03.11.2013 1

The unsinkable Paul Krugman

Paul KrugmanBy Bill Wilson We are all Krugmanistas now.

On the political left and right, there is a perception, succinctly articulated by the New York Times’ Paul Krugman that “[W]e have our own currency” and the government “literally can’t run out of money. After all, it can print the stuff.”

In short, because the Federal Reserve is there to help finance the $16.7 trillion debt, a default “can’t happen”.

A recent paper, “Crunch Time: Fiscal Crises and the Role of Monetary Policy” published by the University of Chicago, Booth School of Business, makes the case that, contrary to conventional wisdom, there is in fact an upper limit to how much money the U.S. can borrow and print to finance its $16.7 trillion national debt before inflation and interest rates crush us into insolvency.

The study examined 20 advanced economies, looking towards interest rates in cases of excessive gross debt and found, “[A] country can quickly move from the group without problems to the group that faces nearly insurmountable problems if its debt rises above 80 percent of GDP, particularly if it is running a large current-account deficit.”

To wit, if the sequestration is cancelled as many on the left and right propose, and unemployment averages 6 percent instead of 5.25 percent as the Congressional Budget Office baseline anticipates, the nation’s debt-to-Gross Domestic Product (GDP) would hit “304 percent of GDP by 2037 and bond yields would skyrocket, eventually getting above 25 percent.”

On Feb. 24, Krugman responded, saying that the “Crunch Time” study actually suggests that countries that can borrow and print in their own currency (i.e. monetize the debt) “have borrowing costs well below what euro-area experience might have suggested.”

The Atlantic’s Matthew O’Brien follows suit, writing “why we’re special”. He explains, “There isn’t any evidence that the U.S., or other countries that borrow in currencies they control, face some debt tipping point after which borrowing costs spiral out of control.”

Pretty clear cut. And, to be fair, the data does show borrowing costs in the UK, the U.S., Canada, and Japan are all much lower than Eurozone countries in the study that cannot borrow and print in their own currency.

The question being posed is if that will always be true. The “Crunch Time” study suggests “[T]he large scale purchases by the Federal Reserve may be one factor that has helped keep interest rates down up to this point.”

And, “Another key reason that U.S. rates have historically been low is that the use of the U.S. dollar as the world’s reserve currency creates a special demand for U.S. Treasury securities.”

Which contradicts Krugman’s complaint of the study (which he may not have fully read) that “they don’t — not at all” address “the own-currency issue”. The study does address it, head on.

In Japan, it suggests that “given Japan’s aging population, its private saving rate is likely to fall significantly over the next decade. Once Japan is forced to sell its debt to international investors and not just domestic institutions, the yield on Japanese debt should start to behave much more like other countries.”

As for the U.S., the paper notes that its approach is actually conservative in predicting an eventual rise in interest rates because its model admittedly “would already be predicting an interest rate for the United States for 2012 that is higher than what we actually observed.”

But that in any event, “In a country like the United States, the debt premium presumably would arise from inflation fears rather than concerns about outright default.” That is because once inflation rises, rates will rise, as they always have historically in the U.S.

To suggest “it can’t happen here,” Krugman, et. al have to adopt the position that interest rates will never rise.

Not in the face of even high inflation. Or if they would, then because there will somehow never be inflation again. He must also maintain that our overseas creditors like China and Saudi Arabia will never, ever dump the dollar no matter how irresponsible we are.

Finally, Krugman must believe there is no limit to how much money we can print to monetize the debt.

A rather bold proclamation. It ignores that monetizing the debt represents a misallocation of credit that inherently leads to a mispricing of risk, just as it did in the housing market in the 1990s and 2000s. It creates bubbles. Which, there is not an asset bubble in economic history that did not eventually pop. We argue the treasuries market will be no different.

But let’s play along with Krugman and everyone else who believe “we’re special”.

If there is no limit to how much we can borrow and print for our debt, why should the American people pay any taxes at all? If we can never default, and the rest of the world will happily import all of inflation for posterity without consequence, then there should be no taxes.

There probably should not be any budget limits either. Instead of spending $3.5 trillion a year, we could probably up that to $10 trillion a year, and then incrementally rise at, say, 10 percent a year. Congress could just erect a wishing wall in the nation’s capital, where citizens can post their favored wishes to be fulfilled by Uncle Sam.

At the end of every day, the politicians and central bank will take the wishes off the wall and the next day produce the necessary legislation and money to fulfill them. We’ll call it Krugman’s Wishing Wall.

Why not? What’s to stop us if Krugman is right? If we simply have the courage of his convictions, then it won’t matter. Because, in Krugman’s words, “we have our own currency” and the government “literally can’t run out of money. After all, it can print the stuff.”

Let’s go for it!

Unlike the Titanic that was unfortunately dubbed to be “unsinkable” prior to crashing into the iceberg, with Krugman at the helm of the Ship of State, we’ll know everything we need to avoid obstacles and wind up sinking into the Abyss. What could possibly go wrong?

After all, “we’re special.”

Bill Wilson is the President of Americans for Limited Government. You can follow Bill on Twitter at @BillWilsonALG.

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