Krugman Surprises

by: Cynicus Economicus

Well, the arch stimulator, the deficit spender in chief, has accepted that there is a limit to government deficits and money printing. This is from Krugman:

So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.

Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on my blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:

Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.

I highlight this from Krugman , as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.

The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.

Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):

It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.

In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.

Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'

Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.

To put this into context, China is once again pulling back on investments in treasuries::

China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:

The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.

The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.

These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.

In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.

For the moment, let's play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.

As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.

All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.

Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.

The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.

Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.

Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?

Note 1:

I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.

I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.

However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the I think I do now have a rough handle on the Japanese economy.

(1) HSBC Global Research, July 2010, Currency Outlook.