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Saturday, July 17, 2010

Is Galbraith Right that Deficits are Never a Problem?

Paul Krugman has a "wonkish" post on deficits rebutting Jamie Galraith's contention that deficits are never a problem. Jamie's reply follows the excerpts from Krugman's post:

I Would Do Anything For Stimulus, But I Won’t Do That (Wonkish), by Paul Krugman: It’s really not relevant to current policy debates, but there’s an issue that’s been nagging at me, so I thought I’d write it up.

Right now, the real policy debate is whether we need fiscal austerity even with the economy deeply depressed. Obviously, I’m very much opposed — my view is that running deficits now is entirely appropriate.

But here’s the thing: there’s a school of thought which says that deficits are never a problem, as long as a country can issue its own currency. The most prominent advocate of this view is probably Jamie Galbraith, but he’s not alone.

Now, Jamie and I are, I think, in complete agreement about what we should be doing now. So we’re talking theory, not practice. But I can’t go along with his view that

So long as U.S. banks are required to accept U.S. government checks — which is to say so long as the Republic exists — then the government can and does spend without borrowing, if it chooses to do so … Insolvency, bankruptcy, or even higher real interest rates are not among the actual risks to this system.

OK, I don’t think that’s right. To spend, the government must persuade the private sector to release real resources. It can do this by collecting taxes, borrowing, or collecting seignorage by printing money. And there are limits to all three. Even a country with its own fiat currency can go bankrupt, if it tries hard enough.

How does that work? A bit of modeling under the fold. ...[see original post for model]...

[L]et’s ask what happens if the government has run up enough debt that the upper limit on the primary surplus is a binding constraint, and it’s necessary to run the printing presses to make up the difference. In that case,... the higher the debt burden, the higher the required rate of inflation — and, crucially,... inflation heads off to infinity. ...

So there is a maximum level of debt you can handle. In practice,... at some point ... the government would decide that default was a better option than hyperinflation. ... So there are real limits to deficits, even in countries that can print their own currency.

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.

Here is Jamie's reply which will appear in comments under the original post once it's approved (it's not there yet or I'd provide the link):

Paul's argument is that *infinite* inflation is a theoretical possibility. Well, yes. It happened in Germany in 1923.
There is no reason to cut Social Security benefits or Medicare now, with effect in the future, in order to avoid the theoretical possibility that some combination of policies might at some time in the future give us the economic conditions of post World War I Germany.
Those conditions were desperately resource-constrained.
In the actual world we live in, government does not have to \"persuade the private sector to release real resources.\" In the actual world, the private sector has already released those resources by the tens of millions of people.
All the government has to do, in the actual world, is mobilize those resources, which it does by issuing checks, preferably to pay people to do useful things.
There is no reason why this should be considered "costly." Done correctly, in economic terms it amounts simply to the reduction of the waste that is associated with unemployment.
Nor is it necessary, when the government issues a check, that it issue a bond to "borrow" the money behind that check. The check creates money in the first place. (Yes, it does this from thin air, by changing numbers in bank accounts.)
Operationally, this is a free reserve in the banking system. The reason the government issues a bond later, is that the banks like to have a higher rate of interest than they can earn on reserves, and the government likes to oblige them.
This is why Treasury auctions don't fail: the government has already created the demand for the bonds, by issuing checks to the banking system.
If the government spent but declined to "borrow," what would happen?
Nothing much. Banks would hold their reserves as cash rather than bonds, and their earnings would be a bit lower. It is *not* true, as a rule, that people (or banks) move readily to substitute lumps of coal for dollars, unless the price level is already moving up and out of control.
It is very difficult to get other people to accept coal in place of dollars!
Paul's logical error here is that of assuming-the-consequent. He assumes the inflation which causes dumping of money. But if there is no dumping of money, the inflation will not generally occur.
Yes, again, it's technically possible that the banks and others would start dumping dollars and buying up oil, wheat, rubber, and so forth (and leasing storage facilities for the stuff) thereby driving up the price level.
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.
Inflation, though unattractive, is not remotely comparable to bankruptcy or insolvency, unless you get to Paul's *infinite* inflation scenario. So what about that?

In his model, it is driven by his monetarist (quantity-theory) simplification, that the increase in money flows directly into prices.

But this is just a modeling error. In the real world, especially in broadly deflationary conditions, people -- and banks -- simply hang on to cash. There is a Paul Krugman who understands this, from close study over many years of the Japanese stagnation.
However, and again, in the present state of the world economy, and for the foreseeable future -- and except for the energy sector -- surely a small rise in the inflation rate is a trivial risk.
My position is that the government should focus on real problems: unemployment, care for the aging, energy, climate change, and the disaster in the Gulf of Mexico.

The so-called long-term deficit is not a real problem. And the capital markets demonstrate every day that they agree with this judgment, by buying long-term Treasury bonds for historically-low interest rates.

I'll keep an eye out for a response from Paul Krugman, and will post it if he does reply. My view is that the debt load does matter at some point, but we are not at the point where it constrains our ability to help an economy struggling to recover from a severe recession.

Update: Paul Krugman responds:

More On Deficit Limits, by Paul Krugman: Jamie Galbraith responded to this post in comments...

My response: there’s no question that right now there is no problem: if the Fed issues money, it will in fact just sit there. That’s what happens when you’re in a liquidity trap. And there’s also no question that right now, the proposition that the government can “create wealth by printing money”, which some other commenters call absurd, is the simple truth: deficit-financed government spending, paid for with either debt or newly created cash, will put resources that would otherwise be idle to work.

But we won’t always be in this situation — or at least I hope not! Someday the private sector will see enough opportunities to want to invest its savings in plant and equipment, not leave them sitting idle, and the economy will return to more or less full employment without needing deficit spending to keep it there. At that point, money that the government prints won’t just sit there, it will feed inflation, and the government will indeed need to persuade the private sector to make resources available for government use.

And that’s why I don’t accept the idea that deficits are never a problem.

Again, as a practical matter I don’t think we have a disagreement: right now we’re in a world where deficits really, truly don’t matter. And at the rate we’re going, it seems unlikely that we’ll have to worry about policy choices near full employment until, oh, late in Sarah Palin’s second term.

Update: Jamie Galbraith:

Paul, thanks for this response.

Let's first notice that the concerns about national bankruptcy, hyperinflation and so forth that characterized your first post have now disappeared.

At this point, we agree on the (fairly trivial, and highly remote) thesis that at full employment, a higher rate of (garden-variety) inflation can be a problem.

And we agree that this thesis is both trivial and highly remote.

However, there still remains an important question.

Should we, or should we not, act *today* to cut *projected* deficits at some future date?

For instance, by cutting Social Security and Medicare?

I say no.

I say there is absolutely no economic reason to enact future cuts in these vital programs.

I say that the economic forecasts of vast deficits and high interest rates *after* the return of full employment are implausible and internally inconsistent, for reasons given in my testimony to the deficit commission, and elsewhere.

I say that good policies cannot be based on bad forecasts, that we should solve the unemployment problem first, and that when we have done so, the most likely thing is that tax revenues will rise and the deficit forecasts will be proven wrong.

This is what happened in the late 1990s. Why should we think it wouldn't happen again?

Paul, I challenge you to drop the long-term deficit argument entirely
-- it will be used in a few months, in a dishonest way by unscrupulous people, to support cuts in Social Security and Medicare that cannot be justified by economic logic. These are cuts which, I am sure, you will oppose when they are proposed.

Don't set yourself up.

    Posted by on Saturday, July 17, 2010 at 01:17 PM in Economics | Permalink  Comments (151)


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