Krugman's Wrong: U.S. Credit Problems Aren't Similar to Ireland's

Up until now, Paul Krugman’s writings on the current economic crisis have always made sense to me. Not that I always agreed with him, but I understood the logic of what he was saying.

He has suddenly lost me. In a New York Times op-ed column on Sunday, he argues that, in a worst-case scenario, the US could become like Ireland: unable to stimulate its economy out of recession/depression because fiscal policy is constrained by the need to satisfy the government’s creditors. I understand why this is happening in Ireland. I don’t understand how it could happen in the US.

There are a couple of huge differences between the US and Ireland, macroeconomically speaking – differences which, to my mind, render the two nations not even remotely comparable, even under an extreme hypothetical scenario. First, the US is much larger than Ireland, a much larger part of the world economy and much more self-sufficient. Second, the US has its own currency, in which its debts are denominated. Paul Krugman, as much as anyone (if not more), must be aware of the implications of these differences; yet he writes as if they could be ignored.

If our debt-to-GDP ratio rises too high, Prof. Krugman suggests, “we might start facing our own problems with the bond market.” But what problems is he talking about? We surely won’t face the same problem that Ireland faces: namely, that, in order to get enough euros to run our government, we would have to offer high interest rates and engage in austere fiscal policies. We won’t have that problem because we don’t need any euros to run our government and never will. If international lenders lose confidence in the US, the result will be a decline in the value of the dollar, not (unless the Fed and the Treasury allow it to happen) an increase in the interest rate that the Treasury must pay.

We might worry about the declining value of the dollar if there were a problem with inflation in the US. But there’s not, and, as I argue in an earlier post, there isn’t likely to be any time soon. As it is, a decline in the value of the dollar would do for the US exactly what Ireland is unable to do for itself with fiscal policy: it would stimulate the economy and get us out of the recession.

Professor Krugman may disagree with the arguments I made in the earlier post, and he may think that inflationary recession could be a problem for the US. But in that hypothetical event, we’d be dealing with a very different problem than what Ireland is experiencing right now.

The closest analogy I can see would be between leaving the euro (in the case of Ireland) and inflating the dollar (in the case of the US). But the analogy isn’t a close one at all, since the former decision is discrete and nobody thinks it’s going to happen, whereas the latter is a continuum and there are varying opinions on the degree to which it might happen. And if this analogy is what Prof. Krugman has in mind, it seems to me that it is incumbent on him to make it explicit, since it’s hardly something that would be obvious to most readers.

I can imagine a worst-case scenario, one where all the arguments I made in my earlier post turn out to be wrong and the Fed ends up having to choose between serious inflation and serious depression, but that scenario doesn't remind me of what is happening in Ireland.

It’s also worth noting that a lot more has to go wrong in the US, as compared to Ireland, before the US gets to that worst case scenario. In the case of Ireland, it was the collapse of the banking system and the government’s lack of resources in reacting to that collapse (an outcome that Prof. Krugman fears for the US, should current policies prove ineffective). In the US that would just be the beginning. Before we reach the worst case scenario, (1) the rest of the world would have to decide that their sovereign investments are more important than their economic recoveries, so that they would refuse to support a collapsing dollar and instead accept a deterioration of trade with the US; (2) foreign producers would have to pass on most of their increased costs to the US (in contrast to what they did, for example, in the late 1980’s); (3) Americans, despite their newfound thrift, would have to accept most of those increased prices rather than substituting cheaper domestic goods; and (4) US producers would have to raise prices rapidly in spite of weak economic conditions, and keep raising prices despite weakening economic conditions. It’s not impossible, but personally it’s not something I spend much time worrying about.

Disclosure: Through my investment and management role in a Treasury directional pooled investment vehicle and through my role as Chief Economist at Atlantic Asset Management, which generally manages fixed income portfolios for its clients, I have direct or indirect interests in various fixed income instruments, which may be impacted by the issues discussed herein. The views expressed herein are entirely my own opinions and may not represent the views of Atlantic Asset Management.

Comments

[Repsonsible...:]

You Miss the point Americans are deep in debt , many have had there credit lines cut down or shut off . Most unemployed Americans have NO jobs to go back too . Theres apx 150K Young people coming into the job market every month , were do they finfd work ?? There will be NO REAL recovery any time soon , were years away if ever from those Good Green jobs OBAMA keeps refering to. And then there may only be a few hundred thousand created NOT the Millions OBAMA Claims. The Gurus argue about so many abstract things its much more simple America will NEVER return to the Glory Days of the 90s its time to face reality , but like the Millions of Americans who still havent opened there 401k statements in a year , Our leaders are Terrified to Tell Americans the truth , which is were a Bankrupt Nation that owes Trillions to other countries and Trillions More to Our retirees in Medicade and SS which we will NEVER Pay On . The future is bleak but then again we're ALL Dead in The End anyway .

Apr 21 12:10 PM

[hanumanhojo:]

Uhh...knock...knock...

A decline in the value of the dollar will result in higher cost for oil. Considering out society is very oil dependent and oil producers will not want to be paid in funny money....oil prices will rise to a point where is kills the economy, be it in recovery or continuing depression.

Your arguement would make sense if our economy was self contained but it is not.

Apr 21 12:24 PM

[conceptwizard:]

Kansas City Fed President and veteran Fed official Thomas Hoenig said:


Too big has failed....
The sequence of [the government's] actions, unfortunately, has added to market uncertainty. Investors are understandably watching to see which institutions will receive public money and survive as wards of the state....


The U.S. Treasury has failed to take “decisive” action to address the bank crisis, pursuing an ad-hoc approach that leaves management in place and avoids necessary asset writedowns....

Any financial crisis leaves a stream of losses among the various participants, and these losses must ultimately be borne by someone. To start the resolution process, management responsible for the problems must be replaced and the losses identified and taken. Until these actions are taken, there is little chance to restore market confidence and get credit markets flowing. It is not a question of avoiding these losses, but one of how soon we will take them and get on to the process of recovery....

I think you will find that there are similarities within all depressed countries right now. Debt, jobless, housing defaults, tight credit, commercial lending issues, commercial real estate issues. The US has the world currency which is the only thing saving the ship.

Apr 21 02:38 PM

[Socialism c...:]

Krugman is right. Read an article somewhere earlier today about how our foreign creditors are selling out of their Treasuries, as witnessed by our increasingly negative balance, with the Fed picking up the slack. We are running out of lenders. It's all quantitative from here out. Prepare for hyperinflation.

Apr 21 02:56 PM

[Andy Harless:]

Just for the record, I didn't come up with the title for this article ;)

Apr 21 03:45 PM

[Andy Harless:]

hanumanhojo, It's not a matter of black and white, self-contained or not self-contained. There are degrees of self-sufficiency. The US is not entirely self-sufficient, but imports are only about 15% of GDP, so even if import prices rise dramatically, it would not have a huge impact on the domestic inflation rate. (See my earlier post to which I linked.) And the dollar is never going to become "funny money" as long as the prices of our domestic product are kept under control. (My expectation is that the weak economy will keep them under control for quite a while.)

Moreover, as long as it's physically possible for them to produce oil at a rate that will satisfy the demand, it won't be in the interests of oil producers to charge prices high enough to kill the US economy. (I think the 2008 experience will be pretty fresh in their minds.) We may (though, given the weak world economy, I doubt it will happen soon) get to a point where oil production capacity is strained, but that is a completely different problem than what Ireland is facing today, and it's not just a US problem.

Apr 21 04:16 PM

[Jasper M:]

I can't see how the threat of a debased currency would not drive up the interest rate creditors would demand to be repaid in that currency.
And no, not a fan of Krugman's ideology, though his predictions seem on target to me.

Apr 21 05:49 PM

[Robert Browne:]

There are similarities and very great similarities with Ireland. You are correct in stating that America has its own currency and a very well oiled printing press. As evidenced by the latest trillion dollar print run. However, like Ireland there are "Real" not just imaginary limits to Americas debt financing. The US can print a trillion or more fiat money to purchase its own debts and government backed securities/bonds. However, at what point does the US cease to have any credibility in having control over its financial affairs? This is where there is a very great similarity with Ireland. Ireland is a republic with a population of just over 4 million people. The Irish banks have wracked up losses (toxic asset) that are roughly equal to two times the current annual total of all tax receipts coming into our exchequer. Our government now wants to take this toxic mess off the banks balance sheets by paying approximately 65 billion Euro for it to deposit in a state bad bank or skip called NAMA. The state has further guaranteed out bank depositors to the tune of 400bn Euro and has recently had to dip into a state pension reserve funds to provide a stimulus of 3.5 billion Euro to each of our two main banks AIB (Allied Irish Bank) and BOI (Bank of Ireland). All this debt is washing over the Irish tax payer and putting them into debt slavery! Just as the US economy is in debt bondage! In 2006, the US economy reached a milestone in borrowing because in that year the marginal productivity of its debt went into negative territory for the first time ever. This presaged and heralded the current mess. In other words, for every dollar borrowed the dollar return is in the minus territory. Why does a country borrow money, surely it is to increase, not decrease GDP as a result of such borrowing? This is no longer the case with America and it is no longer the case with Ireland! Both countries have lived off of their capital bases, created huge bubbles and increased their standard of living by borrowing from countries more frugal than themselves! The day these debtor nations, such as China or Saudi Arabia, say "sorry" but we actually need our money for our own citizens to improve or maintain their standard of living is the death knell of both economies. Obviously America has a bigger problem because of its size but nonetheless it will be very bad news for Joe Six Pack and Paddy. Ireland and America must repent and reform and put the needs of their respective populations before the God of endless credit fixing scams. Mr. Obama promised the American people "Yes we can" so far, with Mr. Geitner the answer has been "no we can't".

Apr 21 07:04 PM

[Andy Harless:]

Jasper, the threat of a depreciating currency would certainly drive up the interest rate demanded by private sector creditors. But under a floating exchange rate system, there's no such thing as the threat of a depreciating currency, because the depreciation will happen as soon as people expect it to happen. It never has a chance to become a threat.

In this case, though, I don't think the behavior of private sector creditors even matters, because the creditors will mostly be sovereigns who have other objectives besides maximizing their investment returns.

Apr 21 08:54 PM

[TWOfold:]

Krugman will say *anything*, especially if untrue, to further his ideological goals (e.g. nationalizing all banks).

Apr 22 09:26 AM

[Ferdinand E...:]

Ireland...Ireland you say. I thought to begin with that it was Iceland where, you remember, people in designer clothes threw garbage at some big shots.

But in reality it was Ireland. According to Krugman, the problems of the US and Ireland are similar. PREPOSTEROUS!

Apr 22 10:00 AM

[wg:]

rule no. 1: krugman is ALWAYS wrong.

Apr 22 10:18 AM

[bob adamson:]

I agree with your position here, Andy, but I think the difference between you and the Paul Krugman column is essentially one of timing and degree. By this I mean that because the US is a very big rich economy and its currency is the world’s reserve currency it will be cut a lot of slack by both its domestic and international creditors as you stress. This, together with the fact that Ireland does not have its own unique currency, means that the tipping point into true grief for the US is much more as you envision it than does the column by Krugman.

However, the US dollar being the world’s reserve currency would, arguably, have its downside if the international community became alarmed that the US dollar was or might depreciate rapidly. Unlike, say, the Canadian or Australian dollars, a large portion of US legal tender is held abroad and used internationally within global companies and for other international transactions unrelated to US domestic or international activities. Further, large volumes of US government and commercial debt denominated in US dollars are held abroad as we all know. The point here is that these reserve currency uses act as a sponge for US currency and currency denoted instruments AS LONG AS THE INTERNATIONAL MARKETS RETAIN SUFFICIENT CONFIDENCE to retain these holdings (and they will be very patient in this regard, which is your point in your differences today with the Paul Krugman column). Conversely, however, if that confidence were ever lost, a deluge of US dollars and US dollar denominated debt SURPLUS TO US DOMESTIC NEED might begin to be dumped in great volume back into the US. Obviously we are far from this contingency but its recognition completes the picture of what having the world’s reserve currency as your domestic currency means for the US.

Nov 21 12:19 AM