In-depth analysis on Credit Writedowns Pro.

Krugman, Tabarrok, Cowen and the bond vigilante fallacy

I don’t expect any response from Paul Krugman, Alex Tabarrok or Tyler Cowen on this but they know who I am and read my articles from time to time. I am going to add my voice to a debate they have been having in the blogosphere on debt, deficits and bond vigilantes. It goes like this (emphasis added):

One question that keeps coming up is, how can I reconcile my scorn for warnings about bond vigilantes with what is happening to Italy? This seems especially pointed because I have in the past used Italy’s ability to carry debt exceeding its GDP as an illustration that debt concerns were overblown.

The answer lies in the concept of original sin. Not the Pope’s kind, but the economics kind — the long-standing notion that developing countries were especially vulnerable to financial crises because they borrowed in foreign currency. (Yes, the linked paper actually raises some distinctions between currency mismatch and original sin; never mind for now).

The key point is that by joining the euro, Italy took a bite of the apple — it converted its advanced-country status, as a nation issuing debt in its own currency, into original sin, with debts in someone else’s currency (Europe’s in principle, Germany’s in practice). That is the root of its new vulnerability.

More on all this later, I hope.

-Paul Krugman, November 2011

Then it went here on New year’s in a post I linked to just yesterday:

Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing. They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments.

This is, however, a really bad analogy in at least two ways.

-Paul Krugman, 1 Jan 2012

Afterwards, Alex Tabarrok caught a shift in position and said so:

Now to be fair, Krugman covered himself in 2003 in a credible way he said “unless we slide into Japanese-style deflation, there are much higher interest rates in our future.” Thus, I do not fault Krugman’s forecasting ability. What I do fault is that despite a 180 degree about-face, one thing remains constant in all of Krugman’s writings, anyone who disagrees with him is portrayed as a mendacious idiot. In truth, Heritage today and Krugman 2003 both have legitimate concerns about the long-term debt situation of the United States and it would have been to the credit of Krugman 2012 had he acknowledged that point more fairly.

-Alex Tabarrok, Yesterday

Paul Krugman responded (emphasis added again):

the Bushies were pushing permanent tax cuts that had nothing to do with economic stimulus, and did so at a time of war with no offsetting spending cuts (and then pushed through an unfunded expansion of Medicare too). This struck me at the time as banana-republic behavior, and still does.

bond investors discounted the politics, and acted as if they believed that America would eventually pull itself together and start behaving responsibly. The jury’s still out on that, but clearly my short-run prediction proved wrong.

-Paul Krugman, Yesterday (recounting a post from 2010)

At which point, Tyler Cowen stepped in:

The reality is that neither the early nor the more recent Krugman is especially convincing on debt, and if anything the conjunction between the two shows that switching sides isn’t quite the same thing as changing your mind. The odds are that government spending cuts are not literally budget balance destroyers on net. How about writing a NYRB essay that lays out the short-run negative output gradient to austerity, presents why austerity is considered a serious option nonetheless, discusses catch-up and bounce back effects and their relevant time horizons, analyzes what kinds of policies are actually possible in a 17 (27) nation collective, engages with the best public choice arguments (including Buchanan and Wagner) on a serious level, ponders the merits and demerits of worst case thinking, and ruminates on the nature of leadership in a way which shows some tussling with Thucydides and Churchill? Surely that is within Krugman’s capabilities and if it still comes out Keynesian or left-wing, great, at least someone will have seen those arguments through. Such an essay would stand a far greater chance of influencing me, or other serious readers, or for that matter President Obama. We should hold Krugman to the very high standard of actually expecting that he produce such work. Not many others are capable of it.

-Tyler Cowen, Today

You are all out of paradigm, just as you were on Italy this summer. It’s not about interest rates, but rather the currency and inflation. To Paul Krugman’s credit, he is steadily moving to a more nuanced position on this issue because Krugman gets it on currency sovereignty. My clue from Krugman was the passage I quoted from the piece on New Year’s talking about how government faces different debt constraints than families do. For those who point out this fallacy, this is code for "families are currency users and sovereign governments are currency creators." Krugman doesn’t come out and say that, but it is crystal clear to me that’s what he is saying.

Here’s the paragraph I highlighted in my links post that makes this plain:

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

For sovereigns with debt in their own fiat currency, there is not the operational constraint that families face. After all, they can go to the backyard and just pick some bills off their money tree – something we can’t do unless we want to go to jail. Italy can’t do that either.

I suggest you read "More thoughts on out of control deficit spending" from last March. Here are the takeaways:

  1. "fiat money makes sovereign default less relevant but currency depreciation and inflation more relevant. And, no, a weaker currency and inflation do not equal default even if it feels like theft."
  2. "Government can default on a fiat currency obligation. Doing so is a political decision not an economic one. The government can always make good on a claim in the money it has created if it chooses to do so. (See Russia, sovereign debt defaults, and fiat currency)."
  3. "The question then is about political choices, resource allocation, currency depreciation and inflation. For example, in the U.S. there has been a lot of discussion about ‘starving the beast’ by shutting down the government until spending is brought to heel. This is an entirely political debate based on choices about the size of government and resource allocation in the economy. It has nothing to do with affordability. I think this kind of brinkmanship is reckless and deeply irresponsible. This is not the way you would see these issues debated in Switzerland or Germany for example. For bondholders, the political risk of potential default in the U.S. is real in a way they are not in those other two countries. There is a real possibility the U.S. could default. For that reason alone, the U.S. doesn’t deserve a AAA bond rating. (See Bill Gross: Deficit Hawk, Bond Vigilante)."
  4. "we must always keep in mind the accounting identity which shows that government deficits are exactly equal to non-government sector surpluses. That is to say, in an open economy like the U.S., the private sector balance plus the current account balance is exactly offset by the government sector’s balance. Any movement in one balance necessarily moves the others."
  5. "budget deficits are the result of an ex-post accounting identity. In plain English that means the policy prescriptions are the economic input and the deficit is the output. Focus on the policy and policy goals, not deficits."

One last point:

"As a result of the two great wars in the 20th century, the UK’s national debt soared such that by the end of World War II, public net debt was well over 200% of GDP. In the period after this, despite the modified gold standard of the Bretton Woods system, the UK was able to work these debt levels down to well under 50% of GDP.

How did the British do it? It was mostly through a combination of currency depreciation and inflation. 100 pounds in 1945 are worth approximately 3200 pounds in today’s money."

That’s where this is headed.

My takeaway from the historical account is that financial repression works — that the British central bank was able to work down a mountainous debt load under a modified gold standard system through repression and not default. The bond vigilantes don’t have the powers you think they do. The currency is the relief valve, not interest rates.

On what Tyler Cowen says about the euro zone and deficits, the argument I made about Willem Buiter’s comments apply here as well:

the demand threat is not tied to fiscal policy at all. The demand threat is about debt deflation dynamics, which could emanate from any significant demand shock, particularly large bank insolvencies. The empirical evidence for this certainly comes from the fiscal path in 2009 when bank distress opened up deficits across the developed economies. The same dynamics were at play in the Great Depression and would occur if a large national government defaulted on its sovereign debt. Moreover, because of the risk of credit availability and demand collapsing in countries with the weakest banking systems like Spain, I believe deficits there will increase – at least in the short-term (unless the cuts are deep enough to overcome the negative shock to house prices, bank balance sheets and credit). This is indeed what has happened in Greece when the spectre of national government insolvency caused capital flight and killed credit availability. Irrespective, time will be the arbiter. Moreover, over the medium-term, absent debt deflation dynamics, cuts will yield results if they are politically sustainable. This is a big if.

Spain is where the action has been most recently since they missed targets and are re-doubling efforts. When it comes to the periphery, I predict "all of these countries are likely to miss their targets. And then the Troika ‘occupations’ will commence" or the euro zone will fall apart. All eyes should be on Ireland since they are considered the model for euro zone austerity. If it doesn’t work there, it won’t work.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

7 Comments

  1. An excellent contribution to the debate! And your tone is so much more civil!

    I think Krugman resists admitting he understands MMT because he’s afraid of what it’ll do to his beltway cred. 

    But using the term “financial repression”, in the context of todays reality of people facing real jobs anxiety, income decline, unemployment, homelessness and destitution, say in Greece or here, due to “Deficit Attention Disorder” really does sound like a bunch or rich kids kvetching about daddy not letting them buy a Porsche. 

  2. Pensive says:

     I agree…great post..very cerebral and medium to long term. Thats where you excell . You do not excell in trading calls or marginable risk. Promote yourself to government and “cost center” brokerage macro. You call the trading game from the bench…not the line of scrimmage. If you could….thats what you would be doing now. Will contribute to your site…

  3. Dave Holden says:

    In my roles as rube there are several things I don’t understand about this discussion.

    Given the risk of currency depreciation why is anyone buying UK debt?

    Given that the cause of this crisis is not in the first instance government debt but private debt isn’t inflation counterproductive unless it comes with wage inflation?

    I’ve read some interesting discussions on this (particularly Nick Rowe at worthwhile Canadian blog), however I think you are absolutely right in saying “focus should be on policy and the policy goals”, but as Karl Denninger points out in his inimitable way http://market-ticker.org/akcs-www?singlepost=2830228 and particularly in this graph
    http://market-ticker.org/akcs-www?get_gallerynr=2321 don’t we have 30 years of evidence that we’re not very good at getting ROI of debt based spending.

    • Happy New year, Dave. 

      I’m not sure if you saw the Bruce Bartlett link I posted about how the deficit under accrual accounting terms is an order of magnitude larger than we believe it is. So I agree that we really do need to make some cuts, ones which special interests don’t want (defense, public pensions, public pensioner healthcare). I don’t think the US can make these cuts until the whole thing gets on top of it in terms of inflation and currency depreciation. If you recall, the UK eventually had to cap in hand to the IMF in the 1970s before the whole inflationary and currency depreciation episode was over. So, the policy space that currency sovereignty gives is a double edged sword.

      As for why anyone buys UK debt, if you’re British-based why wouldn’t you? No currency risk. To buy Canadian or Norwegian or German debt instead means an added layer of risk that may not be warranted. Moreover, the whole thing is somewhat self-equilibriating as the more people that do this, the more attractive British assets become and the easier it is for Britain to export. Eventually the depreciation stops and buyers come back at that level.

      • Dave Holden says:

        Happy New Year! Edward.

        No, I’ll check out the Barlett link – I’ve just had the proverbial scared out of me by Steve Keen’s look at the UK finances http://www.debtdeflation.com/blogs/2011/12/31/debt-britannia/

        “So, the policy space that currency sovereignty gives is a double edged sword.”

        Agreed, somewhat understandably, politicians rarely make hard choices unless they have to.

        Thanks for the explanation of UK debt – it makes sense but I think I need to mull it over.

  4. David Nowakowski says:

    Foreigners can also buy US or UK debt, even if they expect dollars or pounds to depreciate. The key is to hedge the FX risk. If the bonds make money, you unwind your trade and take the (depreciated, but still positive) profits back home.

    Also, Martin Wolf had a good, thorough explanation of your point #4, that many find it hard to understand, despite Richard Koo and a few others’ efforts.

    http://blogs.ft.com/martin-wolf-exchange/2011/12/05/understanding-sectoral-balances-for-the-uk/#axzz1fa1uxaUF