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.”)


==> Nick Rowe agrees with me that Steve Landsburg’s analysis of paying down government debt is only true if we assume perfect certainty. (Steve I think would totally agree, and that’s why I said in my original post that this was an argument over specifying assumptions for the reader, not about the implications of those assumptions.) Incidentally, if you have never seen Rowe in action, just skim the comments section, only reading his posts. You literally could learn a lot of economics just reading him patiently arguing with people. (In contrast, I am so sarcastic in my comments section that even my allies aren’t quite sure what my point is.) The other good thing about Nick is, he’s pretty humble. So you walk away thinking, “It’s not that this Canadian guy is all that smart, it’s just he’s been studying this stuff longer than I’ve been alive.”

==> Speaking of debt, I’m pleased to announce that for once, I agree with Daniel Kuehn on the government debt stuff! I don’t think Arnold Kling’s response to Krugman’s “we owe it to ourselves” position really got at the fundamental problem. To be clear, it’s not that Kling said anything wrong, and in fact he is highlighting one of the serious, real-world problems with deficit finance. But Krugman really did handle this type of thing by admitting upfront that government debt could have distributional implications for future generations. The stuff Kling is talking about doesn’t really show that Krugman is just flat out wrong for focusing on “we owe it to ourselves,” the way Buchanan/Boudreaux/Rowe did.

==> Poor Ron Paul gets ambushed at 13:30 by this host asking about the Murphy-Krugman Debate.

==> It’s kind of interesting: Someone in the comments of my post about Keynesians and consumption pointed to this Krugman article, where he definitely talks about the limitations of the “paradox of thrift” etc. But if I wanted to be a jerk, I would say, “So you prove to me that Keynesians don’t focus much on consumption, by pointing to Paul Krugman chiding Keynesians for focusing too much on consumption?” Anyway in the interest of holiday charity let me say that actual Keynesian economists are not quite the mindless champions of “consume consume consume!” that their critics sometimes attack, but there is no doubt that the caricature is based on a germ of truth: Even Krugman admits as much in the opening paragraphs of that linked article. So it’s not this right-wing myth the way Gene Callahan and Daniel Kuehn are suggesting.

Steve Landsburg Thinks the Current Debt Level Is Juuuuust Right

Steve Landsburg and I can have a perfectly civil discussion on theology. He agrees not to mock me (to my face) for thinking a guy can walk on water, and I don’t make fun of him for worshipping irrational numbers. But when it comes to government debt, I think Steve and I might just have to agree never to talk about the subject. Today he writes:

How high should taxes be? High enough to cover expected outlays going forward — but no higher.

That’s because any additional revenue would be used to pay down the federal debt, which is a bad idea. It was almost surely a mistake to run up this much debt in the first place, but now that we’ve got it, the best thing to do is to keep it forever.

Here’s why:

Every $100 in outstanding debt commits the government to making payments with a present value of $100, and hence to collecting tax revenues with a present value of $100. In a world where the interest rate is 3%, the options include collecting (and paying off) $100 immediately, or $50 this year and $51.50 next year, or $11.38 a year for ten years running, or $3 a year forever. Because deadweight loss (i.e. the economic damage due to the disincentive effects of taxes) is roughly proportional to the square of the tax rate, it turns out that the latter — the policy of paying interest forever without ever making a principal payment — is (at least roughly) the policy that minimizes the present value of deadweight loss.

In other words, as far as the existing debt goes, we’re hosed no matter what we do — it’s painful to pay it off, and painful to keep paying interest forever. But at least if we pay interest forever, we’re minimizing the deadweight losses associated with raising taxes.

As usual with Steve, I think he is probably correct as far as the strict mathematics of the argument. However, I have the opposite intuition. Now the ground rules of this game (even though Steve didn’t say so) are presumably that we rule out government default on its debt as cheating, and we don’t worry about the ethics of taxation per se. In that framework, I would certainly recommend that the US government start paying down its debt, both in terms of outstanding Treasury securities but also in terms of paying people lump sums to renounce their future Social Security and Medicare claims.

Now the tricky thing is, I suspect if we spelled out our assumptions a little more, Steve and I would end up agreeing. I could even imagine after 5 emails, Steve saying, “Yeah, we’re basically saying the same thing.” And yet, it sure doesn’t seem like that, does it?

To see what I mean–that I think Steve and I are actually closer than it first appears–consider that of course I would NOT [added!–RPM] recommend raising taxes, to start paying down the debt. Rather, I would recommend slashing spending tremendously. Then the other subtlety is that you would want to allow for emergency situations where deficits occurred temporarily in the future. So by paying the debt down today (and as a general rule), you were actually just giving yourself breathing room so that the debt down the road didn’t end up higher than where you’re starting today.

In other words, Steve is saying that if the debt is 85% of GDP today, then in a century he wants it to still be 85% of GDP. (For sure that’s what he’s saying if GDP is constant; in the comments of his post it wasn’t clear if he actually wants to maintain constant dollar amount of debt, or constant debt/GDP ratio.)

Suppose I too want the debt/GDP ratio to be the same in 100 years. But, I predict that there will be periods between now and then when the deficits will be so large that the debt/GDP ratio will grow during those years. In order then to reach my target, there must be periods when debt/GDP shrinks. And unless I happen to think the present is a time that requires growing debt/GDP, why wouldn’t I start paying it down right now?

(This is a little awkward because presumably right now–coming out of the financial crisis–is an “emergency” time when tax revenues are depressed and you could expect the government to run a budget deficit. But, that’s not really important for Steve’s argument. He would have written the same post in 1984 I believe.)

Anyway, the above is just to get your wheels turning. The real problem with Steve’s analysis–by which I mean, the assumption that makes his conclusion right, but which is a bad assumption to make–is this:

Note: The above assumes that spending policies and tax policies can be set separately (subject to the constraint that tax revenues are at least high enough to cover interest payments). Things of course get more complicated if you believe that debt levels and/or tax rates constrain future spending through some political mechanism. I’ve often heard this alleged, but I’m unaware of any strong evidence for this assertion.

How about this Steve?

(The footage is from a riot in Greece earlier this month.)

Thomas Jefferson – Still Offering his Wisdom Years Later….

I ran across a great quote from Thomas Jefferson and I wanted to post it so I didn’t forget it. Each day, I want to ask myself the question: what am I doing to stop this imminent “..wretchedness and oppression…” that will come from our public debt problem? And I urge you to do the same. What what will you do to help save our country from economic ruin?

“We must not let our rulers load us with perpetual debt. We must make our election between economy and liberty or profusion and servitude. If we run into such debt, as that we must be taxed in our meat and in our drink, in our necessaries and our comforts, in our labors and our amusements, for our calling and our creeds…[we will] have no time to think, no means of calling our miss-managers to account but be glad to obtain subsistence by hiring ourselves to rivet their chains on the necks of our fellow-sufferers. …And this is the tendency of all human governments. A departure from principle in one instance becomes a precedent for[ another] …till the bulk of society is reduced to be mere automatons of misery… And the fore-horse of this frightful team is public debt. Taxation follows that, and in its train wretchedness and oppression.”

— Thomas Jefferson

Financial Insanity…

Below is one disturbing graph…it shows total federal debt per household, including “off-budget” liabilities, little items such as medicare and social security…

us-household-share-of-debt(link here for the full USA Today article)

As the USA Today article notes, the monstrous number for Social Security, Medicare and pensions, are a projection of the “gap” between what’s currently collected for the programs and what’s needed to fund future liabilities.  The “official” US debt is $11,374,265,930,605.76 as of June 3, 2009, or about $38,000 per person.

…and, are our civil servants in Washington working feverishly to bring sanity to the situation?   To the contrary, the numbers indicate Congress and the Obama administration are apparently of the “spend like a drunken sailor” school of economics.  The federal government projects it will spend another $3.9 trillion this fiscal year, and will be borrowing $2.5 trillion, to make ends meet (from the US Treasury Monthly Treasury Statement for April 2009)

Our debt is approaching 100% of GDP (the total US estimated GDP for 2008 was about $14 trillion) and our leadership’s intentions are to continue to increase social spending, develop a new layer of government intervention and cost with “cap and trade” nonsense, and fund Wall Street/Big Bank losses.  For them, the “solutions” include:

– “soak the rich” for more taxes (even though the top 10% already pay over 70% of income tax collections, bottom 50% represented less than 3% of tax collections, per

– Value-added taxes.  Yes the VAT is being explored, which will add to the cost of virtually everything, as reported by the Washington Post.

How have we gotten here?  Let’s consider what we’ve done — 76% of our representatives and 84% of our senators are lawyers and politicians/public service employees, (plus one “community activist” President).  On average, we leave them in place for over a decade!  (11 years for representatives, 12.9 years for senators, from Profile of 111th Congress.)

“Out of touch” is perhaps too kind a term — our representation needs a dramatic overhaul, and we need to wake up to the fact that pretty speech makers appparently don’t know “poop” about fiscal sanity!

…off the topic, if you have 4 minutes you’ll enjoy this video created by an Alabama teen for his Mom’s Tea Party. It sends a powerful message, about the real power of the “silent majority.”

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