Paul Krugman: Debt and Denial

Paul Krugman is worried that Ben Bernanke has inherited a difficult set of economic conditions due to ballooning trade and budget deficits, housing bubble zones, and denial among economic agents creating these conditions. Because of this, Krugman is worried about a hard-landing outcome for the U.S. economy. I have more faith in the soft landing scenario than he does, but perhaps that's wishful thinking or denial on my part. In any case, this time I hope Krugman is wrong:

Debt and Denial, Commentary, by Paul Krugman, NY Times: Last year America spent 57 percent more than it earned on world markets. That is, our imports were 57 percent larger than our exports. How did we manage to live so far beyond our means? By running up debts to Japan, China and Middle Eastern oil producers. ... Sometimes large-scale foreign borrowing makes sense. ... But this time our overseas borrowing isn't financing an investment boom: ... business investment is actually low by historical standards. Instead, we're using borrowed money to build houses, buy consumer goods and, of course, finance the federal budget deficit.

In 2005 spending on home construction as a percentage of G.D.P. reached its highest level in more than 50 years. People who already own houses are treating them like A.T.M.'s, converting home equity into spending money: last year the personal savings rate fell below zero for the first time since 1933. And it's a sign of our degraded fiscal state that the Bush administration actually boasted about a 2005 budget deficit of more than $300 billion, because it was a bit lower than the 2004 deficit.

It all sounds unsustainable. And it is. Some people insist that the U.S. economy has hidden savings that official statistics fail to capture. I won't go into the technical debate about these claims ... except to say that the more closely one looks at the facts, the less plausible the "don't worry, be happy" hypothesis looks.

Denial takes a more systematic form within the federal government... Last week Mr. Cheney announced that a newly created division within the Treasury Department would show that tax cuts increase, not reduce, federal revenue. That's the Bush-Cheney way: decide on your conclusions first, then demand that analysts produce evidence supporting those conclusions.

But serious analysts know that America's borrowing binge is unsustainable. ... So how bad will it be? It depends on how the binge ends. If it tapers off gradually, the U.S. economy will be able to shift workers out of sectors that have benefited from the housing boom and ... into sectors that produce exports or replace imports. Given time, we could bring the trade deficit down and bring housing back to earth without a net loss in jobs.

In practice, however, a "soft landing" looks unlikely, because too many economic players have unrealistic expectations. This is true of international investors, who are still snapping up U.S. bonds ... seemingly oblivious both to the budget deficit and to the consensus view ... that the dollar will eventually have to fall 30 percent or more to eliminate the trade deficit.

It's equally true of American home buyers. Most Americans live in regions where housing remains affordable. But ... most of the rise in housing values has taken place in a "bubble zone" along the coasts, where housing prices have risen far more than the economic fundamentals warrant. ... houses in the bubble zone are overvalued by between 35 and 40 percent, creating trillions of dollars of illusory wealth.

So it seems all too likely that America's borrowing binge will end with a bang, not a whimper, that spending will suddenly drop off as both the bond market and the housing market experience rude awakenings. If that happens, the economic consequences will be ugly. All in all, Alan Greenspan, who helped create this situation, can consider himself lucky that he's safely out of office, giving briefings to hedge fund managers at $250,000 a pop. And his successor may be in for a rough ride. Best wishes and good luck, Ben; you may need it.

Previous (2/10) column: Paul Krugman:  The Vanishing Future
Next (2/20) Column: Paul Krugman: The Mensch Gap