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Home Publications Blogs Beat the Press Greece vs. Zimbabwe: More on Krugman and Deficits

Greece vs. Zimbabwe: More on Krugman and Deficits

Sunday, 27 March 2011 07:54

Paul Krugman added another post on the potential impact of large deficits on the U.S. economy in which he argues that it doesn't matter that the U.S. can print its own currency; it still faces the same constraints from financial markets. I would argue that it matters a great deal for two reasons that I laid out in my previous post.

The first reason is that at any point in time the Fed would have the option to intervene in bond markets and buy up debt, if private investors were demanding very high interest rates. This is important because the decision by the Fed to not buy debt would always be a policy choice, not an economic fact.

There is a popular mythology in economic policy circles that in 1979 there was no alternative to putting Paul Volcker in as chair of the Federal Reserve Board to really tighten the screws and get inflation under control. At the time inflation was rising and the dollar was falling. Volcker sent rates through the roof, giving us the recessions of 1980 (destroying Carter's re-election chances) and then 1981-82. The latter recession was at the time the worst of the post-war era.

Volcker is widely touted for making the tough call to throw millions of people out of work. (Somehow rich and powerful people are always credited with being "tough" when they inflict pain on ordinary workers and the poor. It seems that if they were really tough they would be inflicting pain on the rich.) Arguably Volcker made the right call even though it did impose enormous costs on the country.

However, it is also possible to envision an alternative scenario. It is unlikely that the dollar would have continued in any sort of free fall even without Volcker's actions. At the time the U.S. had near balanced trade, with manufacturing a much larger segment of the economy. A sharp fall in the real value of the dollar against the currencies of our trading partners would have made U.S. goods hyper-competitive destroying the U.S. as an import market and leading to a surge of U.S. exports. Our trading partners would have been forced to take steps to support the dollar regardless of Volcker's actions.

Inflation had gotten too high by any measure in the late 70s, but it likely would have come down even without Volcker's heavy hand. One major cause of the surge was the jump in oil prices following the Iranian revolution. This jump in prices was completely reversed by the mid-80s due to increased supply and falling demand (e.g. more fuel efficient cars and less driving). This response would have occurred with or without Volcker. (An error in the consumer price index [CPI] also fueled inflation in an era where many contracts were legally tied to the CPI, but economists don't like to talk about this one.)

This is a long way of saying that we had a choice and we will always have a choice. Greece had very little choice in agreeing to the terms of the EU/IMF because it did not have its own currency. The United States will therefore always have the option to risk higher inflation to buy its own debt. Those who claim that we do not have this option are not being honest.

The other reason why it is important that we are not Greece is that we do not have to worry about the psychology of the markets (i.e. the bond market vigilantes [BMV]) in the same way. The story goes that everything was going along just fine with investors willing to hold Greek debt at a very small premium over German debt. Then the BMV got freaked and suddenly interest rates on Greek debt went through the roof. 

In an analogous situation, the Fed could just step in and buy the debt that private investors were unwilling to hold. If the economy is fundamentally unbalanced (i.e. we are operating above full employment levels of output) then this will give us a serious problem of inflation, but if the fundamentals are essentially fine and the BMVs just freaked for nothing, then we don't have to worry. The Fed can keep interest rates at reasonable levels and eventually private investors will step in and buy our debt.

It is also important to recognize that there are literally zero incidents of inflation just going through the roof in an advanced economy, absent war, natural disaster, or political collapse. Inflation rises through a gradual process; we don't have to worry that the inflation rate will jump from 2 percent to 20 percent overnight. This means that if the BMV bolted and the Fed filled the gap we would have the luxury of waiting and seeing whether this action was leading to higher inflation and then responding accordingly. The idea that we are sitting on a hairspring trigger that could go off at any moment is just nonsense.

For these reasons it is important that the U.S. has its own currency. It can never be Greece. It may end up as Zimbabwe, but this sort of hyper-inflation would be the result of long period of badly failed policies in which our economy essentially unraveled. While that may not literally be impossible, even the biggest pessimists would have to acknowledge that we are very far from seeing this situation.

Comments (22)Add Comment
Volcker Fed
written by bakho, March 27, 2011 9:00
I agree with your observation of the Volcker Fed. In fact, Volcker high interest rate policy probably made investments to oil alternatives and investments in energy conservation more expensive.

Carter energy policy does not get enough credit for ending inflation. However, that is not the point. Volcker policy helped break unions and decrease labor costs. Our wealthy elites love cheap labor and will find reasons to sell any policy that decreases labor costs.
written by AndyfromTucson, March 27, 2011 10:08
Thanks for holding out against the deficit hysteria, which has apparently begun to infect even Paul Krugman.

Zimbabwe's inflation was associated with a substantial reduction in real agricultural output that was in turn associated with new farmland policies. It is not an example of hyperinflation caused by monetary and/or fiscal policy alone.
Am I the only one tired of hearing what PK thinks?
written by bailey, March 27, 2011 10:09
It's a good thing PK opines in the NYT, it provides him a readership. Let me repeat for newbees a little PK history: He was silent during the Boskin decision that reved up the printing press, he was silent when he SHOULD HAVE BEEN vocal during the Glass-Steagall debate (it might have been an important debate if PK challenged AG when it mattered), he didn't call the housing Bubble until AFTER it popped, and he's supported absurd actions of Bernanke. Yes, ages ago he did some good stuff (Japan) but considering the role Economics might have played over the last 15 years & his stature in the field, he's no longer an Economist who deserves much consideration.
written by ellis, March 27, 2011 11:00
In this discussion on inflation, there are two things you ignore. First, there is the privileged position of the U.S. dollar as the currency used in international trade. With so many dollars remaining overseas, this allows the U.S. government to export its inflation to other countries. Second, the inflation of liquidity feeds one speculative bubble after another: in various commodities, currencies, etc. If anything, this speculation has actually grown bigger since the last crash. So, watch out what you wish for, Dean!
Good thing medicine isn't done economics style.
written by Bill H, March 27, 2011 11:03
Economics as a "science" always cracks me up. They come up with a theory based on observation of a period of history that pleases them, then view other periods of history with that theory as their lens, and claim that theory proven. They then try to cram today's events into that theory, whether it fits or not, and to make social policy based on their economic theories.

If medicine were done that way, after discovering that Penicillin came from mold, we would be scraping our bathroom walls to cure Cancer.
"It [the U.S.] may end up as Zimbabwe"
written by Paul, March 27, 2011 11:28
The U.S. will NEVER end up as Zimbabwe, period.

For more than 3 decades, Zimbabwe has been ruled by the most corrupt dictator in modern history. Mugabe's blatantly racist policies completely destroyed Zimbabwe's leading export: agricultural products. According to the BBC, "the forced seizure of almost all white-owned commercial farms, with the stated aim of benefiting landless black Zimbabweans, led to sharp falls in production and precipitated the collapse of the agriculture-based economy."

With nothing left to export and its domestic economy in shambles, Zimbabwe's currency is worthless, but that is the result of Mugabe's insane policies, not the cause.

Open the Window - This Place Could Blow Any Minute
written by izzatzo, March 27, 2011 11:45
The idea that we are sitting on a hairspring trigger that could go off at any moment is just nonsense.

Funny how that works. Rich conservatives weren't running around yelling about hairspring trigger risk during the housing bubble, instead cheering it on as a way to replace lost wage income while masking further concentrations in their own wealth ...

... earned not through the individual risks they so faithfully worship, but through the collective systemic risks they conveniently ignored while shifting it onto everyone else ...

... and what have they miraculously discovered these days? ... the coming hairspring trigger of collective systemic inflationary risks of course, caused by the Fed attempting to offset an even worse counterpart risk of massive unemployment ...

... of course such counterparty risks must be avoided at all cost, lest these conservatives start jumping out of windows in 1929 fashion, leaving the rest of us to fend for ourselves with tin cup in hand since the trickle would be gone - out the window with the only ones who produce it ...
One thing that hasn't been mentioned by anyone
written by Brett, March 27, 2011 12:14
Is that the GOP wants to drastically reduce funding for the IRS. Part of Greece's problem is rampant tax evasion, especially by the wealthiest members of their society. If the GOP gets their wish and cuts funding for the IRS, then tax evasion may become a bigger problem in America and that would lead to worse deficits than we currently are dealing with.
Spot on
written by BT, March 27, 2011 2:50
written by izzatzo, March 27, 2011 5:02
The Tom the Dancing Bug cartoon is not only sarcasm BT, it's full blown ironic satire subject to economic rent collectable and protected through the very copyright law that Baker attacks on a regular basis that creates inefficient pricing above marginal cost.

If it's to be passed around for free while mocking the rich on this site, expect a DRM takedown notice and requirement that it be resubmitted under Copyleft Commie Commons law attributable to Whose Your Nanny Not-Me Baker.
Thanks Bailey for the Reminders
written by Union Member, March 27, 2011 6:48
I respect Krugman and think he has done much good from his platform at the NYT (considering all the other unethical and misleading voices out there).

However, I am very troubled by Krugman's resent remarks on world food prices, and have always been suspicious of his explanation of energy pricing. (Krugman himself does not seem convinced of his own arguments on oil.)

I'm not an economist, and put down opinions here with only the greatest self-consciousness, but I will never accept the price of oil as being driven by market forces/supply and demand. Never! Not with all these wars, and bubbles. And bubbles and wars. And especially when the bubbles and the wars are optional. And especially when Paul Krugman's newspaper did as much as any news outlet to foster the Endless War Bubble we are now in and can't exit.

My apologies to Dean if this is too off topic, but I believe in Beat the Press because it is as much about decent and high standards for journalism as it is about getting the economics right.

written by Matias Vernengo, March 27, 2011 10:11
As always I agree, but it should be remembered that Volcker not only caused pain domestically with unemployment, he caused the debt crisis by hiking interest rates to the stratosphere. Also, the US will not be Greece, but will also not be Zimbabwe. Hyperinflation is not about monetization of public debt. The German and Latin American cases show that is about being unable to keep the external value of the currency when faced with a balance of payments crisis.
iphone for sale
written by iphone for sale, March 27, 2011 10:39
Excellently written article
iphone for sale
written by Fempus Tugit, March 28, 2011 11:34
izzatzo once again exposes his ignorance of market forces that don't fit his paradigm. The problem with paradigms is that they're only good for the problems they were created to solve. Now we have new problems that were created by izzatzo's beloved belief set. Roll over and fly on, old man, we appreciate your efforts and won't throw out the baby with the bathwater (as regards to the conservative flim flam of the past 35 years) but it is good to know when to retire.
written by flow5, March 28, 2011 3:04
You don't even understand the basics of money & central banking:::

Paul Volcker’s version of monetarism (along with credit controls), was limited to Feb, Mar, & Apr of 1980. With the intro of the DIDMCA, total legal reserves increased at a 17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 year’s-end).

Why did Volcker fail? This was due to Volcker's operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. That's before the discount rate was made a penalty rate. And the fed funds "bracket racket" was simply widened, not eliminated. Monetarism actually has never been tried.

Then came the "time bomb", the widespread introduction of ATS, NOW, & MMMF accounts -- which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, and the U.S. government).

It was monetary mis-management (a loose monetary policy - not a tight one), that propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%.

By the first qtr of 1981, the damage had already been done. But Volcker screwed up again (supplied an excess rate of legal reserves to the banking system), in late 1982-83. AAA corporates yields later hit 13.57% May 31st 1984.
I agree with most of the post but..
written by Floccina, March 28, 2011 4:15
One major cause of the surge was the jump in oil prices following the Iranian revolution.

I agree with most of the post but perhaps you could do a post describing how an increase in petroleum prices can cause a general inflation.
Please include:
1. How such a small part (petroleum) of our economy can cause a double digit inflation rise.
2. If people spend more on on petroleum how would they not have to spend less on other things putting downward pressure on the prices of those other things.
written by ko, March 28, 2011 8:55
There are some fundamental misguided presumptions in this piece. For example, "It is also important to recognize that there are literally zero incidents of inflation just going through the roof in an advanced economy, absent war, natural disaster, or political collapse". This is a non-argument. Just because something has not happened in recent history does not mean it cannot and will not happen. AAA bonds basically never defaulted in the history of the world either - until 2008. And was German hyper inflation in the 20's a success?

What the author - and Krugman miss - is that the "prisoners dilemma" mentality can take hold in financial markets, and that is a panic. Each individual actor looks to run out the door before other people run out the door. And yes, that can happen in currencies. So to wave an economists' hand and just say the fed can control interest rates and currencies, is simplistic thinking, and ignores the science of human nature. I seem to remember the "breaking of the pound" in the early '90's. That was a junior varsity example of an event that could be much larger.

I think a useful exercise for the author of this piece would be to invert the question, ask yourself what it would take to break a "reserve currency" like the U.S.? What would that take? A goverment debt to GDP ratio of 150%, 200%, 500%, 1000%? And as you think that through, ask yourself how such a Margin call would play out.
I am not saying there is an imminent collapse of the dollar; however, I think that those who poopoo the notion for half baked precedents do nothing other than give comfort to the politicians who drive us closer to the cliff's edge. Take a look at the countries with the lowest govt spending and govt debt to GDP, and those are the countries that are most prosperous. This evidence speaks much more powerfully, than anything written in this pierce or by Mr. Krugman.
written by Brant Williams, March 28, 2011 11:42
"Take a look at the countries with the lowest govt spending and govt debt to GDP, and those are the countries that are most prosperous."

Actually...it is TOTAL debt to GDP that really matters.

In the US for instance...we could NEVER support the government debt that Japan can...because we have much more private sector debt, whereas Japanese citizens and companies are much more conservative (ie savers).

In fact...if there is one area that the US excels in...it is consistency. We are consistently short sighted and irresponsible.

Fed Gov, Consumer, Mortgage, State& Muni...Corporate... ALL sectors of debt in the US are too high. This makes for a high overall debt to GDP ratio.

Many other countries look worse than the US...but they do not have the private sector debt we do...
written by Brant Williams, March 28, 2011 11:47
I also love your point about the curve fitting methodologies that pass for economic 'analysis' these days. They simply can not see past their own flawed religion...the pseudo 'science' of quantitative economics... Establishing a correlations between different economic metrics and measures is not the same as understanding how the economy functions.
Godwin's law of economics
written by Tom Hickey, March 29, 2011 12:36
OMG, didn't anyone ever tell you that "Zimbabwe" is the Godwin's law of economics?
written by Calgacus, March 30, 2011 2:09
Floccina: 1)Petroleum was a bigger part of the economy at the time, so it caused much more inflation then than it does nowadays.
2) Yes. This lowered demand and caused the stag in stagflation. OPEC could not spend their US dollars in the US as fast as they were making them. And as Dean & others have pointed out, the 70s inflation was overstated.
written by whathappened, April 03, 2011 6:00
What really happened in Zimbabwe



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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.