Back in February, amidst the neo-Keynesian rage to spend our way out of recession, I argued that stimulus wouldn’t stimulate. Pointing to the graph of the 10-year Treasury vs. 30-year mortgage rates I said that the government wouldn’t be able to flood the market with Treasurys without driving up interest rates. Higher rates on government debt imply higher rates for mortgages, which would hammer house prices and blow an ever-larger hole in bank balance sheets.
The Fed knows long-term rates can’t be allowed to rise because that would run their economic “recovery” off the rails. Enter “quantitative easing,” the policy by which the Fed prints money to buy fixed-income securities like Treasurys and MBS. By printing money to inflate demand, they hope to hold interest rates down.
Sounds great, right? Why can’t the Fed just keep printing money to buy bonds in order to hold interest rates artificially low?
Because bond investors call bullsh*t. As the Fed prints money, inflation expectations rise. When investors anticipate higher future inflation they demand higher interest rates to buy debt. After all, they don’t want to hold fixed-income securities when fixed-incomes lose their purchasing power to inflation.
And so we have a great game of chicken between the Fed and the bond market. The Fed prints money to keep interest rates down while bond investors zip tight their wallets because Fed printing makes bonds less appealing. What is the Fed going to do, become the lender of last resort to the federal government? Print whatever cash is necessary to literally displace vanishing private demand for government debt? This is no solution of course; in the long-run it implies hyperinflation.
And so we return to the question Keynesians like Krugman simply wouldn’t address when advocating government “stimulus”: how do we pay for it? If we run up additional debts without making some provision to pay them, then in long-run interest rates have to rise.
You could raise taxes to pay down debt, but that would destroy the positive impact of additional government spending.
The point is there’s no way to financially engineer our way out of this crisis.
Economists love the idea that the Fed is all powerful, that it has some magic wand to wave which can rescue Americans from debt deflation. I suspect this is because, deep down, they harbor ambitions to be Fed Chairman themselves. For most economists, the Fed’s printing press is the ultimate toy….one they’ve always wanted to play with.
And it is a powerful one. Most recessions are easily “solved” because the Fed can always use that printing press to inflate a credit bubble, to inflate demand artificially. This works great until it doesn’t. Eventually the credit bubble becomes so big it’s simply impossible to sustain with more printing.
I suspect this is why Keynesians never bothered asking how we’d pay for stimulus. The answer—”we can’t”—shatters their economic theories.
Krugman offers a rebuttal to this argument in his column today. He argues that inflation isn’t a big issue right now. And he’s right: deflation is the real threat. He argues that Fed printing is necessary to counteract it, but he misses the larger point that, in the long-run, higher government debts imply higher interest rates regardless of what the Fed does. Debt is not a static thing. It has to be rolled over, paid down or repudiated (via default). In ascending order of economic violence, each of these implies a debt deflationary depression.
Outright default isn’t an option. Imagine the worldwide economic calamity if Tim Geithner stops making interest payments on Treasurys…
Paying down debt means running surpluses. To do so would require draconian cutbacks in spending by indebted governments, corporations and individuals. Aggregate demand would collapse, leading to depression.
Both of the above are unappealing so the Fed conspires with government to inflate aggregate demand with more borrowing. But more borrowing means more debt that has to be paid down later. More debt means bigger future cutbacks. The longer we kick the can down the road, the deeper the depression we’ll be faced with in the “long-run.”
The bottom line is that we have to pay down debt. We’ve no other choice. Yeah, it’s going to be very painful, but we should have thought of that some time over the past generation as we inflated the credit bubble.
I can’t leave this piece without rebutting the conclusion to Krugman’s op-ed:
But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.
Because Republicans lost their fiscal bearings during the Bush years doesn’t mean that budget arithmetic somehow no longer applies. Deep down, Krugman desperately wants to support Democratic ambitions to dramatically increase the size of government. But “Republicans did it so we can too” is not an argument. Paul knows this but, hyper-partisan that he is, he can’t resist getting in the dig. He should know that plenty of independents abhorred runaway government spending under Bush. We were hoping Obama would bring “change” by putting our fiscal house in order.
Needless to say, the president should not let himself be bullied. The economy is still in deep trouble and needs continuing help.
Yes, we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself.
Here, for the first time that I’m aware of, Krugman acknowledges the paradox of his prescription. Spending creates a long-run budget problem! But in calling it a “long-run” problem, he gets to kick the can down the road. Deficits aren’t an issue we have to address now so Democrats shouldn’t let themselves be “bullied” into a policy of spending restraint.
But my goodness: what is the the “groundwork” we should be “laying” to provide a “long-run solution” to this “problem?” Krugman owes his readers an answer to that question.
Originally published at Option ARMageddon and reproduced here with the author’s permission.