Greece vs. Zimbabwe: More on Krugman and Deficits

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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.