Krugman and the Pied Pipers of Debt

Investors are celebrating an incipient “recovery,” but the interventions that were responsible for it are sowing the seeds of a more violent contraction down the road. The problem, quite simply, is debt. We’ve accumulated record amounts, yet many economists tell us we need more.

Leading the charge is Paul Krugman. He exhorts us to borrow our way back to prosperity, but he doesn’t acknowledge that his brand of Keynesian economics ignores the consequences of debt. If you look at a chart of America’s total debt burden, he’s leading us over a cliff.

(Click chart to enlarge in new window)

The problem begins with the flawed way Krugman and other economists measure well-being. Primarily, they look at measures of activity, like GDP. These tell us how much people spend, but say nothing about where we get the money.

Every so often, we overextend ourselves, buying too much useless stuff with too much borrowed money. So we cut back, dumping the third family car and swapping the McMansion for a townhome.

But this is problematic for Krugman and other economists. Less spending means falling GDP. It means “recession.”

They ride to the rescue with two blunt instruments — monetary and fiscal policy — that encourage more borrowing and thus more spending. More spending equals “growth” so economists congratulate themselves for engineering “recovery.”

But if recessions never happen, bad businesses and unpayable debts are never washed away. They grow like cancer inside the system.

Since the mid-1980s, we’ve intervened whenever the economy hiccuped, so sectors that should have shrunk sharply — like housing and finance — never did. Feasting on easy credit, these sectors have exploded as a percentage of the economy.

Now, since individuals and corporations refuse to borrow more, the only way to grow spending is for the government to borrow.

According to George Cooper, author of The Origin of Financial Crises, “what is missing from today’s debate is recognition that previous growth rates were artificially supported by an unsustainable credit binge, itself the result of the misapplication of Keynesian policy.”

Cooper counts himself a Keynesian but says Keynesian policy has become “dangerously distorted.”

“We should be using Keynesian stimulus only to arrest the rate of credit contraction not to reverse it. The harsh truth is that our economies desperately need a recession.”

That’s because they desperately need to de-lever. As you can see in the first chart, debt relative to GDP is at record highs.

If we want sustainable growth, spending that drives it must come from savings, not more borrowing. To get there, we must first pay old debts. And that means recession.

Krugman is clearly aware of the consequences of excessive borrowing.

“I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits,” he wrote in 2003, citing a $1.8 trillion 10-year deficit projection from the Congressional Budget Office.

Fast forward six years, total debt has jumped 70 percent relative to GDP and optimistic projections put the 10-year deficit at $9 trillion.

This time, however, Krugman dismisses deficit “hysteria,” arguing that we can grow our way out of debt. “We did it during the Clinton administration,” he told me when he visited Reuters last week.

But we didn’t. While Clinton balanced the federal budget, Americans plowed through their savings. We kept growing because, in the aggregate, we were still accumulating debt.

(Click chart to enlarge in new window)

Krugman has also argued that we can handle larger deficits because we have in the past. After all, public debt peaked at 118 percent in 1945 compared with 65 percent today.

Two problems. First, the argument ignores tens of trillions of unfunded obligations for Medicare and Social Security, debt Krugman loudly lamented in his 2003 column.

It also ignores the higher private debt burden facing us today. According to economist Steve Keen, “Private sector debt accumulated in the 1920s was wiped out by the Depression, so in 1945 the private sector’s debt burden was only 45 percent of GDP. In that situation it was easy to wind down public debt from levels reached to finance WWII.”

Today, private debt is a suffocating 300 percent of GDP, making more public debt that much harder to pay down.

We know how this movie ends. Look at California — or Argentina.

We chortle from afar — “how did their budget get so out of whack?” — yet our own profligacy puts us squarely on that path. Like them, we’ve shown no political will to deal with debt. And so it will deal with us.

But we can print our own currency, you say. If all else fails, the United States can inflate its way out of debt.

Nonsense. If we try, our foreign lenders will cut us off.

As Krugman warned in 2003: “My prediction is that politicians will eventually be tempted to resolve the (fiscal) crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.”

Yet today Krugman is leading the march, arguing that we can borrow indefinitely as long as deflation remains a threat.

Tell that to the Chinese.

What happens when they stop buying our bonds? To Cooper’s point, we’ll need government intervention to cushion the blow of de-leveraging. But there’s a difference between cushioning the blow and reinflating the bubble, which is what we’re doing, wasting trillions propping up housing and banking.

The risk is that we’ll have nothing left when we really need it, when the Great Leveraging becomes the Great De-Leveraging.

Comments

[jimboy:]

Rolfe - I'd barely read half of this article before shifting my cursor in the direction of the "Follow" button. It radiates good sense and skewers Krugman using his own words as a bonus. You also correctly cite Argentina - not Japan - as the final destination for all of this. I do the same in my article arguing that US economic decline is starting to look terminal:
hubpages.com/t/c5575
Someone better start paying attention to people like you instead of weasel-mouthed debt sirens like Krugman before it's too late.

Sep 30 06:11 PM

[LilBob:]

One point I'd have liked to see included in this article was that WWII was largely funded by the sale of war bonds. After WWII, we sent a great deal of international aid and grain to Europe and Japan, but many Americans were also able to cash in those bonds they'd bought from Bob Hope, and that contributed to the rapid economic growth that lifted the country out of the postwar recession. Unfortunately this time around that kind of government borrowing wasn't even a real option, as declines in real inflation adjusted wages (and I mean a REAL adjustment, where you factor in the cost of things like health care and a college education) have fallen so low that a "Recession Bonds" or "Bailout Bonds" drive would be largely fruitless. So, instead, we'll be paying back foreign banks, and there will be no post-bailout interest boost.

That being said, the notion that the government may be steering a course toward managed inflation and an intentionally devalued dollar, with an eye toward restoring domestic production and building a more sustainable economy for average working class people-one which also makes existing mortgage and student loan debts relatively more manageable-may sound tempting to some, but it's a very difficult course to manage, and I'm not sure any human being is really capable of managing something as cumbersome as the entire US economy on so difficult a course.

One area where Krugman may be correct is in assuming that inflation of non-oil based products may not be so severe as some fear, at least until employment picks up again and the national unemployment rate falls to the range of 5 to 7 percent, at which point significant tightening of the money supply will be necessary to prevent massive inflation.

Sep 30 07:03 PM

[The Geoffster:]

Great article. Krugman is a partisan political hack. When he was bemoaning American profligacy in 2003, George Bush was President. Now that he has a fellow traveler in office, profligacy is the order of the day. On another note, what happened to all those war protesters?

Sep 30 08:06 PM

[E Nuff Sed:]

While it is true that government debt is increasing rapidly in response to the great recession, private debt is falling even more rapidly. Without government monetary and fiscal support we can fall into a deflationary spiral.

This is the same kind of ignorant rhetoric which turned the a bad recession into the great depression in the 1930's.

Sep 30 09:48 PM

[BullnBear:]

My math skills tell me that if you get 4 economists together you end up with 11 opinions with 15 of those 11 being contradictory or hypothetical based on future results that have yet to materialize with indicators supporting the data.

Great article by the way, thanks for the detail and clarity.

Sep 30 11:59 PM

[bob adamson:]

The responses of ‘LilBob’ and ‘E Nuff Sed’ make important and valid points. It is much too early in the recovery to focus on the government debt issue; important as it will be to curtail the continued growth of such debt at later stages of the recovery once true stability and sustainable growth have returned.

We are faced with a paradox. When the international investment banking crisis came to a head in 2008 and threatened to metastasize in very short order into cascading general financial and deflationary crises the first order of business was to stabilize the banking sector and pump monetary and fiscal stimulus into the economy across the G8 to stabilize the credit system and the economy generally. The paradox is that these vary measures mirror the excesses that generated the US trade deficit, over-emphasis on the consumer sector of the US economy, US government deficits and personal, corporate and government debt accumulation all of which together helped inflate the bubble that set the stage for the aforesaid crisis in the first place. Further, measures to correct the lending practices that fuelled the accumulation of debt and to put a break on shady financial institution practices that generated excessive creation of secularized debt and derivative instruments, a large portion of which having little value, were downplayed in practice by governments so as to not further confuse and destabilize the investment banking sector at the height of the crisis. In short, the first step was not to attack the underlying causes leading to the crisis but rather to stabilize the situation even though this entailed continuing and even increasing for a short term the bad policies and practices to some degree of the recent past.

While paradoxical this was the right thing to do provided it was seen as only the first short stage of a many stage long term process to place the economy on a sounder footing. The only plausible alternative to taking the dramatic stimulus measures over the past year was to allow the economy plunge into a global deflationary depression of unimaginable severity; one that would amongst its other effects have plunger governments into even greater debt than will arise from the stimulus measures.

Oct 01 02:01 AM

[stefalb:]

There is a difference between debt and money creation. More money creation is necessary to support a less disruptive deleveraging. Yes, we created a gigantic mess, there is no easy solution and it will be painful one way or another. The money creating process is the only only sensible solution and we will have to see how it will progress. There is still a high probability of failure since our economic imbalances are so huge. The alternative is more rapid debt defaults and an accelerating deflationary collapse. Those who favor debt defaults should always have in mind that ultimately all losses will collect in the banking system. The banking system is already BANKRUPT. This shifts the losses to the FDIC, which has no reserves left! So we have another shift of the losses to the government/tax payers. Both have no money nor credit left. This leaves only the FED to create the money and here we go again. The more debts default the more money the FED has to create, that's why it makes most sense to back stop defaults as early as possible because it is the cheapest. Now debt levels have to come down somehow because we can not service them any more and only the FED can create the new money. Let's see what future consequences this will have but we are screwed whatever path we choose!!!

Oct 01 08:01 AM

[Gregman2:]

Thanks Rolfe. If we back out household debt (which is in current deleverage mode) the picture looks slightly less grim. However, M3 (velocity of money) is not doing well at all. You advocate probably the Mellon-liquidationist school of thought. I'm still on the fence with respect to the difference between public and private debt. It would seem that the real underlying issue has to do with real productivity--the
U.S. is still too inflated in terms of wages, prices and real estate relative to China.

Oct 01 08:42 PM