Krugman: Nobody Understands Debt (Least of All, Me)

“So last week I switched to a fixed-rate mortgage. It means higher monthly payments, but I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits.

. . . But what’s really scary – what makes a fixed-rate mortgage seem like such a good idea – is the looming threat to the federal government’s solvency.

. . . My prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money to pay current bills and to inflate away debt. And as the temptation becomes obvious, interest rates wil soar. ” – Paul Krugman, March 11, 2003

At the time Krugman was concerned that rising deficits, which were coincidentally around $450 billion that year, would make investors think twice about buying U.S. debt. As a result, he feared that interest rates would be forced to rise, causing massive problems for the federal government and other debtors.

It was sensible and well reasoned. George Bush also happened to be President.

Fast forward to today with a spend-happy Democrat in the White House. If you happen to now believe what Krugman said in 2003, as a significant number of economists and policymakers do, then you are now a “mendacious idiot” with a “wrongheaded, ill-informed obsession with debt,” according to the 2011 version of Paul Krugman.

In a recent op-ed entitled “Nobody Understands Debt” the accomplished economist turned partisan gadfly argues that “when people in D.C. talk about deficits and debt, by and large they have no idea what they’re talking about.” The reasons, he says, is that people are focused on budget deficits and the expectation that they will “send interest rates soaring. Any day now!”

Krugman also argues that conservatives are also completely off base about the long-term impact of debt. The reason, he says, is that unlike families which “have to pay back their debt. Governments don’t – all they need to do is ensure that debt grows more slowly then their tax base.”

In arguing such things Krugman proves that he, despite his impressive credentials, belongs amongst the crowd he derides for not understanding the debt.

When it comes to the short term the United States is right to be concerned about interest rates. Although we possess a unique status as the world’s reserve currency, which helps protect the value of our paper, and we happen to be revealing our profligacy at a unique time in history, when every other nation once considered a sound investment actually looks worse than we do, those aren’t exactly facts you want to hang your hat on.

Indeed, the run we’re on can’t last forever, just as Krugman argued in 2007. The fact is the time margin between safe investment and junk bonds is relatively slim – a testament to bond traders’ fickleness. Just take a look at this chart of Greek bonds and how quickly their situation went from awesome to awful.

And it’s not as if the warning signs aren’t there. Economics blog Zerohedge reported on Friday that “foreigners are offloading US paper hand over fist” – a sign that Treasuries may be falling out of favor and a disturbing development for a nation dependant on people buying our debt.

I won’t spend as much time on arguing with Krugman over the long-term risk of debt, for no other reason than his argument is ridiculous on its face. I’ll just point to the CBO’s report on the “Long Term Budget Outlook” in which the CBO argues,

“Under the assumptions of the alternative fiscal scenario, the path of federal debt would be unsustainable, and therefore major policy changes to stablize the budget would be required at some point. The longer the necessary adjustments were delayed, the greater would be the negative consequences of the mounting debt, the more uncertain individuals and businesses would be about future government policies, and the more drastic the ultimate changes in policy would need to be. Waiting to address the long-term budgetary imbalance and allowing debt to mount in the meantime would make future generations worse off . . .”

In other words Krugman was right, it’s just the 2003 version. Whatever happened to that guy?