Paul Krugman's Call For Re-Thinking The Debt And Deficit Crisis

by: HiddenValueInvestor

In his new column in the New York Times ((NYSE:NYT)) Fighting Fiscal Phantoms, Paul Krugman says on a fundamental level, the debt and deficit fears that are driving the fiscal cliff doesn't make sense. He states:

For we have our own currency - and almost all of our debt, both private and public, is denominated in dollars. So our government, unlike the Greek government, literally can't run out of money. After all, it can print the stuff.

Basically, he argues that since the U.S. federal government can print money any time it needs to, it cannot run out of money to pay creditors. Therefore it cannot go bankrupt. If the U.S. doesn't actually have a debt and deficit problem because of its ability to print money, then it calls for a fundamental re-thinking of how we are approaching our deficit. Krugman starts off by asking that we ignore those crying wolf that the bond market will any day create a spike in interest rates and a plunge in the dollar driven by fears we may turn into the next Greece. But there are other things to re-think that Paul Krugman didn't mention in his column.

It is well known that Standard & Poor's owned by McGraw Hill (MHP) downgraded the U.S. credit rating from AAA to AA+ in August of 2011. The purpose of the downgrade was to lower the credit rating of the U.S. federal government because of an increased likelihood that it will not be able to pay its bills in the future. Now Moody's (NYSE:MCO) has also threatened to lower the credit rating from AAA if the U.S. fails to reach a suitable agreement to lower deficits and avoid the fiscal cliff. But if the U.S. can print money at any time to pay its obligations and it can never go bankrupt, then why does it even have a credit rating? Credit ratings are designed to measure the financial strength of borrowers and their ability to repay their debts. An entity that can print its obligations if need be and that can never be in a position to not repay its debts and go bankrupt by definition has a AAA credit rating. If Paul Krugman is right, then we should ignore the rating agencies as any rating is meaningless when applied to a sovereign entity that can print its obligations. With 10 year Treasury Bonds yielding 1.65% in interest it is obvious the bond market doesn't have fears that over the next ten years the U.S. government will not be able to pay its bills.

Krugman also argues in his article that contrary to popular belief, printing money is not automatically inflationary in a depressed economy. This position makes sense because wages are unlikely to come under pressure to rise until unemployment rates are much lower. This insight from Krugman could alter investors' perception of the value of holding investments in gold and gold stocks. Many investors in gold anticipate high future inflation rates directly related to money printing. If market perceptions were to adopt Krugman's view that the threat of high inflation in unfounded, then holdings in investments like the SPDR Gold Trust (NYSEARCA:GLD) may not be warranted as an inflation hedge.

Krugman in the past has said we didn't have a short-term deficit crisis and we should focus on creating more near-term demand via larger stimulus packages. But he has said we have a long-term deficit problem that needs to be addressed. However, his column today is straight out of Modern Monetary Theory, which calls for as much deficit spending as necessary, for as long as necessary, to provide for strong economic growth. Followers of Modern Monetary Theory believe that since the U.S. federal government can print money and can never go bankrupt, that fiscal policy should be focused only on economic growth and inflation and not on the status of the debt. It remains unclear if Professor Krugman has now partially adopted their viewpoint or fully adopted their viewpoint. Either way, Krugman has called for a fundamental re-thinking of the direction of the fiscal cliff talks and fiscal policy.

The fiscal cliff has kept the markets on edge because investors are concerned that too much deficit cutting too soon will hurt the economy. The White House has released a report showing that if just the Bush tax cuts and the alternative minimum tax cuts are allowed to expire for the middle class, it will cost consumers $200 billion in disposable income. According to the report, just the loss of the middle class tax cuts will lower the GDP in 2013 by 1.4%. The economy was only growing at 2% in the third quarter. When the spending cuts and other tax cuts are added to the equation, estimates are the economy could be impacted by a fiscal drag of close to 4%, sending the economy into a new recession. Without a deal, the expectations are for a sharp correction in the stock market with a massive risk-off trade. What makes Krugman's new pronouncement significant for investors is it makes a fiscal cliff deal more likely, not less. If deficit reduction is not imperative, Democrats have more flexibility to give in on raising tax rates on the wealthy and Republicans have more room to back off on insisting any deal has to be tied to changes in Social Security. If a deal is struck, the stock market should have a relief rally as long as some unknown event doesn't intervene. General retailers like Wal-Mart (NYSE:WMT), Target (NYSE:TGT), and Costco (NASDAQ:COST) would be hit hard if the tax cuts are not extended. Any deal to keep money in the pockets of consumers will be a welcome relief for the stock market and investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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