Saturday, July 17, 2010

Krugman Surprises!

Well, the arch stimulator, the deficit spender in chief, has accepted that there is a limit to government deficits and money printing. This is from Krugman:

So there is a maximum level of debt you can handle. In practice, if it makes sense to say such a thing with regard to a stylized model, at some point lower than the critical level implied by this model the government would decide that default was a better option than hyperinflation.
Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs). I must also add Krugman's caveat to his acceptance that massive deficit spending and money printing might cause hyperinflation:

Now, I’m sure I’m about to get comments and/or responses on other blogs along the lines of “Ha! So now Krugman admits that deficits cause hyperinflation! Peter Schiff roolz” Um, no — in extreme conditions they CAN cause hyperinflation; we’re nowhere near those conditions now. All I’m saying here is that I’m not prepared to go as far as Jamie Galbraith. Deficits can cause a crisis; but that’s no reason to skimp on spending right now.
I highlight this from Krugman, as his analysis is very interesting, and I would recommend reading the article in full. It has a few equations, but is largely user friendly. When you are finished reading, you can come back to this post.

The reason I highlight this is that Krugman accepts the principle of seigniorage, an inflationary taxation, and accepts that (somehow) 'the government must persuade the private sector to release real resources'. However, there is an almighty assumption in the entire article that he is looking at a closed system, one in which the resources are closed. He does not exclude the consideration that the 'private sector' might include overseas provider of resources, but seems to believe that they will accept the seigniorage that those within the country might accept. He also fails to note that, even those within the country indulging in money printing have an option of moving their funds to a currency that is not subject to seigniorage.

Here is the problem for, for example, the United States. About $US 4 trillion of US government debt is held overseas, and the US is reliant on continued overseas provision of 'resource' being funded by overseas creditors. If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage. At present, the US has been benefiting from the safe haven/reserve currency status to offset these fears in troubled times. However, as I have long argued, this can only last so long. This view is now starting to become mainstream. This from HSBC (1):

It’s not hard to see how in six months time we will all say it was obvious that the dollar would eventually fall. The US has a highly indebted economy, the global imbalances needed to unwind as the US needs to export more, and EM countries need to import more. Meanwhile, the Europeans have aired their dirty debt in public and taken some measures to address it, whilst the US has not. By this time everyone would have forgotten about the risk on/ risk off fad just as quickly as Dubai disappeared off our radars. As the US economy slows and others in the world raise rates to fend off inflation the dollar will come under pressure. The euro break up premium is coming out and the next phase in this rotation will be a weaker USD and we very well may have seen the first signs of this – the worm is turning.
In this scenario, of a falling $US, the US is left in the uncomfortable 'Chimerica' system, in which China continues to fund deficits in order to keep their export machine turning. Again, as I have long argued, China will eventually reach a limit, the point at which they will no longer continue to subsidise the US with credit that will never be fully repaid (or paid at all?). This is the real 'resource' that Krugman is discussing. Having a borrower tax you on your lending to the same borrower is not really a very attractive prospect, especially where the tax leaves you lending at real negative interest rates.

Then we come to the creditors within the US economy (see graphic here). Just over 60% of US government debt is held by the Federal Reserve and 'intragovernmental holdings', and a further 6.2% held by state and local governments. We then have the curiosity of the circularity of government taxing other branches of government with seigniorage. All I can say to such an idea is 'Huh?'

Then there are the other domestic holders of US government debt, such as pension funds, mutual funds and so forth. If they are lending money to the US government, they do so in the interests of their own investors. Just as with overseas lenders, they might reasonably expect a positive real return on their investments, and there is no real block to moving their investments into currencies that might offer such a real return, except habit and a fear of greater risks in overseas investments. The point at which fear of domestic risk is enough to overturn fear of overseas risk and habit is a difficult one to pinpoint, but nevertheless there is such a point - it is just a question of where? Volatility in world markets has served to reinforce fears of overseas investment, but expectations for the US economy, and US government policy, are a factor in the volatility. It would not take much for a panic to commence.

To put this into context, China is once again pulling back on investments in treasuries:

China reduced its holdings of U.S. Treasury debt in May as total foreign holdings of government debt posted a slight increase.

China's holdings fell by $32.5 billion to $867.7 billion, the Treasury reported Friday.

There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage:

The US Federal Reserve has already pumped some $1.2 trillion (£780bn) into the US economy to try to promote recovery.

The continued fall in prices will add to pressure on the central bank to take further unconventional measures to push inflation into positive territory.

These measures may include increasing the money supply via further quantitative easing or intervening in the US government bond markets to hold down long-term interest rates.

In recently released minutes from the Fed's June meeting, policymakers raised the possibility of further action later this year, if the economy slows down further.

For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy. The first impact will be that the demand for US dollars will fall, and with it the value of the $US. This will, of itself, be an inflationary impetus, as all imported goods, services and commodities will increase in price. The second impact will be that, the resources which were formerly entering the US economy (as a result of overseas credit) will no longer be available within the economy. You then have a situation within the economy of a greater supply of money, and less resources available within the economy.

As an offsetting factor, the supply of credit within the economy may be contracting at the same time, due to a wider reluctance of overseas creditors to provide credit in the US economy, except at interest rates that might offset the devaluation of the $US. However, that reluctance will further fuel inflation by reducing demand for $US for private lending into the US economy (further devaluation), and by increasing the cost of credit more broadly within the economy.

All of this will take place whilst the US economy is working under a burden of the existing debt, meaning that a proportion of internally generated resource will be needed to service the existing overseas debt. Even if the size of the debt is being diminished by inflation, there will still need to be an extraction of that internally generated resource to provide payments for overseas debts, and that will be proportional to the level of inflation. The relationship is this; the more resources going to overseas, the higher the inflation in the economy, the higher the inflation in the economy the less resource will be extracted to overseas. Whichever way it is regarded, it is an inflationary impetus - at least until the debt is repaid.

Now let's add in the private domestic investors in government debt. If they start to worry about achieving such poor returns on government debt, they may overcome their fear of overseas investments. In this case, we have an additional problem of capital flight. US dollars will appear in larger numbers on the currency markets, and further depress the $US, and this will provide a further pressure for devaluation of the $US. Likewise, private investment overseas will appear more attractive, depressing investment in private businesses, which will already be suffering from the withdrawal of the use of overseas resource in the economy, due to the lack of credit being provided to the US government. In other words, there will not be credit available to expand the resource generated within the US economy, and make up for the shortfall of resource that was previously provided from overseas.

The only answer for the government is to print yet more money, which will short term ameliorate the problems, but will medium term just heighten the problems. The problem is that it is only possible to go so far with massive deficits and printing money. The US economy is currently reliant on a combination of habit and fear, the 'safe haven' effect, and the inherently unstable 'Chimerica' system.

Krugman is right that there is a limit. The key point in his analysis is he has accepted something close to my own analysis, that money must relate to the provision of privately provided 'resource'. In other words, he seems to accept one of the key arguments of this blog; which is that abstracting money from real goods and services is delusional. In so doing, he is accepting that, in the long term, currency valuations and wealth must be determined by output within an economy. He simply fails to see that, in a world of mobile capital, that there is no such thing as domestic policy acting in isolation. As long as investors have choice, they will seek the best or safest returns.

Real negative interest rates for investors are the danger for economies indulging in deficit spending and money printing, as investors will only accept these up to a point. Words like 'safe haven' and 'reserve currency' are evaluations, and evaluations might change. I recall some time back, an analyst suggested that the $US was nitroglycerin, and we are seeing the US government packing ever more explosive under their currency. In reality, the $US has been nitroglycerin for a long time. It seems that it has just taken more of the explosive to be added for analysts to realise the dangers. Who knows, perhaps even Krugman might get there?

Note 1:

I have been noting that there has been ever more widespread talk about a Chinese property bubble, and this was something I discussed in July of 2008. I can not find an article that mentions this, but I have recently read about the problem of investors keeping apartments empty, and this reminded me of one of my first commentaries on China. I went back to the original article, and found this:

My essay was focused just on the UK and one of the assumptions was that the UK was going to suffer more than any other economy in the current downturn. I knew that the US was going to hurt, and hurt badly. However, the US economy has greater flexibility than the UK, and I therefore expect the pain to be shorter lived, albeit it will still be very bad indeed. I believed Germany and France would hurt, but not too badly. For Italy, I believe that they will suffer very badly indeed. They no longer have the freedom to use their currency to save their economy, and many of their businesses are facing tough competition from the emerging economies. They lack the flexibility or will to rise to this challenge, and will need a crisis before they can even think of rebuilding their economy.

As for Spain, this country was largely off my radar. I was aware that their economic growth was largely built on construction. However, I did not realise how reliant. I read an article in the Telegraph which suggests that Spain may be a candidate for the hardest hit in the current turmoil. It seems that they have allowed a property and construction bubble to rage out of control, and the popping of the bubble will be catastrophic.

Japan I will leave for one side, as I plan to talk about it more at a later date. I also plan to discuss China at a later date, but will just mention a couple of points for the moment. The first point is that it is quite possible that China has a construction bubble. Whilst I was in China I noted that there were lots of apartment blocks being built, and that it was very popular for these to be purchased by investors. In many cases the investors were leaving the apartments empty (Chinese people like to buy property brand new, once it has been lived in the value falls), and they were holding on to the apartments in an expectation of increases in value. In addition to this there has been a boom in the construction of shopping malls, and I noted that they were already (back in January) starting to exceed demand. If the Chinese economy is pulled back due to world demand for exports dropping, it is likely that such investments will lead to a bust. It is also worth considering the state of the Chinese banks. If they are lending into construction in this way, will there be a repeat of the previous Chinese bad lending problems of a few years ago? What other bad lending is buried in their books?

Set against this is that the finances of the Chinese government are very healthy, as are the levels of savings in China. The real question with China is how much their continued growth is reliant on exports, and how much growth can be sustained within China. I will readily admit that I am not sure on this at all. I am not sure that anyone is. My best guess is that China will also hurt, and hurt badly, with a significant potential for civil unrest as a result.
I was wrong about the US, whose policy has gone in the opposite direction to that which I expected. As for the other points, I think I have mostly been right (but missed Greece entirely). With regards to China, I elaborated in the promised later post (again July, 2008) with the following:

So where does this leave the economic future of China? Where would I place my bet? Would it be on ongoing growth, recession and instability, or what outcome? The honest answer is that I would not place the bet at all but, with a gun to my head forcing me to to make the bet, I would choose continued economic growth, albeit at a slower pace than before.
However, I should also mention that I expected a $US collapse a long, long time ago, and was absolutely wrong (the optimism expressed in the first post quoted above rapidly dissipated in the face of actual US policy responses). However, the reason I gave for the problems with the $US are exactly the reasons that analysts are now discussing. As for Japan, I struggled for a long time to 'get' Japan, and never delivered on the article. Perhaps some time in the I think I do now have a rough handle on the Japanese economy.

(1) HSBC Global Research, July 2010, Currency Outlook.


  1. article mentioning the 65M empty homes:

  2. This sounds very like the climate change deniers. Jump on a set of words that sound appealling from your point of view and ignore the context.

    Governments should not 'print money'. That is a classical economic myth, resulting in a financial operation that gets nobody anywhere because banks don't work in the way central bankers think they do.

    (Banks lend to people who are good bets - everybody who is a good bet. The problem is that there are little or no good bets at the moment. Reserve pushing is pushing on string).

    What the government needs to do is directly purchase aggregate demand that is not required by the private sector - ie the real resources that would otherwise be lost to the economy as an 'opportunity cost'.

    The US$ would not collapse for the same reason that the Yen hasn't collapsed for 20 years. The analysis you are doing is fundamentally flawed and the real world doesn't work like that.

    "For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy"

    Once again you are driving from the financial not the real. Treasuries are bought with dollars that are ultimately 'appropriated' from the US. You can't get dollars from anywhere else (ultimately) other than the Federal Reserve.

    To get those dollars in the first place a boat load of stuff or service must have already been sold to the Americans. The transaction in treasuries is just people trying to get the best return on dollars. If they stop buying treasuries they have to do something else with their dollars to get a return.

    The only way to get rid of those dollars is to buying something real from the Americans, who will then, ultimately, pay those dollars back the Fed in the form of taxes.

    So the foreigners have no choice with dollars other than to buy something American. That's the deal when you export real stuff to other countries.

  3. "For the moment, lets play with the scenario that just overseas creditors stop the purchases of treasuries, and that the 'resources' of these overseas lenders will not be available in the US economy."

    That is fundamentally flawed.

    Firstly the Fed doesn't have to borrow. It has infinite financial capacity in the fiat currency and can purchase all treasuries for cancellation at any time. So if there is a overhang, they can easily be eliminated in all cases and the yield can be managed.

    Secondly think what it is 'borrowing'. It is borrowing dollars which by definition are issued by the Fed in the first place. There is nothing new created or obtained here. All you are doing is swapping a non return asset (US dollars) for a return asset (US treasuries).

    Those 'Eurodollars' come about from imports into the US. Those would have to drop substantially before anything changed. In which case the Chinese and lots of other countries suddenly have a big problem.

    At macro level somebody's output is always somebody else's input. Analysing in isolation causes the 'fallacy of composition' that is demonstrated here.

    And that is why 'export led recovery' in this global collapse is simply not going to work.

    The US economy and all economies are limited only by their real productive capacity. With a fiat currency the government should really be concentrating on providing enough money in the right places to ensure that productive capacity isn't lost to 'opportunity cost'.

    The key question is how do you construct a policy framework that allows that to happen automatically without requiring 'Wisdom of Solomon' decisions from politicians.

  4. Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs

    Unfortunately, this is all a waste of time. Krugman is utterly wrong (as you are) in accusing James K. Galbraith of believing that “deficits are never a problem.” In fact, Modern Monetary Theory says that, even though deficits are not “financially” constrained, they face real constraints in available resources, capacity utilization, the unemployment level, the exchange rate, the external balance, and inflation rate.

    It is quite clear that James K. Galbraith also believes this, as I show here:

    If these creditors believe that seigniorage will result in inflation, a tax on their holdings of $US, they will start to find better investments, unless the interest rate offered exceeds the seigniorage

    Your assumption is that deficits spending will cause significant inflation. The US is experiencing deflationary pressures, so there is little reason to believe that continued deficits will do anything expect keep inflation low to moderate in the short term (between 1% and 4%) – i.e., much where the inflation rate was between 2000 and 2006. If investors are really concerned about inflation like that, then why didn’t they flee the US then?

    There is increasing speculation that the Federal Reserve is about to restart the printing presses, and this will only serve to undermine confidence in the $US, as this means more seigniorage

    When QE began in 2009, how many people were predicting hyperinflation? And where is it now? The US got deflation in 2009 despite the QE, and inflation is falling yet again.

    These tiresome predictions of hyperinflation are utterly embarrassing.

    The $1.2 trillion of QE plus the deficit spending just sent the inflation rate to 2.7% in early 2010 but then the inflation rate fell again to 1.1%.

    If the US slips back into deflation (which it appears to be doing), the US has plenty more room for large stimulative deficits.

    As for the prediction that the US dollar will collapse in 6 months time (and that presumably the US dollar will collapse as the global reserve currency too), I expect this prediction will be as embarrassingly wrong as the prediction that hyperinflation was 100% certain in 2009.

  5. Both Krugman and Cyncius rely on the flawed quantity theory of money, see here on why it is wrong:

  6. Those of us who look at collapse dynamics and the like are getting worried. Tipping points and all that.

  7. Galbraith Responds to Krugman:

    It is quite clear Krugman has misrepresented Galbraith. Modern Monetary Theory has always said there are real limits to deficit spending. Galbraith says:

    I wrote — correctly and deliberately — that bankruptcy, insolvency and high real interest rates were not risks. Inflation *is* a risk. By this, to be clear, I mean an ordinary garden-variety increase in the inflation rate is a risk — not the *infinite-inflation* scenario.

    Galbraith also notes the flawed nature of the quantity theory.
    Cyncius’ complaint about seigniorage or the inflationary taxation is all based on a flawed quantity theory of money, which is false as I have shown here.

    Cynicus also states:

    Krugman is responding to Jamie Galbraith, who appears to believe that money printing and deficit spending can resolve all ills (a regular commentator on the blog appears to hold similar beliefs).

    But Galbraith and the Modern Monetary Theorists like Bill Mitchell have never said that “deficits are never a problem,” and have always stated that there are real limits to government spending. Moreover, Post Keynesians, Old Institutionalists (like Galbraith) and Modern Monetary Theorists have ALL said that the establishment of new effective financial regulation is also a fundamental policy requirement now, as well as develeraging and reduction of excessive private debt. Addressing trade imbalances is also an issue in Post Keynesianism. So accusing them of believing that “deficit spending can resolve all ills” is nonsense.
    Setting up a straw man like this and knocking it down is easy, but utterly pointless.

  8. Lord Keynes,

    Cynicus has a difference of opinion to you, however it is you who is wrong. Unfortunately for us, you can only be proven wrong when it is too late, whilst we would rather not get to that point.

    Common sense, to spend what you earn also applies to governments, whilst your policies of endless borrowing and spending and printing/creation of money do reach an unsustainable irreversible level. You Keynesians can never define the point where austerity is required to prevent further increase in debt yet alone ever the need to repay it back.

  9. To be fair to Lord Keynes I believe he did put on record on this blog in response to my questioning that he considered the limit of govt spending as a percentage of GDP to lie somewhere in the 80-120% range. As we are currently at around 62%, and rising rapidly, we will soon I suspect enter that danger zone. Once we do I assume Lord Keynes will stop calling for increased public debt issuance in order to stimulate the economy. I await this with bated breath..............


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