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Home Publications Blogs Beat the Press Krugman Is Wrong: The United States Could Not End Up Like Greece

Krugman Is Wrong: The United States Could Not End Up Like Greece

Friday, 25 March 2011 03:58

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.

Comments (25)Add Comment
written by Terypat, March 25, 2011 5:21
I expect you will get a big "thank you" and clarification on his blog from PK today for pointing out how the sentence about Greece looks to others in your profession. I'm sure in has to do with trying to hit upon too many points in the limited space of his column.

I look forward to reading both you and PK daily (and equally!). Keep up the great work, as there are way too many voices out there that only want to confuse matters having to do with the economy and America's recovery in it.
Vigilante Takeover of Government is the Only Way Out, Low-rated comment [Show]
written by Ignacio, March 25, 2011 6:21
An excellent commentary about an otherwise excellent article.
written by skeptonomist, March 25, 2011 8:11
When the IMF and/or the EU impose austerity conditions on potentially insolvent countries, do they make it a condition that taxes will not be raised in those countries? Confidence in the credit reliability of countries is certainly not raised by totally irresponsible tax policies.
written by joe, March 25, 2011 9:06
I was surprised to see that comment in Krugman's column since he has pointed out many times in his blog that we are not like Greece. He specifically said that Greece can't devalue and has to deflate it's way out of the crisis.
written by JTM, March 25, 2011 9:08
PK said he was "under the weather" yesterday, so we need to give a break!
Krugman's comment section
written by Benedict@Large, March 25, 2011 11:00
Krugman's comments section on this looks like everyone was practicing to write a book, so I think by now he gets the idea that his Greece reference didn't go over too well. I also chimed in, but even as fast as I did, I only score comment#125 ... But at least he gave me an "A" (highlight) on my comment.
In One Sense, We Are Like Greece
written by Paul, March 25, 2011 11:20
Virtually all of our state governments have large budget deficits that they can't deal with except by cutting spending or raising taxes, just like Greece. Meanwhile, the federal government is just like Germany: it could bailout the states and prevent their austerity measures that are a major headwind for our economic recovery, but the feds, for no good reason, refuse to help the states with their budgets.

So we are like Greece because a major part of our government spending is being forced into austerity that is counter-productive to economic recovery. Unlike Greece, Ireland, Portugal, etc., our state governments are not fighting the feds for bailouts.
In Theory and In Reality
written by PeakVT, March 25, 2011 12:07
Technically, Krugman is wrong.

Practically, he's right, because Obama nominated a Republican to be the Fed Chair as soon as he came into office. If the bond vigilantes suddenly returned from the Gamma Quadrant or wherever it is that that they are hiding out, the probability of the FRB acting in a logical manner is close to zero.
banana republic
written by ang, March 25, 2011 12:16
Ah, but what if congress and the Fed completely abrogate their responsibility?
..., Low-rated comment [Show]
Deficits and the Printing Press (Somewhat Wonkish)
written by for Paul Krugman, March 25, 2011 3:00

"The key thing to remember is that current conditions — lots of excess capacity in the economy, and a liquidity trap in which short-term government debt carries a roughly zero interest rate — won’t always prevail."

"once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation."
sevitavresnoc diputs
written by Fempus Tugit, March 25, 2011 11:29

izzatzo can't even recognize who's on his own side. I'd rather have the marshals ride into town than the vigilantes. Can thugs be relied on to put things right?
written by Brant Williams, March 26, 2011 1:21
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.

Are you actually serious? Food and energy costs are already outpacing income gains by a huge margin. You need to get out of your ivory tower and get out in the real world.

If we go down this road, we will be looking a whole new world...one which you can not fathom. The same as the now FED washes its hands of these revolutions around the world, which at their heart are about FOOD prices skyrocketing due to dollar weakness and liquidity sloshing around where we dont want it to... ...you will be washing your hands of things like political assassinations, widespread street riots, breakdowns in economic systems. Try to built a water treatment plant or power plant with 10% inflation.....

The notion that we can inflate out debts away in a controlled manner is a fantasy. You can not control where the liquidity you create goes. Look at QE1,2... Supposed to create jobs...yeah right. All it is doing is causing bubbles, weakening the dollar...and indirectly leading to all these revolutions around the world..which threaten oil prices...in a very interesting case of economic blowback...

In addition, you will be bankrupting the banking sector.... Recall...they are the CREDITORS. Inflating away debts screws who? Stagnant incomes and increasing costs means the masses have less capacity to service their debts...mortgage...consumer, auto, etc. The Banks are left holding the bill...

Any plan to inflate away our problems is 100% dependent on incomes rising on pace with the inflation on the cost side. That is not happening now. Please explain why it will happen if the FED is forced to expand QE to 5,6,7,8 times its current size?

Finally...there is no middle ground once everyone starts thinking like Bill Gross. 10% long term rates? Keep dreaming. Private holders will not hold long term debt at all....at ANY rate. Once the only debt you can sell is short term...explain how you can inflate away your debts? Your debt rolls over to the new rates before you can get out from under your burden.

The US's overall fiscal situation is in some respects WORSE than that of Greece. Just because we can print they same currency we owe our debts in does not mean we have a free pass. It just means the disaster will unfold differently....
..., Low-rated comment [Show]
written by skeptonomist, March 26, 2011 8:13
The U.S. did print money during WW II and although there was significant inflation it was in no way catastrophic. There was certainly no liquidity trap by anyone's definition. There were very special circumstances and policies at that time such as removal of a large part of the work force into the military, price controls and rationing, but some of these things could also be done in peacetime if necessary. Of course tax rates were extremely high during and after the war, but this did not prevent the economy from booming and unemployment from remaining low after the war.

In the 40's and 50's the Fed did not attempt to "control" inflation by raising interest rates and lifting unemployment to over 10%, as it did in the 1970's and 1980's, but inflation subsided anyway.
This article is snake oil
written by RebelEconomist, March 26, 2011 10:59
The alternative to Greece that is proposed is Argentina. Yes, it might be possible to expand the base money supply without inflation while the economy has excess capacity and/or demand for safe assets like money exists even at zero interest rates, but once this capacity is used or depreciated and/or risk appetite returns, unless that expansion of base money is withdrawn, it will generate inflation. Then, either selling bonds to withdraw the excess base money will generate the sharp rise in yields that you were trying to avoid, or else allowing inflation to surge will, by imposing losses on creditors, motivate a long-lasting risk premium on future borrowing. Either way, you end up paying.
We have no bananas
written by V Ray, March 26, 2011 11:11
Yes, we cannot become a banana republic. We have no bananas.

We do have paper which we can print with $s, 1s, and 0s. So, we can be a "paper" tiger.
written by Bill H, March 26, 2011 11:29
Sometimes the subtlety of Paul Krugman is over the head of literalists like Dean Baker. A remark such as, "Could America cease to exist? Sure, if a humongous asteroid were to land in the middle of Kansas," would almost certainly draw criticism from him that the writer was claiming that America is in danger of ceasing to exist.
he actually cares about inflation, you don't
written by dave, March 26, 2011 11:37
I know you think hyperinflation and paying $1000/barrel for oil because of a currency collapse would be fantastic positives for the US economy, but some of us actually see them as bad things.

That's the difference. You're right that the government can set its own interest rate if it doesn't care about inflation or what its currency can buy. That's not some amazing revelation that the rest of us don't "get". The difference is those of us that use that currency do care. I do care I'm getting a negative interest rate on my savings. I do care that my gas gets more expensive.

I can agree to a point that the US can issue currency to use idle resource without causing inflation. Krugmen believes this too. But we all have different ideas of what an idle resource is and exactly what policies can properly utilize them. Your policy solution, that is doesn't matter and we can do whatever the hell we want, is just childish and asinine.
The misleading federal debt
written by Rodger Malcolm Mitchell, March 26, 2011 2:34
All this concern about what others will be willing to pay for our debt and whether printing money causes inflation, ignores three facts:

1. The federal government, being Monetarily Sovereign, does not need to borrow. Rather than "printing" T-securities it could "print" dollars. So-called "borrowing," (misnomer for federal T-security sales)became obsolete in 1971. So worry about what the market will pay for your T-bills, when you don't need to sell T-bills?

2. Since 1971, there has been zero relationship between federal deficit and inflation. So what has caused inflation? Oil prices.

3. There is no possibility of hyperinflation in the U.S. We really should ask the Cassandras to stop talking about hyperinflation. These sky-is-falling types have no idea what hyperinflation is, nor what causes it, nor how to prevent it. Every time I read about the federal deficit, I see some guy predicting we are headed for hyperinflation, and then inevitably, they mention Germany, as though in vague way, we are similar to what Germany was.

It as though someone told you not to go on a cruise, because "you know what happened to the Titanic." Until you understand what actually causes hyperinflation (no, it's not deficit spending), stop predicting it.

Rodger Malcolm Mitchell
You admit the possibility of inflation, but assume that that's always better than paying private creditors
written by Paul Andrews, March 26, 2011 11:22
"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"

Cna you explain why the latter is worse than the former?

Looks like Krugman may finally be waking up.
written by giulio, March 27, 2011 2:39
Krugman is saying that the alternative to Greece if debt is not brought under control in the long run is Zimbabwe or Germany in 1923 (possibly a better comparison). You are saying that being Germany in 1923 is better than being Greece. Maybe...
There need to be more disscussions!
written by Intrinsic Value, March 28, 2011 2:49
Like they say, I think this is the beginning of a beautiful friendship. Or not.
Question for Roger Malcolm
written by Tom Cobb, March 29, 2011 11:44
I am trying to get my head around this debate. I get the point about the fact that Sovereign Money controls its own destiny with respect to solvency. I am less sure about the 'risk' side of controlling its destiny by way of printing itself out of any troubles, which is the inflation question. I need a fuller explanation from the MMT crowd on their understanding of inflation, ie, its root cause, the risk/cause/definition of hyperinflation, and how do you guard against those risk? How do you gauge when you've reached a tipping point on that front? To my mind, there must be SOME point at which the federal government becomes effectively 'income constrained', ie, the hazards of inflation make the printing of money an unviable policy option.

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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.