Readers of SwiftEconomics know I’ve been just an incy wincy bit critical of Paul Krugman (see here, here, here and here), but I guess I kind of agree with a column he wrote last month… at least part of it:
“So what will happen? In the end, I’d argue, what must happen is an effective default on a significant part of debt, one way or another. The default could be implicit, via a period of moderate inflation that reduces the real burden of debt; that’s how World War II cured the depression. Or, if not, we could see a gradual, painful process of individual defaults and bankruptcies, which ends up reducing overall debt.”
Well I agree we’re almost certainly going to need to default in one way or the other. However, I thought that according to Krugman, World War II cured the Depression by increasing aggregate demand, not by reducing our debt burdens through inflation. Regardless, it’s an interesting admission that Krugman makes, especially as he pushes for stimulus package after stimulus package. He said the initial $787 billion stimulus package “falls well short of what’s needed.” I guess if you’re gonna default anyway you might as well live it up.
Furthermore, he continues to argue against any form of austerity to return to fiscal sanity both on the part of the private and public sector:
“A naive view says that what we need is a return to virtue: everyone needs to save more, pay down debt, and restore healthy balance sheets. The problem with this view is the fallacy of composition: when everyone tries to pay down debt at the same time, the result is a depressed economy and falling inflation, which cause the ratio of debt to income to rise if anything. That is, we’re living in a world in which the twin paradoxes of thrift and deleveraging hold, and hence in which individual virtue ends up being collective vice.”
So paying down our debts is bad, because if we all do that together deflation happens and the economy falls into a depression. That’s what happened in 1920 when the United States fell into a deep recession and cut spending… oh wait, that recession ended in record speed.
Deflation, in fact, does not result in a depression and is not even correlated with depressions. According to a study by Andrew Atkeson and Patrick Kehoe that studied 17 countries over 100 years, 65 out of 73 episodes of deflation had no depression and 21 of the 29 depressions had no deflation. The evidence shows that pre-World War II there is a small correlation between deflation and depression (slope coefficient of 0.11), but there is actually a negative correlation post-World War II (slope coefficient of -.03). Which would mean inflation has an ever so slightly higher chance of leading to a depression than deflation.
Furthermore, all of that can be misleading because an economy suffering runaway inflation is not necessarily in a recession, but instead has to go through a recession by significantly reducing the monetary supply to get inflation under control. This is what happened in the early 80’s when Paul Volker hiked up interest rates. He stopped inflation, but the United States suffered a severe recession as a result.
So deflation may not be bad, but spending boosts aggregate demand, so Paul Krugman would have us spend more. Unfortunately we have no savings, so we’d have to borrow or inflate. We’ve already talked about inflating, so what if the government borrows the money. Well Paul Krugman is all about that, too. As he wrote, an “obsession [opposed to] deficit spending could cause depression.” Unfortunately, the data shows too much deficit spending will simply make things worse. A study by Carmen Reinhart and Kenneth Rogolf concluded the obvious; too much debt is bad:
“Our analysis is based on new data on forty-four countries spanning about two hundred years. The dataset incorporates over 3,700 annual observations covering a wide range of political systems, institutions, exchange rate arrangements, and historic circumstances. Our main findings are: First, the relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of GDP. Above 90 percent, median growth rates fall by one percent, and average growth falls considerably more. We find that the threshold for public debt is similar in advanced and emerging economies.”
Paul Krugman didn’t agree with that study (as you can see here and his logic refuted by Robert Murphy here) and instead believes the United States should spend its way to prosperity. But let’s stop and put the pieces together to see what Paul Krugman is actually proposing we do here:
Step 1. Spend a ton of money we don’t have
Step 2. Finance step 1 by piling up a ton of debt
Step 3. Inflate away so we can pay back that debt in a significantly depreciated currency
Just like one of those schemes where an individual summarily racks up a bunch of credit card debt only to declare bankruptcy, Krugman is literally recommending we rob our creditors. If the United States defaults because of a series of fiscal errors, that would be akin to a homeowner being foreclosed on because they could no longer make their payments. But to intentionally run up a debt that we have no intention of paying is a scam. And of course, such a scheme would have savers and those on fixed incomes see their savings and living standards evaporate.
Given that Krugman is simply recommending we steal from other people, there may in fact be some stimulus there. But it’s not a model the whole world can use and it’s not something we can get away with very long before people figure out what we’re up to. Indeed, it’s a good thing for Krugman that to him “individual virtue ends up being collective vice.” Because if it wasn’t, individual virtues (like not stealing) would be completely unacceptable at the government level. And yes, let’s hope China and every other nation, company and individual who is considering buying American debt isn’t reading Krugman’s recommendations too carefully. They may just stop financing our fiscal binges.