yikes! That’s pretty bad. So does it prove that running up a humongous debt can lead to bad consequences? Of course not! Krugman explains:

But what about the brief but nasty slump in 1927? That wasn’t caused by spiking interest rates; it was, instead, caused by fiscal austerity, by the measures taken to stabilize the franc.

So even when we look at the closest thing I can find to the scenario the deficit scolds want us to fear, it doesn’t play out at all as described.

Everyone see what’s going on here? Krugman points to France as the only example of a bond vigilante attack he can think of, on a nation issuing its own currency. (I guess he’s not counting the gold standard as being binding here; I’m not sure when France went back on. Remember in those 1930s charts of industrial output that the Keynesians like to point to the idiot French as hurting their economy by clinging to gold far longer than other countries.)

So here’s the progression:

(1) The French emerge from World War I with a debt of about 240% of GDP. (That was its value in 1921, which was a big jump from 1920. I’m not sure what was going on there.) Of course the reason the French government has such a massive debt, is that it ran massive budget deficits during the war years (and went off gold).

(2) What did the French do in the early and mid-1920s to deal with the problem? Did they run massive budget surpluses? Nope, Krugman himself says, “How did France achieve that big drop in debt after 1925? Basically by inflating it away.”

(3) Krugman admits that the bond vigilantes saw this depreciation coming, and so interest rates spiked.

(4) The French authorities eventually reversed course to stop the plunge of the franc. Krugman acknowledges that this led to 11% unemployment in 1927.

(5) Krugman says this pain was avoidable, because the French authorities shouldn’t have tightened in 1927.

So, it seems to me we need to think of an historical example of a country that did just what Krugman suggests, in order to test out his recommendations. So let’s see: Can anybody think of a major industrial power that emerged from World War I with a huge debt, but that issued its own national currency the way the French issue francs, and that turned to the printing press but without looking back? In other words, can anybody think of a European power that followed the French pattern, except stuck to Krugman’s advice by continually depreciating rather than a foolish move to stabilize its currency?

(Don’t worry Keynesians, there’s no danger here. Even when an Austrian in the crowd thinks of the answer, Krugman will just point out, “Ah, but they ate a lot of sauerkraut. Hardly relevant for the US today.”)

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