The nobel prize winning economist is (in)famous for his belief that more government spending will help solve short term unemployment without threatening Federal long term fiscal health. The first half of his position is arguably correct but the second half is a dangerous gamble.
Let’s assume Krugman gets his way and deficits increase even beyond their present day historical levels, how much debt will be on the books by the time we experience an economic recovery? Nobody can know for sure, but despite the market for Treasuries being the largest and most liquid in the world, the government already issues more bonds than can be absorbed today. The only reason the Treasury is able to continue even at the present inadequate (according to Krugman) levels is because during a depression the Federal Reserve can intervene without causing price inflation – the Federal Reserve is “printing money” to buy them.
However, by the time Krugman is satisfied with employment levels and government spending can begin to decline, the debt will have reached such historic proportions it will not be practical for the Federal Reserve to allow interest rates to rise; any increase will swamp the Federal government in interest payments. In response to such a crisis, the government will either have to raise taxes and kill the fledgling recovery or continue selling bonds to the Federal Reserve (printing money) despite the economic recovery… imagine how QE during an economic boom will be received by the market. How can the system keep inflation under control while printing money to finance the debt?
While Krugman is technically correct, the best kind of correct, about the ability of the government to increase spending today and not experience a fiscal collapse until some point in the future, he is not correct about the ability of the government to get its finances in order before that crisis hits. There will be no calm before the storm, we will transition directly from depression to crisis with no time to catch our breath.
But I’m sure you’re telling yourself they are smarter than that, if random internet guy has figured it out, I’m sure all the PHD’s at the Federal Reserve have as well. You’re partially correct, they have been buying longer term bonds in recent years to help prevent a sudden tsunami of interest payments when rates start to rise, but that means the Federal Reserve is sitting on an enormous amount of government securities that will soon plummet in value. There is no way they can sell long term government bonds yielding 3 or 4 percent back into the market to return it’s balance sheet to normal and prevent inflation from getting out of control, nobody will take them.
The Federal Reserve will have to mark down the value of those assets and probably render itself insolvent. Of course, the Federal Reserve can print money so maybe it doesn’t matter, but just imagine the politics. The economy is booming with inflation raging out of control and the central bank that brilliantly engineered a recovery without a tsunami of interest payments is now bankrupt and demanding the government reduce liquidity by raising taxes because it is unable to intervene in the market with anything other than words and interest rates. So much for independence, do you trust Congress that much?
And besides, this all assumes the economy will recover. What happens to the economy when the spending stops? If the economy never rebalances to something more sustainable than complete dependency on consumer debt and bubbles of various flavors, what happens to all those shiny new jobs once government demand disappears again? Can the government ever actually stop spending? It’s an important question we should not dismiss.
The value of any asset, no matter how vital, cycles between under valuation and over valuation – does the same concept hold true for aggregate demand? Can it ever be too high and actually need to drop for the economy to improve its health? It’s hard to argue America hasn’t been on a consumption and spending binge for the better part of the past several decades, perhaps a drop in demand is not the problem, but the solution.
