Depression Aftershock and Paul Krugman

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In his New York Times column today, Paul Krugman derides what he calls "the big inflation scare." He writes that "stern opinion pieces warn that hyperinflation is just around the corner." He acknowledges that the Federal Reserve "has been buying lots of debt both from the government and from the private sector, and paying for these purchases by crediting banks with extra reserves," but he claims that this is not an inflationary threat because "banks aren't lending out their extra reserves" but instead are "just sitting on them--in effect, they're sending the money right back to the Fed. So the Fed isn't really printing money after all." The Bank of Japan "purchased debt on a huge scale between 1997 and 2003," yet there was no inflation. No are huge budget deficits, whether financed by borrowing or by increasing the supply of money, bound to create inflation. The United States "emerged from World War II with debt exceeding 120 percent of G.D.P.," yet did not have to resort to inflation to reduce the burden of the national debt to a tolerable level.

So if inflation isn't a threat, why are people saying it is? The answer, Krugman tells us, is that "the current inflation fear-mongering is partly political, coming largely from economists" who hope "to bully the Obama Administration into abandoning" its costly efforts to stem the economic downturn and speed recovery"--in other words, conservative economists, "who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy." There are economists like that, but even they don't say that hyperinflation--the sort of thing Germany experienced in the 1920s and Zimbabwe in the 2000s--is just around the corner.

Krugman acknowledges in the last paragraph of his column that "we have a long-run budget problem, and we need to start laying the groundwork for a long-run solution. But when it comes to inflation, the only thing we have to fear is inflation fear itself."

Krugman is an able economist. He is also a fiercely partisan liberal. He is the gingham dog to Milton Friedman's calico cat. His column of today is slash and burn economics.

If there is any responsible economist who believes that the nation is on the verge of a hyperinflation, I do not know who it is, and Krugman names no names. In fact the danger of inflation in the short run is minimal, but the qualification is essential and can nowhere be found in the column. He explains why it is minimal, but not clearly, and let me try. Suppose (the example is ridiculous, but I think illuminating) that the national income is $1,000 and that it is spent entirely on consumption goods, which consist solely of ten 1983 Chevrolet Caprices. Then the average price of a Caprice will be $100. The following year, all the Caprices bought the previous year having rusted away, ten more 1983 Caprices are brought to market. Only this time the government has doubled the supply of money. Again the entire national income, now $2,000, is spent on the Caprices, so the average price is now $200. That is inflation--an increase in price due solely to an increase in the ratio of money in circulation to the goods available for purchase.

But "in circulation" is vital. For suppose that, in this second year, the people become fearful and decide to stuff half their income under their mattresses. As a result, only $1,000 is spent on Caprices, and so the average price is unchanged, even though the supply of money has doubled. For it is only money that is put to use to buy things that influences prices. As Krugman points out less clearly than he might have done, the depression has caused both banks and individuals to hoard cash. The cash that the Federal Reserve has pumped into the economy by buying bonds has mainly ended up as "excess reserves" of banks, meaning lendable cash (as opposed to "required reserves," the cash that the regulatory authorities require the banks to hold on to, either in their vaults or as accounts with a federal reserve bank, rather than lend or otherwise invest) that the banks are sitting on rather than lending or otherwise investing. And the personal savings rate has soared because people are worried about the economic situation and so are cutting back on spending and, if they can afford to, saving more of their income instead.

But the curtailment of spending is, we hope, a temporary condition. As the economy improves, the banks will start to lend, and individuals will spend more. The excess reserves will become money in circulation (before the onset of the current depression, total excess bank reserves were only about $2 billion). And so there will be a risk of inflation. The Federal Reserve can, in principle anyway, prevent the risk from materializing, by selling its huge inventory of public and private debt and retiring the cash that it receives in exchange. But by sucking cash out of the economy it will drive up interest rates, which will impede recovery from the depression, because high interest rates curtail lending and therefore spending. So it may forbear, and the consequence may be inflation.

And the money that the Federal Reserve has created in an effort to lower interest rates and stimulate economic activity is only a small part of the liabilities that the government has taken on in an effort to fight the depression. There are the bank bailouts, the auto-industry bailouts, the mortgage-relief measures, the $787 billion stimulus program, and the guaranties that the Federal Deposit Insurance Corporation has issued. The grand total of current and planned commitments, both actual and contingent (the guaranties), has been estimated at almost $13 trillion. Most of that, in all likelihood, will be recouped or avoided--eventually. But in the meantime they are adding to the government's overall debt load.

We have, besides the liabilities specially incurred to combat the depression, a "structural" budget deficit of some $500 billion a year; I call it structural because it seems to be deeply embedded in the "normal" economy. Quite apart from the special liabilities that I've mentioned, the structural deficit swells in a depression because tax revenues plummet and the cost of unemployment benefits soars. It is estimated that the budget deficit this year will reach $1.8 trillion. That will increase the national debt by almost 20 percent. No doubt the budget deficit will be formidable next year as well, and perhaps for years to come.

And then of course there is the Obama Administration's long-range program of social and economic improvement, which however worthy will be immensely costly; and any economic benefits from the program--from having a healthier or better educated population or a slowing of global warming--will be realized long after immense costs are incurred. The Administration's prediction of eventually halving the annual budget deficit is a tissue of optimistic conjectures.

So we have a long-run budget problem indeed, as Krugman acknowledges. What we do not have is a long-run solution, or even the groundwork for it. There is much wasteful government spending--but try cutting it! Even the ridiculous farm subsidies are sacrosanct. We have low taxes--but try raising them! Every sensible path to a long-run solution seemed blocked by special interests and political demagoguery. We are likely to be left with either inflation, the standard debtor's remedy, or an increased dependence on loans by foreign nations and foreign investors, at increasing interest rates because the more we borrow, the higher the interest rates we have to pay. And interest on loans from abroad is a drain on American wealth, when the loans are financing budget deficits distended by inefficient government programs, rather than productive activity.

We cannot take comfort in Japan's example of promiscuous money creation that does not lead to inflation, because the Japanese people are great hoarders. (In economic jargon, their "propensity to consume" is much lower than Americans'.) We cannot take comfort from our situation at the end of World War II, because tax rates were higher than they are now and the end of the war led to a conversion of military to civil production that resulted in a large increase in consumer goods, which sopped up the money that had accumulated in people's savings accounts because of the high wages that full employment in a wartime economy had generated.

Just to make clear where I stand, I support the government's efforts to speed recovery from the current depression, including the $787 billion Keynesian stimulus program. I strongly support measures for reducing carbon emissions, though I would prefer a heavy tax to a permit system. I agree that spending on medical care is out of hand (not because of its absolute size, but because so much of it is wasteful) and that we need educational reform. But I fear the Administration is biting off more than it can chew.

An economist can design a long-run solution to our budgetary problems that would be efficient: the combination of eliminating inefficient government programs and adopting a stiff federal value-added tax would probably do the trick. But a solution that is politically unrealistic is only of academic interest.

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Richard A. Posner

Richard Posner is an author and federal appeals court judge. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. More

Richard A. Posner worked for several years in Washington during the Kennedy and Johnson Administrations. He worked for Justice William J. Brennan, Jr, the Solicitor General of the U.S., Thurgood Marshall, and as general counsel of President Johnson's Task Force on Communications Policy. Posner entered law teaching in 1968 at Stanford and became professor of law at the University of Chicago Law School in 1969. He was appointed Judge of the U.S. Court of Appeals for the Seventh Circuit in 1981 and served as Chief Judge from 1993 to 2000. He has written more than 2500 published judicial opinions and continues to teach at the University of Chicago Law School. His academic work has covered a broad range, with particular emphasis on the application of economics to law. His most recent books are How Judges Think (2008), Law and Literature (3d ed. 2009), A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (2009). He has received the Thomas C. Schelling Award for scholarly contributions that have had an impact on public policy from the John F. Kennedy School of Government at Harvard University, and the Henry J. Friendly Medal from the American Law Institute.
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