It does not happen often, but it does happen; I have to disagree with Paul Krugman this morning. In an otherwise excellent column criticizing the drive to austerity in the United States and elsewhere, Krugman comments:
"But couldn’t America still end up like Greece? Yes, of course. If investors decide that we’re a banana republic whose politicians can’t or won’t come to grips with long-term problems, they will indeed stop buying our debt."
Actually this is not right for the simple reason that the United States has its own currency. This is important because even in the worst case scenario, where the deficit in United States spirals out of control, the crisis would not take the form of the crisis in Greece.
Greece is like the state of Ohio. If Ohio has to borrow, it has no choice but to persuade investors to buy its debt. Unless Greece leaves the euro (an option that it probably should be considering, at least to improve its bargaining position), it must pay the rate of interest demanded by private investors or meet the conditions imposed by the European Union/IMF as part of a bailout.
However, because the United States has its own currency it would always have the option to buy its own debt. The Federal Reserve Board could in principle buy an unlimited amount of debt simply by printing more money. This could lead to a serious problem with inflation, but it would not put us in the Greek situation of having to go hat in hand before the bond vigilantes.
This distinction is important for two reasons. First, the public should be aware that the Fed makes many of the most important political decisions affecting the economy. For example, if the Fed refused to buy the government's debt even though interest rates had soared, this would be a very important political decision on the Fed's part to deliberately leave the country at the mercy of the bond market vigilantes. This could be argued as good economic policy, but it is important that the public realize that such a decision would be deliberate policy, not an unalterable economic fact.
The other reason why the specifics are important is because it provides a clearer framing of the nature of the potential problem created by the debt. The deficit hawks want us to believe that we could lose the confidence of private investors at any moment, therefore we cannot delay making the big cuts to Social Security and Medicare they are demanding. However if we have a clear view of the mechanisms involved, it is easy to see that there is zero truth to the deficit hawks' story.
Suppose that the bond market vigilantes went wild tomorrow and demanded a 10 percent interest rate on 10-year Treasury bonds, even as there was no change in the fundamentals of the U.S. economy. In this situation, the Fed could simply step in and buy whatever bonds were needed to finance the budget deficit.
Does anyone believe that this would lead to inflation in the current economic situation? If so, then we should probably have the Fed step in and buy huge amounts of debt even if the bond market vigilantes don't go on the warpath because the economy would benefit enormously from a somewhat higher rate of inflation. This would reduce the real interest rate that firms and individuals pay to borrow and also alleviate the debt burden faced by tens of millions of homeowners following the collapse of the housing bubble.
The other part of the story is that the dollar would likely fall in this scenario. The deficit hawks warn us of a plunging dollar as part of their nightmare scenario. In fact, if we ever want to get more balanced trade and stop the borrowing from China that the deficit hawks complain about, then we need the dollar to fall. This is the mechanism for adjusting trade imbalances in a system of floating exchange rates. The United States borrows from China because of our trade deficit, not our budget deficit.
This also puts the deficit hawks' nightmare story in a clearer perspective. Ostensibly, the Obama administration has been pleading with China's government to raise the value of its currency by 15 to 20 percent against the dollar. Can anyone believe that China would suddenly let the yuan rise by 40 percent, 50 percent, or even 60 percent against the dollar? Will the euro rise to be equal to 2 or even 3 dollars per euro?
This story is absurd on its face. The U.S. market for imports from these countries would vanish and our exports would suddenly be hyper-competitive in their home markets. As long as we maintain a reasonably healthy industrial base (yes, we still have one), our trading partners have more to fear from a free fall of the dollar than we do. In short, this another case of an empty water pistol pointed at our head.
The deficit hawks want to scare us with Greece in order to push their agenda of cutting Social Security, Medicare and other programs that benefit the poor and middle class. This is part of their larger agenda for upward redistribution of income.
We should be careful to not give their story one iota of credibility more than it deserves. By implying that the United States could ever be Greece, Krugman commits this sin.
Addendum: In response to the Krugman post, which I am not sure is intended as a response to me, I have no quarrel with the idea that large deficits could lead to a serious problem with inflation at a point where the economy is closer to full employment. My point is that the problem with the U.S. would be inflation, not high interest rates, unless the Fed were to decide to allow interest rates to rise as an alternative to higher inflation.
This point is important because the deficit hawk story of the bond market vigilantes is irrelevant in either case. In the first case, where we have inflation because we are running large deficits when the economy is already at full employment, the problem is an economy that is running at above full employment levels of output. The bond market vigilantes are obviously irrelevant in this picture.
In the second case, where the Fed allows the bond market vigilantes to jack up interest rates even though the economy is below full employment, the problem is the Fed, not the bond market vigilantes.
We have to keep our eyes on the ball. The deficit hawks pushing the bond market vigilante story are making things up, as Sarah Palin would say, their arguments do not deserve to be treated seriously.
There is one more important point about the fact that the real issue is risk of inflation and not an attack by the bond market vigilantes. While the bond market vigilantes can be fickle -- they can change their attitudes towards the U.S. government or any government overnight -- this is not the case with inflation. There are literally no examples of an advanced economy doing this in the absence of a cataclysmic event like a war, natural disaster or collapse of the political system. Inflationary pressures build gradually through an overheated economy.
This means that while Greece may have to worry about the bond market vigilantes going nuts after hearing an impassioned tirade by some honcho deficit hawk, the U.S. need not have this concern. If the bond market vigilantes go nuts on U.S. debt, the Fed can simply step in and fill the gap, buying up the bonds that the vigilantes are selling. If it turns out to be the case that the economy really is overheating, then the Fed would face the choice of raising interest rates or letting inflation rise, but the Fed has the option to respond to the economy's fundamentals, it does not have to let the economy's fate be determined by the vigilantes.
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