The Old Paul Krugman

I’d like readers to take a look at something Professor Krugman wrote in the New York Times in 2003:

During the 1990s I spent much of my time focusing on economic crises around the world — in particular, on currency crises like those that struck Southeast Asia in 1997 and Argentina in 2001. The timing of such crises is hard to predict. But there are warning signs, like big trade and budget deficits and rising debt burdens.

And there’s one thing I can’t help noticing: a third world country with America’s recent numbers — its huge budget and trade deficits, its growing reliance on short-term borrowing from the rest of the world — would definitely be on the watch list.

I’m not the only one thinking that. Lehman Brothers has a mathematical model known as Damocles that it calls “an early warning system to identify the likelihood of countries entering into financial crises.” Developing nations are looking pretty safe these days. But applying the same model to some advanced countries “would set Damocles’ alarm bells ringing.” Lehman’s press release adds, “Most conspicuous of these threats is the United States.”

O.K., let’s run through some reassuring counterarguments.

First, economists are very good at devising models that would have predicted past crises, but each new crisis tends to happen where and when they didn’t expect it. So even though our budget deficit is bigger relative to the economy than Argentina’s in 2000, and our trade deficit is bigger relative to the economy than Indonesia’s in 1996, our experience needn’t be the same.

Second, nasty crises in third world countries have a lot to do with the fact that their debt is in foreign currency, usually dollars. As a result, when the peso or the rupiah plunges, debts explode while assets don’t, and balance sheets collapse. By contrast, thanks to the special international role of the dollar, America’s burgeoning foreign debt is in our own currency.

Finally, financial markets are generally willing to give advanced countries the benefit of the doubt. Even when an advanced country seems to be deep in a financial hole, lenders usually assume that it will somehow find the resources and political will to climb back out.

So is America safe, despite its scary numbers?

Third world countries typically suffer from institutional weaknesses. They have poor corporate governance: you can’t trust business accounting, and insiders often enrich themselves at stockholders’ expense. Meanwhile, cronyism is rampant, with close personal and financial links between powerful politicians and the very companies that benefit from public largesse.

The crisis won’t come immediately. For a few years, America will still be able to borrow freely, simply because lenders assume that things will somehow work out.

But at a certain point we’ll have a Wile E. Coyote moment. For those not familiar with the Road Runner cartoons, Mr. Coyote had a habit of running off cliffs and taking several steps on thin air before noticing that there was nothing underneath his feet. Only then would he plunge.

What will that plunge look like? It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government’s access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos.

I know: it all sounds unbelievable. But would you have believed, three years ago, that the U.S. budget would plunge so quickly from a record surplus to a record deficit? And would you have believed that, confronted with that plunge, our leaders would offer excuses rather than solutions?

So. The global economy has certainly changed since 2003. And the crisis we face today is entirely different to the kind of crisis described here. But in the longer run, maybe there is still a significant chance of the kind of crisis the old Paul Krugman worried about.

16 thoughts on “The Old Paul Krugman

  1. read joe weisenthal much?! he linked to the same article this morning on twitter. and my comment remains, we’re facing a different problem today, hence a different solution. balance budgets when times are good (or even save a surplus), spend when there is a lack of demand.

    • Not exactly. The real problem today in my eyes is debt saturation, which is absolutely an output of firstly budget deficits and less directly trade deficits. I agree with Reinhart and Rogoff’s interpretation — countries can’t generate organic growth or much demand if there is huge residual debt overhang.

      In fact, Krugman’s present stance (while undoubtedly focused on demand) does recognise this problem, which is why he is keen to see some inflation to devalue the debt. The problem is, this doesn’t necessarily work:

      My solutions to keep the present system functional are as follows:

      1/ A partial debt jubilee, to devalue all debt across the board in the system by something like 50%, perhaps staggered over 5 years (this avoids a default cascade, and liquidity panics, because there is no counterparty risk as everything is lowered by the same proportion)


      2/ Next time we get a liquidity shock we let the system fail, bail out account holders, and recapitalise the stronger banks with lower debt/derivatives exposures that do not fall with the system.

  2. I think Krugman is more a Democrat than an economist – to him Bush’s deficit is warning but Obama’s is good for the economy.

    • I think there is something to this.

      Krugman correctly recognises that Bush’s deficits were funding huge destructive wars, with little material value to the economy other than raised demand. Krugman also instinctually believes that Obama’s deficits will be funding more “productive” things, and that the additional demand is helpful particularly in what he calls the Lesser Depression.

      I for one have not seen much evidence that Obama’s deficits are any less corrosive than Bush’s. America is becoming more dependent on Chinese goods, shipping more of its productive capital and labour off to service its empire, and its financial system is still extremely fragile. Unemployment is still elevated, and industrial output is even lower.

  3. bush overspent when times were good and economy was roaring, hence no need for a deficit because there was demand. now, there is no deman, because as the op noted there is a debt overhang. consumer spending is 70% of gdp. over-leveraged consumers cannot afford to spend. i would argue there is a difference between public and private sector debt though. excess private will inhibit growth, i’m less sure about public.

    • If over-leveraged consumers cannot afford to spend, then how can over-leveraged government? The two options are raising taxes (not politically feasible in a Depression) and acquiring more debt at very low interest rates, which seems attractive (because interest rates are low today), but as Krugman notes in the article eventually we’ll have a Wile E. Coyote moment when institutions and governments are sick of the negative real rates they are currently getting on US debt. Negative real rates are very dangerous, because while they do have some positive effect on demand, there is always a danger that a negative reaction by debt holders can cause rates to spike uncontrollably. That’s your Wile E. Coyote moment.

      • gov’s and household’s finances are very different. this has been well krugmanned. the external debt relationship is symbiotic. china cannot have growth without a cheap yuan, which binds it to buying treauries. yes, this cannot go on forever, but certainly for now, at the rates the us gov can borrow at and with the complete absence of consumer demand and with the overleveraged consumer, the gov has to step in. austerity doesn’t work, ask greece.

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