Thursday, July 26, 2012

Krugman, Delong and Inflation

Quite a few commenters and correspondents have asked me what I think of the latest blast, "What Chicago Doesn't Know" from Krugman and the obliquely-titled "The need for a higher rate of increase in prices" from Brad DeLong.

Yes, I've been worried for some time that our current debt could lead to inflation. And yes, that inflation has so far not happened, and US government interest rates remain low.

Well, they made fun of Friedman when he said in 1968 that inflation was coming. They made fun of Greenspan when he said in 1996 that stocks seemed awfully high, and stocks went up for a few more years. They made fun of Shiller when he said in 2005 that house prices looked awfully high, and they went up for a few more years. Greek interest rates were really low in 2007.

Krugman asks whether I have realized I have the "wrong model." My model is arithmetic.

The Federal Government has about $15 trillion of formal Federal debt outstanding. It has uncountable trillions more unfunded promises and credit guarantees. Right now it takes in about $1.5 trillion and spends about $3 trillion a year.

We must, by arithmetic, either pay off this debt, default on it, or inflate it away. Which will we do?

I hope we pay it off. The only hope for paying it off is to return promptly to strong long-run growth, and to reform entitlements. Doubling Federal revenues by raising income tax rates on "the rich," or by cutting discretionary spending by more than $1.5 trillion per year, forever, seem unlikely.  That's arithmetic too.

But I'm not optimistic. Growth economics is unanimous: You get such growth only from higher productivity, and from letting new innovative competitors dethrone established interests. That's not where our economy is going. Keynesian stimulus doesn't give 10 or 20 years of sustained growth, even in Krugman's "model." 

Defaulting on the debt means financial catastrophe.* And it doesn't solve the entitlement problem. Bad as our past debts are, our projected deficits are worse. 

I happen to dislike inflation. Krugman and DeLong are all for it. They must have been smoking better weed in the 1970s.  But I notice that lots of people seem to agree with them. So, it seems to me that inflate it away, and print money to pay the bills,  remains a decent possibility. 

That's arithmetic. I wonder which part of arithmetic Krugman would have me abandon.

What Chicago does "know" is scholarship. DeLong cites a transcription from discussion at a long ago conference. Krugman doesn't even bother to have an RA dig up a direct link so he can pretend he's reading anything but DeLong. At Chicago, we take a little time to research what people actually have to say before calling them "numbskulls" on the New York Times' website (Krugman) or less than "half-intelligent" (DeLong).  You know what I think of that. Why you continue to read these guys is a mystery to me.

For those of you  infected with that old-fashioned spirit who want to  read what I really wrote on the subject, let me suggest Inflation and Debt in National Affairs, Understanding Policy in the Great Recession in the European Economic Review, or even an accessible  Wall Street Journal OpEd as a good starting place.

All these sources make it quite clear that I view inflation is a danger, not a forecast. The popping of "bubbles" is hard to predict. We're sitting on an earthquake fault. When or if it goes is anyone's guess.

I also pointed out that inflation can come quickly, as it surprised the Keyensians of the 1970s, and as its quick disappearance surprised them again in the 1980s when the US returned to growth-oriented policies.

You can't repeal arithmetic. That which is unsustainable cannot last.

Update 2: A correspondent reminded me that I forgot the obvious zinger, from Alex Tabarrok.
Paul Krugman (March 11, 2003): …I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits. …we’re looking at a fiscal crisis that will drive interest rates sky-high….But what’s really scary — what makes a fixed-rate mortgage seem like such a good idea — is the looming threat to the federal government’s solvency. …How will the train wreck play itself out? ….my prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt...
See Alex's post for more, including the Krugman response. I'll promise to hammer away at Romney's budgets just as hard, if his promises do not materialize. 

*Update: I was trying to keep it short (for once), and focused on the Krugman/DeLong affair, but a few commenters pointed out that in my own writing I equate inflation and default, that I've argued that Greece should default, and I've argued for forms of debt that make it easier for the US to default. So.. what's this calamity with default?

At issue here is really what our leaders will choose to do. When they have not chosen to grow, so it's down to default or inflation, will they choose default or inflation? Now, though I've been arguing for a Greek default for almost 3 years now, European leaders clearly consider that a "catastrophe." Yesterday's announcement that the ECB will do anything to "save the euro" -- swallowing the trope that sovereign default means the end of the euro -- is essentially an announcement they'll choose inflation over even Greek default. Let alone France. Or Germany. 

Evean a Greek default will not be painless. A large (we need tens of trillions) and unexpected US default will be financially much more chaotic. All those too big to fail banks holding treasuries go under.  The US loses all its "reserve currency" status. It's a big deal.  The Fed is talking about printing money again to buy mortgages because it doesn't like the current once in a century deal on mortgage rates (for those who can get them). Will the Fed really refuse to monetize in a rollover crisis and force the US to default? In my view, not a chance. 

Finally, as I did point out briefly, a default might help Greece, but our big fiscal problem is the looming entitlements not (just) paying off our stock of existing debt. Defaulting on all the debt doesn't solve that problem. And after  a default, the US will have a lot of trouble borrowing, so it will have to pay for entitlements by just printing more money. So the default won't even stop inflation.

All this is a long way down the road, remember. And a return to growth means none of it has to happen.

To Mr. Krugman, we are sailing in smooth waters, nobody has seen an iceberg yet, so it must be safe, so stoke the boilers.  All I am saying is, there are icebergs out there in the middle of the night. Let's distinguish forecasts from risk management.