Paul Krugman had two bizarro blog posts this weekend wherein he had a thought experiment. He took today’s government deficit (something he supports) and extrapolated it indefinitely into the future. Further, he speculated a world, set in 2017, where today’s deficits have resulted in a world with full employment, but where government (because of supposed ideology) still needs to incur a deficit, and -- this is the kicker -- where the country has lost access to the bond market. He concludes that the scenario he described – 6% deficit, all money-financed rather than bond-financed -- will result in 400% hyperinflation a year.
Crucial to understanding where Krugman is in error is knowing why he thinks the U.S. will lose access to bond markets; under what circumstance can it lose it; and why losing access is the logical outcome in that scenario.
Suppose, now, that we were to find ourselves back in that situation with the government still running deficits of more than $1 trillion a year, say around $100 billion a month. And now suppose that for whatever reason, we’re suddenly faced with a strike of bond buyers — nobody is willing to buy U.S. debt except at exorbitant rates.
Here’s his mistake, in a nutshell: Countries that lose access are usually those losing productive capacity, filled with dying industries, its people out of work. Hence, it could not produce the income needed to credibly pay its obligations, or it will simply monetize the debt, inflating away the real value of the bond. It is in this scenario that foreign bond investors will only buy at exorbitant rates, to compensate for the bond’s high credit risk and the calculated depreciation loss due to monetization. Also, in this scenario, where many locals do not have income, they cannot take the place of the disappearing foreign bond investor.
Now if the U.S. ever really gets to a full employment scenario, its locals will have productive income. Some of them will begin to think of the future, and save some of that income. The logical choice would be in the currency that they plan to use in the future. U.S. bonds are the logical choice.
And if there is full employment, we can deduce that the economy is growing; hence there is less risk of the bond payment being monetized and inflated away, or of deflationary measures eroding the productive capacity of the country and its ability to pay. Hence, foreigners will be even more likely to see it as a safe haven to invest in.
So how can we see a scenario in 2017 where the U.S. has full employment, but the government still has to incur a deficit, and at the same time has lost access to the bond market?
And yet the same Krugman fully supports the unconventional monetary policy we call QE2. QE2 depreciates the currency, thereby discouraging foreigners from buying U.S. bonds. (The future currency loss means they actually incur negative yield from investing in it. QE2 doesn’t improve employment, so it doesn’t increase the number of locals with income who can invest in the missing foreigners’ place.
With QE2, only the Fed ends up the natural buyer of bonds, resulting in even more QE, leading to more depreciation and even fewer natural buyers. Even more so, if QE convinces investors that it will cause future inflation, QE results in more would-be buyers shunning it altogether.
So could Krugman’s scenario, where the U.S. has lost access to the bond market, really be an extrapolation of today’s policy choices, where there’s endless flooding of reserves into the banking system while government’s cutting fiscal spending?
It’s unfortunate that a lot of people (and economists) don’t know what policy choices actually lead to destroying the currency, or to restoring aggregate demand, or to stimulating the economy. More often, people who are most vocal about what policy choices to follow actually attribute the cause and effect to exactly the opposite of how it is.
Krugman wrote the post to illustrate his differences with the Modern Monetary Theory (MMT) crowd -- which is again unfortunate, because I’ve found that MMT descriptions of how the macroeconomy works is the most technically correct, provides a seriously objective framework to understand what actions cause which vs. what, and is the only economic framework that incorporates how credit and investment actually functions and affects the overall economy.
To use an analogy: MMT looks at a fire and notices that firemen are the most effective method to combat the fire. By comparison, the classical explicators are those who notice that whenever there is a fire, there always seems to be a lot of firemen. So hence, the best way to decrease the number of fires is to decrease the number of firemen.
Previously, if you were in any financial type of work, you could safely ignore macroeconomic prognoses on your industry based on the classical view, and your ignorance of the prognoses would not affect you in any way. Now you ignore macro analyses based on the MMT framework at your peril.
Scott Fulwiller provides a more technical reaction to Krugman here.