Krugman Ignores His Own Theory and Misses An Important Piece of European History
This whole “what danger is there for a country issuing its own currency?” argument is really slippery. First of all, what these people really mean is, “What danger is there for a country issuing its own currency and in which most of its debts are denominated in this currency?” I.e., even on their own terms, it’s not enough for a country to issue its own currency. I believe this extra hoop is how they rule out things like Russia defaulting on its bonds and causing a bit of a ruckus, as you may recall.
When you think about it, there are only a handful of countries for which this concept even applies, and even then it only really works from 1971 onward. But anyway, let’s put aside that objection and consider Krugman’s latest:
What [a critic of the fiscal scaremongers] doesn’t note, however, is that the problem with bond vigilante scare tactics runs even deeper than that — because it’s actually quite hard to tell a story in which a loss of confidence in U.S. bonds hurts the real economy. Why wouldn’t it just drive down the dollar, and thereby have an expansionaryeffect?
Yes, I know, Greece — but Greece doesn’t have its own currency. What’s the model under which a country that does have its own currency and borrows in that currency can experience a slump due to an attack by bond vigilantes? Or failing that, where are the historical examples?
This is really amazing. Krugman is acting like it’s not even theoretically possible to imagine this kind of thing. But sure it is. Here’s a theory of it:
So suppose that we eventually go back to a situation in which interest rates are positive….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.
So then what? The Fed could directly finance the government by buying debt, or it could launder the process by having banks buy debt and then sell that debt via open-market operations; either way, the government would in effect be financing itself through creation of base money. So? …
Does this mean 400 percent inflation? No, it means more — because people would find ways to avoid holding green pieces of paper, raising prices still further.
I could go on, but you get the point: 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…
At this point I have to say that I DON’T EXPECT THIS TO HAPPEN — America is a very long way from losing access to bond markets, and in any case we’re still in liquidity trap territory and likely to stay there for a while. But the idea that deficits can never matter, that our possession of an independent national currency makes the whole issue go away, is something I just don’t understand.
So there you have Paul Krugman himself, explaining how a bond strike on Treasuries would either force the government to balance its budget, or risk hyperinflation itself. If Krugman is now admitting that he can’t even come up for a theoretical basis for his objections to the MMT guys (that was the context of the above quotation), then he should send an apology to James Galbraith.
But let’s go back to Krugman’s recent post. It gets better:
The closest I can come to anything resembling the danger supposedly lurking for America is the tale of France in the 1920s, which emerged from World War I burdened by large debt, and which did in fact face an attack by speculators as a result. Yet the French story does not, if you look at it closely, offer any support to the deficit scare talk we keep hearing.
So Krugman walks through, and shows how France followed Krugmanian advice and let the franc depreciate, inflating away the real value of its post-war debt. Krugman claims that everything was great, and points to a table showing French unemployment. Only thing is, in 1927 it jumps up to 11 percent. Yikes! That’s pretty bad. So does it prove that running up a humongous debt can lead to bad consequences? Of course not! Krugman explains:
But what about the brief but nasty slump in 1927? That wasn’t caused by spiking interest rates; it was, instead, caused by fiscal austerity, by the measures taken to stabilize the franc.
So even when we look at the closest thing I can find to the scenario the deficit scolds want us to fear, it doesn’t play out at all as described.
Everyone see what’s going on here? Krugman points to France as the only example of a bond vigilante attack he can think of, on a nation issuing its own currency. (I guess he’s not counting the gold standard as being binding here; I’m not sure when France went back on. Remember in those 1930s charts of industrial output that the Keynesians like to point to the idiot French as hurting their economy by clinging to gold far longer than other countries.)
So here’s the progression:
(1) The French emerge from World War I with a debt of about 240% of GDP. (That was its value in 1921, which was a big jump from 1920. I’m not sure what was going on there.) Of course the reason the French government has such a massive debt, is that it ran massive budget deficits during the war years (and went off gold).
(2) What did the French do in the early and mid-1920s to deal with the problem? Did they run massive budget surpluses? Nope, Krugman himself says, “How did France achieve that big drop in debt after 1925? Basically by inflating it away.”
(3) Krugman admits that the bond vigilantes saw this depreciation coming, and so interest rates spiked.
(4) The French authorities eventually reversed course to stop the plunge of the franc. Krugman acknowledges that this led to 11% unemployment in 1927.
(5) Krugman says this pain was avoidable, because the French authorities shouldn’t have tightened in 1927.
So, it seems to me we need to think of an historical example of a country that did just what Krugman suggests, in order to test out his recommendations. So let’s see: Can anybody think of a major industrial power that emerged from World War I with a huge debt, but that issued its own national currency the way the French issue francs, and that turned to the printing press but without looking back? In other words, can anybody think of a European power that followed the French pattern, except stuck to Krugman’s advice by continually depreciating rather than a foolish move to stabilize its currency?
(Don’t worry Keynesians, there’s no danger here. Even when an Austrian in the crowd thinks of the answer, Krugman will just point out, “Ah, but they ate a lot of sauerkraut. Hardly relevant for the US today.”)
Nicely done.
Not an answer to your final question, but Greece itself is an example of limits to the sovereign bond market even when a State issues its own currency. Yields on Greek sovereign debt were much, much, much higher than anything experienced during the ongoing debt crisis. One thing that a lot of people don’t consider is that in order for a country to enjoy low borrowing rates its central bank needs to be trusted. Countries with high inflation rates aren’t likely to have credible central banks, and bond yields soar.
Ugh, yields on Greek debt in the early 1990s.
Bob, Germany had debt denominated in foreign currency. You seem to acknowledge that Krugman thinks foreign currency debt can be a problem. Are you just bashing him for not being clear enough? Is this today’s two minutes hate?
The MMT example is about inflation, not a bond strike itself. Krugman is saying a bond strike would be good now. He both wants higher inflation and it seems a lowered valued dollar. I’ve said this before but the MMT post was most likely Krugman hippy bashing as not even the MMT guys say we should keep inflating the currency in the face of runaway inflation. Basically for Krugman to be contradicting himself you’d have to believe he not only want to stimulate the economy now, but thinks that there is no limit to government spending at all.
(Basically the MMT guys claim he’s straw-manning them by saying they actually don’t think hyperinflation is a problem, when they what they actually say they claim it is the *only* “real” constraint on government spending, besides self-imposed constraints or inability to collect taxes.)
Bob notice this qualification:
“I could go on, but you get the point: 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…”
Government cannot guarantee to deliver an endless flow of material goods, thus the physical world imposes a limit on government spending. It may manifest in inflation, or it may manifest in interest rates, but the limit is hard regardless of how you want to deal with that.
Krugman fails to explain how we could sit in a liquidity trap for four years running while the Fed doubles or triples the money supply and the government runs the largest debt ceiling on record by a decent margin. I guess we just haven’t done enough.
Tel, Dean Baker has said the collapse of the housing bubble cost about 1.2 trillion in annual demand while the stimulus only added 300 billion in spending for I think about two years and less after that.
But are you worried about rates being too low or too high? On the one hand you complain about the liquidity trap on the other you’re worried about rates going up.
Sorry, did I complain about the liquidity trap? That’s Krugman’s bag, I merely mentioned it.
I understand about the debt deflation in the housing market, but the US government is spending one trillion dollars every year more than it brings in. That’s about the same size as the entire housing bubble, every year of new money coming from somewhere.
Admittedly, not all of the federal deficit has been monetized by the Fed, but QE1 reached a peak of approx two trillion of monetized debt (not all of it treasury debt) then eased back a nit (call it one and a half), along came QE2 which was of the order of half a trillion monetized debt, and QE3 is approx another half trillion of monetized debt per year.
That sounds like a lot of liquidity to me.
Tel, what you’re missing is that total government spending has actually gone down relative to the size of the economy, not up.
The increased deficit is entirely attributable to the economic downturn: lower tax revenues and increased social spending from a depressed economy. Maintaining the same or less level of government spending as before the recession (with a higher deficit) does not cancel out the lost demand from the housing bubble, it completely ignores it.
If the government cut spending or raised taxes to maintain the same deficit level as before the recession we would suddenly have two holes in the economy rather than just one.
I don’t know what your point about QE is meant to convey. My understanding is that QE is an asset swap and not a way to “monetize” the deficit. Any government bonds it buys are still on the books and still must be paid out of tax revenue or further borrowing.
The only thing I can think of that you might mean is that you’d prefer deflation or higher interest rates now for some reason.
When government runs a deficit, what that means is they are putting more money into the system than they are taking out of it. This extra money is financed by selling treasury bonds. In theory if Joe Public buys those bonds, and then if Joe Public just sits on the bonds (note sometimes the bonds themselves get used as money thus increasing the monetary supply by the back door, but let’s ignore that) the result is a wash — same amount of money comes out of the system as what goes in.
However, when the Federal Reserve buys bonds they just invent the money for that purpose, and sure they write a balancing note in a book somewhere — so what difference is that note in the book making? Now you are monetizing debt plain and simple and the Fed is backstopping government spending with printed money (not physically printed, electronically printed, which is the same in today’s world).
Thus there is plenty of liquidity out there, but people are not spending it, nor are businesses investing it. The reason being a complete lack of trust, firstly people don’t expect that the rule of law can reliably be applied, secondly they know that government can change the rules at any time for arbitrary reason, so “investment” these days is just making bets against your expectations of future government policy. Thirdly, more and more of the economy is moving towards central planning which tends to be clunky and inefficient (and inevitably also corrupt) so it just isn’t the sort of conditions anyone would want to be making a real physical commitment in terms of investment.
However, when the Federal Reserve buys bonds they just invent the money for that purpose, and sure they write a balancing note in a book somewhere — so what difference is that note in the book making?
It makes a difference because the money must be made up out tax revenue or further borrowing and so isn’t the same as monetizing.
Monetizing would be spending money without an offsetting asset.
I imagine your problem is that you’d prefer the Fed not target interest rates based on the Austrian view that the Fed is fooling people into malinvestments.
(Note that if you think the Fed is buying at above market rates it is monetizing. And there are perhaps other legitimate criticism of QE.)
When banks makes loans, I believe the Fed prints money too to accommodate reserves at their target rate of interest. (Though this process is somewhat murky to me.)
I think the economy is depressed because of lack of demand from the collapse of the housing bubble resulting in unemployment.
Consumer spending (as opposed to savings) is still high by historical standards and investment in software and equipment is almost back to what it was before the recession. (We shouldn’t expect the household savings rate to fall back to bubble levels, to raise spending you have to raise incomes. You can do this by lowering unemployment.)
Because the bubble was driving the increase in spending before the recession it’s not obvious where the new spending can come from. So it makes sense to have the government invest in things like infrastructure, research and education while the private sector recovers.
Also, note that the Fed has presumably been doing QE to keep prices from falling since inflation has been low.
It seems hard to make an argument of deficit monetizing when inflation is low unless you’re saying you think there should be deflation or even higher unemployment (and so even lower tax revenue and higher deficits).
Now, some people would like to see the Fed do even more: not just support prices and accommodate fiscal policy, but actively try to raise prices or spending according to an NGDP target or higher inflation target, but that’s another debate.
Bob you wrote “So let’s see: Can anybody think of a major industrial power that emerged from World War I with a huge debt, but that issued its own national currency the way the French issue francs, and that turned to the printing press but without looking back? In other words, can anybody think of a European power that followed the French pattern, except stuck to Krugman’s advice by continually depreciating rather than a foolish move to stabilize its currency?”
I am having a hard time here. I know you don’t mean Weimar. Not only did the reparations from the Treaty of Versailles require payments in various forms such as coal, steel, and other goods that can’t be inflated away, but also, Weimar was forced to purchase foreign currency to pay off the debt (Per wiki, http://en.wikipedia.org/wiki/World_War_I_reparations). But also Weimar did move to stabilize the currency, using the Rentenmark (and then the Reichsmark). So on both counts, Weimar doesn’t fit.
But I know Bob is really smart, and is making a good point here, so I just want to know what country he means.
And don’t forget the sauerkraut Yosef. No matter what historical example one picks, it will never be relevant.
Bob, the debt not being in own currency, and the currency being stabilized are integral to the point. Sauerkraut is just delicious. This isn’t dismissing the historical example over an irrelevance.
I may not be that smart, but I think the fact that the debt was not payable in marks is quite significant. There was surely a reason why German war debt was not allowed to be payable in German currency, and my guess would be that the creditors recognized that they would most likely be paid back in worthless paper.
The idea that history is unique seems to make an appearance by positivists whenever the need arises for evading falsification.
But when the need arises for confirming the positivist’s theory, then all of a sudden, history is no longer unique. It repeats.
This is what I think lends credence to the conclusion that the theory of falsification has itself been falsified.
Having said that, I think the criticism that Weimar doesn’t apply is a warranted one.
There is a difference between inflating to pay back foreign denominated debt, and inflating to pay back domestic debt. I think there is a lot more inflation that comes with inflating to pay back foreign denominated debt, because the foreign exchange rate can fluctuate to the disfavor of the domestic currency, whereas the debt principle and interest payments on already issued domestic debt do not fluctuate.
It’s like you owing $100 in Murphy Moola currency denominated debt, and you owing €100 in Euro currency denominated debt. If younwere going to inflate Murphy Moolas to pay back your domestic debt, you only need $100 Moolas. But if your foreign Euro lender is going to be paid back, and Euro sellers know you’re printing Moolas, then you might need to print $100,000,000 Moolas to buy €100 Euros to pay back the €100 debt.
Read your first paragraph. The reparations could not be paid in marks.
Holy cow you guys, this is getting painful. Krugman *gave us* an example of a country being attacked by bond vigilantes–France in the 1920s. And it indeed sucked–unemployment shot up to 11% when the French dealt with the consequences of their decision to inflate away the debt. Krugman deals with this by saying:
“But what about the brief but nasty slump in 1927? That wasn’t caused by spiking interest rates; it was, instead, caused by fiscal austerity, by the measures taken to stabilize the franc.”
OK, so that suggests that if only those idiotic French hadn’t taken steps to stabilize the franc, everything would have been fine. No need for a painful adjustment to stabilize the currency.
Now how do we know Krugman is right? We don’t. The actual historical example–just like the example of Russia, Greece, etc.–show countries suffering because of their reckless borrowing. But Krugman seems to suggest that in a hypothetical alternative universe, when the French in the 1920s just kept inflating and depreciating, things would have been great.
So that’s why I’m saying no, Germany did just that, and look what happened.
Or are you guys saying perpetual debasement is only bad, if you have debts denominated in foreign currencies?
Let me try to be clearer on this: Suppose, out of the blue, I had said, “Hey guys, I have an example of a bond vigilante attack, to show how vulnerable the US is right now. It’s Weimar Germany!” I agree with you that that would have been unhelpful. That would have given us no more information than more recent examples of countries with their own currency but foreign-denominated debt.
However, that’s not what I’m doing here. Krugman came up with an example, and in that example the bond vigilantes wreaked havoc. Krugman’s recommended strategy of currency debasement did buy the French a few years, but then when they eventually dealt with the consequences of that decision, they got 11% unemployment. (And go look at the chart; this 11% sticks out like a sore thumb. So this was an enormous spike in unemployment.)
Krugman explains that away as saying it was their poor tactical handling of the situation, not a flaw with his debasement strategy. If only the French had never stabilized their currency, they would have continued to enjoy surging exports and low unemployment.
At this point, Krugman’s theoretical apparatus–the one he believes when he talks with MMTers, at any rate–kicks in. We see that the problem with perpetual debasement is you get hyperinflation. And yes, that’s exactly what happened to France’s neighbor during the same time period, when it followed the Krugman strategy of perpetual debasement with no effort to stabilize the currency.
Bob, let’s take for granted that when Krugman speaks about depreciation/debasement he means perpetual. (He doesn’t, as anon pointed about above, but leave that be).
Bob you wrote, “that’s exactly what happened to France’s neighbor during the same time period, when it followed the Krugman strategy of perpetual debasement with no effort to stabilize the currency.”
Krugman’s strategy is not “perpetual debasement”, it is “perpetual debasement if you have your own currency and debt in that currency”. So, Weimar did not follow Krugman’s strategy.
Krugaman walks up to every country and says “Got your own money? Got debt in that money? Boy do I have the thing for you!” When Weimar walked up for this cure-all Krugman said “Beat it Kraut, we don’t serve your kind (who have foreign currency denominated debt)”
OK Yosef I’m glad we got this straight. I asked, half-jokingly, if you guys thought perpetual currency debasement would pose a problem for a country only if it had foreign-denominated debts. And yet you amazingly agreed, disagreeing not only with common sense, but also Krugman’s post about the US risking hyperinflation if it perpetually monetized its *dollar-denominated* debts.
Bob, I opened my reply by specifically saying that I am taking the perpetual part for granted in this argument. Yes, Krugman and common sense say there is danger in perpetual debasement, really of any kind of debt (own or foreign currency). I even said in the reply in parenthesis that he doesn’t support perpetual debasement. But since you framed things in terms of perpetual debasement I left it as that. To then say “Aha! But even Krugman says there are risks to perpetual debasement” doesn’t mean anything.
Yosef,
Krugman writes that France, after the First World War, resolved its debt issue by debasing its currency. In another post, Krugman writes that there is a limit to debasement: confidence in the currency. Back to France, Krugman points out that the 1927 spike in unemployment was caused by a cessation of the inflationary policies that dealt with the debt issue, and that it wouldn’t have happened had the French continued their “easy money” policy.
The disconnect in the logic is that Krugman admits that debasement can’t be perpetual (at the risk of hyperinflation), but then he advocates continuing an inflationary policy to avoid a recession associated with tighter money. You can’t have it both ways. Either: (a) you acknowledge that the 1927 recession was caused, at least in part, as a result of the (maybe positive) resolution of the debt problem, because inflationary policies can’t go on indefinitely; or (b) you acknowledge your mistake in believing that the limit to currency debasement is hyperinflation, and that debasement can indeed go on forever.
Thanks JMFC, your explanation has convinced me that Bob’s original criticism is warranted.
Bob, I was initially on the fence about your original criticism, not because I was trying to find an excuse to believe that inflating away domestic debt is all sunshine and roses, such that I latch onto any criticism, however weak. Rather, I was thinking that comparing Weimar with a country with predominantly domestic debt wasn’t a valid comparison.
I was thinking there is a “middle ground” between the inflation that comes with inflating away domestic debt, and the inflation that comes with inflating away foreign debt.
It is my understanding that Weimar went hyperinflation because they had gold and foreign denominated debts to inflate away, so I didn’t think that the alternative to France’s austerity, was Weimar as per your original post. I was thinking US since 1971. Teetering on a razer edge.
But JMFC explained it in a way that made me see your point. Krugman denied the middle ground. He said that debasement cannot be perpetual lest hyperinflation, so it makes no sense for him to also hold that France was stupid and could have had sunshine and roses if only they engaged in…perpetual debasement.
I feel somewhat embarrassed about this, because I should have known better, since this goes back to Mises’ argument that recessions are inevitable after an inflationary boom, and that the only alternative is to stop inflation and bring on recession, or delay delay delay the recession via accelerating inflation, and bring on hyperinflation.
I got somewhat sidetracked in the technicalities of foreign currency debt versus domestic currency debt.
No problem MF. I think you are probably right, incidentally: If someone is dumb enough to try to pay off foreign-denominated debts by running the printing press, then yeah they are going to get hyperinflation.
But by the same token, if someone is dumb enough to think they can ignore international investors because they can just print money, then yeah they are going to get hyperinflation (unless their gov’t runs a balanced budget or perhaps a very small deficit forever after).
Jonathan summed up my critique better perhaps than I did (though in my defense I had to quote Krugman and that took up space). This is yet another example of Krugman pointing to a country that *suffered* as proof of how good his policy recommendations are. Like how he currently points out that US from 2009-12 as proof of how bad things would have been without the stimulus. (!?)
Jonathan summed up my critique better perhaps than I did
I don’t think it’s a question of “better” or “worse”. I think it’s just a matter of what makes people see things when they are explained in a different way. Like maybe someone would get your critique more so that JMFC’s because they just understand it when it is explained in that way.
We all have our individual nuances and quirks. Most of the time I get it when you explain things. This is just one of those “I didn’t see it” times.
Same thing.
MF, more redefining?
A budget surplus is the same as a balanced budget?Appreciation is the same as a fixed exchange rate?
Apparently France was politically unstable after the war and after Poincare took power in 1926 inflation stopped almost immediately with no policy changes at all.
If tight money policies supposedly cause recessions, even in the non-Austrian framework, and easy money *must* be followed by tight money to prevent hyper-inflation, doesn’t that merely demonstrate that the Austrian theory of the business cycle at least has the right “cure” (no easy money) – even if we assume that they are wrong somehow on the causal mechanism for the cycle?
JMFC, Krugman’s saying there was austerity, not just a “cessation of inflationary policy”.
I’ve been trying to look up what actually happened and supposedly France had a low deficit by 1925 and a possibly sizable budget surplus by 1926 which was then used to appreciate, I think in 1927, but the inflation was already stabilized in 1926.
The appreciation was stopped after a short time and the franc was supposedly still locked in at an undervalued price. There’s apparently some dispute over whether the undervalued Franc played a role in France’s resistance to the great depression.
This is the best I could find. There’s shockingly little about the 1927 episode, or the period from 1927-1931, on the internet, from what I can tell, but I’m not very skilled in internet research.
JMFC, Krugman’s saying there was austerity, not just a “cessation of inflationary policy”.
Same thing.
Because the USA could no longer buy oil on the open market.
http://www.pkarchive.org/trade/CompetitivenessDoesItMatter.html
Paul Krugman argued that what happens inside a nation is the only important thing, therefore international competition over access to resources is irrelevant, emigration of the best and brightest minds from one nation to another is irrelevant, and presumably military hegemony would have to be irrelevant as well. Load of cobblers of course, but at least Krugman is being Konsistent for a change.
Have a chat to someone who grew up in South America about all of those international competitiveness thingies.
This almost came up in Australia, since we were saddled with a large WWI debt, and it was denominated in pounds. Whether these were Australian pounds or Imperial pounds was a moot point since Australia was determined to keep parity with England (even when England returned to the gold standard and refused to devalue their currency, Australia also did the same). The federal government insisted on deflation and paying the debts come what may, but Jack Lang in New South Wales wanted to piss off the gold standard, allow the currency to inflate and at least temporarily stop debt payments (similar to FDR’s plan in the USA).
Ended up almost coming down to a military standoff but Jack Lang was sacked by the Governor of New South Wales (who was from England himself, appointed by King George and presumably completely loyal to the Empire). The people of New South Wales voted against Jack Lang at the following election, so we remained tracking the Imperial pound for a bit longer (and eventually we gave that up, and inflated our currency). No one knows what the story would have been had we hit the printing press in the 1930’s, but personally I would guess that Australia was highly exposed to foreign trade sanctions at the time. Most of our wool shipment went to England for processing and most of our machinery came from England.
If you think that the only bad thing that can happen to an economy is an inability to sell products and so, reduced production and employment, then an attack of the bond viligantes doesn’t directly cause that problem. It is rather a contractionary monetary policy aimed at defending the exchange rate that would cause reduced spending on output, reduced production and reduced employment. If the exchange rate is left free to float (downward,) then spending on output rises when the viligantes attack. If monetary policy is _not_ aimed at protecting the exchange rate, but rather at prevending excessive increase in spending on output to avoid hyperinflation, then the bond villigantes would have the effect of raising spending on output (if it was too low,) and then monetary policy would keep spending on output from rising too high.
Anyway, the depreciation of the exchange rate results in higher import prices and reduced real incomes. And so, the bond viligantes cause damange to people’s real standard of living directly. It is just that the problem doesn’t show up as an inability to sell products. Demand is strong, but wages and other nominal incomes don’t keep up with prices.
Further, a monetary policy that prevents excessive growth in spending on output is going to impact public finance. Either higher taxes and reduced government outlays (other than interest) would be necessary.
In the limit, the tax hikes or cuts in government spending could be extreme. Paradoxically, the reason for the attack of the bond viligantes is the expectation that this would never be done. But if it is done, then the viligantes should relent.
For Bob
Best eaten cold, like sauerkraut.
http://dailycaller.com/2012/11/21/krugmans-twinkie-defense/
But of course, Krugman is spot-on when he writes a call for tax policies out of the 1950’s. The economic conditions are practically identical.
How is raising taxes “spot on”?
Woosh.
Now that was a woosh.
So, has Krugman accepted the Krugman vs Krugman debate?