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Paul Krugman is Dead Wrong: Debt Matters

Interest-Rates / US Debt Jan 09, 2012 - 06:29 AM GMT

By: Money_Morning

Interest-Rates

Best Financial Markets Analysis ArticleShah Gilani writes: Paul Krugman, the Princeton University economics professor, Nobel Prize winner, and regular New York Times op-ed contributor says, "Debt matters, but not that much."

Not only is he off the reservation on this one, but he's completely fallen off his high horse.


In the real world, debt actually matters a lot.

In a Houston Chronicle opinion piece last week, Krugman, riding his horse - whose name might as well be Liberal Conscience - trampled conservatives under the guise of an economics lesson that derided "deficit-worriers" for wrongly seeing "America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments."

According to Krugman, that's a bad analogy and "the way our politicians think about debt is all wrong, and exaggerates the problem's size."

Decide for yourself. Either debt matters a lot, or not that much...

The World According to Paul Krugman
Professor Krugman calls all the conversation in Washington about debt and deficits a "misplaced focus" and says all of the economic experts "on whom much of Congress relies have been repeatedly wrong about the short-run effects of budget deficits."

He derides the fears that deficits will cause interest rates to soar by pointing out that they haven't moved.

What he doesn't say is that they haven't moved because they're not free to move.

The fact is that the U.S. Federal Reserve has corralled the free market in interest rates by knocking short-term rates to almost zero through successive open market operations and extraordinary quantitative easing measures.

Mr. Krugman mocks those waiting for rates to rise and notes that while they wait "rates have dropped to historical lows."

Maybe what he doesn't realize is that the Fed's actions themselves have been nothing short of historical.

The crux of Mr. Krugman's supposition that debt doesn't matter much is based on his bashing of the popular analogy comparing America's debt problems to those of a mortgaged homeowner.

All of which Krugman claims is "a really bad analogy in at least two ways."

He says, "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."

"Second," he says, "an over-borrowed family owes the money to someone else; U.S. debt is, to a large extent, money we owe ourselves."

He goes on to say that the debt from World War II was never repaid and didn't make postwar America poorer.

In fact, the Professor points out, "the debt didn't prevent the postwar generation from experiencing the biggest rise in incomes and living standards in our nation's history."

Krugman is Flat Out Wrong
First off, the homeowner analogy is excellent--not irrelevant.

Mr. Krugman is wrong when he says that homeowners have to pay back their debt. The truth is they don't have to.

Just like the government, as long as their creditworthiness is intact and money is available, at whatever cost, homeowners can refinance their mortgages over and over. That's no different than how the government rolls over its own debts.

We saw this phenomenon play out in stark reality during the housing bubble.

Not only were homeowners refinancing their homes to take out money for consumption purposes, they leveraged themselves to buy more homes to multiply the wealth effect they were already experiencing.

In the case of the housing crash, borrowers were counting on rising property values to finance their expanding debts. That's the same as what Krugman says governments should do: make sure debt expansion doesn't outpace revenue growth, in this case taxes.

In the end, though, didn't the bursting of the housing bubble prove that debt eventually matters?

To me, the housing bubble was a pretty darn good analogy as to what happens when mounting debts aren't repaid. When it happens on a systemic basis, the entire economy suffers.

Doesn't our nation's expanding debt and deficit in the face of falling tax revenues and worse, a lower base, portend similar problems on an even larger scale?

Of course, Krugman has it all figured out.

We just have to grow our debt at a slower pace than our tax base grows. Who knew the answer was so simple...

We'll just meet our expanding debt obligations by raising taxes faster. Perfect!

Second, to claim that U.S. debt doesn't matter because we owe it to ourselves, and that homeowners' debts do matter because they owe them to someone else, is absurd.

It is as if we are all going to say to the government, "It's okay you took all of those taxes from us and spent them on stuff we'll mostly never see, wipe the slate clean, we're good. And all the stuff you promised us that you didn't budget for, or worse, those set aside budgets you stole from, it's okay, we're good, we relieve you of what you owe us." It's just stupid.

Also, if you are a homeowner you are paying yourself too, in a sense.

While you are paying the mortgage to your bank you are also paying into a capital asset known as your home. You end up with something of fairly equal value, or more when home prices appreciate.

The Truth about Debt
But we screwed that all up because debts do matter.

Too much debt leads to depreciation and deleveraging, which leads to lower demand, lower production, fewer jobs and a lower tax base.

The last piece of Krugman's argument that our World War II debts were never repaid and that the huge deficits to pay for the war effort led to an extraordinary peacetime expansion is also frighteningly off the mark.

Of course, the savings bonds issued to fund the War have matured and been paid off. And the portion of our national debt brought on by the War was paid off a long time ago.

Just because the U.S. continues to add to its deficit and has to continually rollover debts doesn't mean that we're rolling over debts from 70 years ago.

Mr. Krugman's own argument even addresses that. Rising incomes and our rapidly expanding economy in the postwar period generated a vastly rising tax base and led to prosperity.

But, that had nothing to do with deficits not mattering.

That had everything to do with soldiers returning home and being educated under the G.I. bill, being able to find work in revved-up manufacturing facilities, and the ensuing baby boom that would lead to a substantial increase in the population and tax base.

A Political Axe to Grind
There are a lot of problems with Professor Krugman's argument that deficits don't matter.

But, the biggest problem I have is that instead of addressing deficits in an organic, holistic and objective way, Mr. Krugman addresses these important issues from his political perspective rather than a purely economic perspective.

Bashing conservatives who say deficits matter and spending cuts along with a smaller government are the best way to solve our long-term fiscal problems, and arguing that "responsible governments -- that is governments that are willing to impose modestly higher taxes when the situation warrants it" are the answer to deficits that don't matter much, is polarizing at best and dangerous at worst.

What economists should be advocating is an apolitical approach to both our short-term and long-term problems.

We need smaller deficits over time and a smaller, more responsive government in the long-term.

In the short-term, we need real infrastructure spending, not quantitative easing for banks to increase their bonus pools. We need a massive investment in education and we need an industrial policy that promotes manufacturing and job growth - not the exportation of our capital to less developed countries where labor cost advantages fatten up public corporations that don't pay enough U.S. taxes and hide the money from Uncle Sam in the loopholes Congress digs for them.

Both deficits and politics matter.

And if we don't figure out how to bridle both we are all going to end up in the dirt being trampled by stampeding emerging economies everywhere.

[Editor's Note: If you're fed up with the rampant corruption, double-dealing, and protection of Wall Street by Washington (at the expense of the taxpayers on America's Main Street), then you need to read Shah Gilani's Wall Street Insights & Indictments newsletter. As a retired hedge-fund manager, Gilani is a former Wall Street insider who knows where all the bodies are buried. But unlike most insiders, he's not afraid to tell you where they are. He's also got some pretty good ideas how to fix this mess - and how to protect yourself until the cleanup takes place. Please click here to find out more. The newsletter is free.]

Source :http://moneymorning.com/2012/01/09/paul-krugman-is-dead-wrong-debt-matters/

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