Only Paul Krugman Understands Debt

When I read Paul Krugman's Nobody Understands Debt, I wasn't sure whether or not to respond. It's not as if anybody cares what I think. I'm pretty far down the food chain. But Krugman doesn't care what anybody thinks. If I'm interpreting his title correctly, Paul Krugman's view is that only he understands debt. Everybody else is laboring in the dark.

Deficit-worriers portray a future in which we’re impoverished by the need to pay back money we’ve been borrowing. They see America as being like a family that took out too large a mortgage, and will have a hard time making the monthly payments.

This is, however, a really bad analogy in at least two ways.

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. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves.

Being of two minds about how to respond, I prepared this rather dogmatic but instructive graphic.

Paul Krugman — megalomaniac

But the message in this graphic seemed unfair. Yes, it expresses the bottom line, but I would have to explain myself. In order to do that, I would have to rely on common sense and articulate first principles.

First, Krugman seems to be a little confused about what year it is.

This is not 1946 right after World War II. It is 2012, and the world is a far, far different place than it was 66 years ago.

Second, if I understand Krugman correctly—only he understands debt—this next assumption must be correct.

Government debt doesn't matter because we are never required to pay it back. (The debt will wither away in the fullness of time as the economy grows and grows.) Therefore, outside the interest on the debt, running the government, waging wars, paying out benefits and so on costs us nothing.

That second assumption—the first was that we live in 2012, not 1946—seemed incomplete, but everything falls into place if we remember this convenient truth.

Unlike households, the U.S. government has a money printer. Households owe money to banks and must pay it off. Our government, to a "large" extent according to Krugman, owes money to itself — intragovernmental holdings for social security and medicare— but it has already spent that money on other things. (31% of the current government debt is held in those trust funds.) We must therefore sell those IOUs (Treasury Bonds) to cover revenue shortfalls in funding those programs. Or the government can print dollars to cover those shortfalls. (You can't send a retiree an IOU or pay a medical bill with one; you've got to have cash.)

And then I ran into some confusion. Krugman says we need to "ensure that debt grows more slowly than the tax base." Well, government debt, which came in at $1.3 trillion in 2011, is clearly growing faster than the tax base. Much faster, even if we consider only debt which we owe to others (debt held by the public), not the trust fund debt we owe to ourselves. And didn't this corollary follow from the foregoing discussion?

Dollars are not "real" in some sense because we can just create them — Poof! — right out of thin air. Actually, we create IOUs (Treasury Bonds) out of thin air to create more debt held by the public. These IOUs (like barrels of crude oil) are denominated in dollars. (It's actually the Federal Reserve that prints money by pressing a button on some "magic computer" housed in a secret place.¹)

1. One hopes they don't press the wrong button and create 1 quadrillion dollars (1,000,000,000,000,000) by mistake.

Even I knew that I had stumbled onto something big here—when there is a growing supply of dollars circulating in the economy, all other things being equal, the things we buy in dollars go up in price! There's a name for this phenomenon. It's called inflation. Indeed, I had read on several occasions that Krugman believes that a little inflation right now would be a good thing. He also thinks that "Helicopter" Ben Bernanke has not done nearly enough to counter the deflationary trends in housing and credit. But then I remembered that there is a potential problem with inflation.

Too much inflation destroys the purchasing power of the dollar, which puts everybody except the richest of the rich in the poorhouse.

So the question becomes how much "borrowing" (IOU printing) is the "right" amount of "borrowing" so as not to create too much inflation, but rather just enough. Clearly we can not raise taxes. If we soak the rich, given that we live in a plutonomy where the rich do a hugely disproportionate amount of the spending, our "consumer" economy will far apart. Or so we've been told. And the government is "borrowing" far more money than can be paid off by the rich in any case. And we can't raise taxes on anybody else because nearly all of them have no "extra" money to spare. In fact, 147 million of them are engaged in what we might call subsistence living. Just a "little" inflation (2-4% per year) wouldn't hurt them!

In fact, hadn't I read that according to the General Accounting Office, we've had budget deficits equal to or exceeding $1.3 trillion (1,300,000,000,000) for three years in a row now? Wasn't that enough "borrowing" (IOU printing) to satisfy Mr. Krugman?

Well, apparently not! And why not? Because debt doesn't matter! But haven't we just demonstrated that it does matter? If it didn't matter, why would we have to ensure that debt grows more slowly than the tax base? And what about that inflation problem?

And then I remembered that Paul Krugman—only he understands debt—believes that if we create even more debt, a lot more, and pass the money out like Halloween candy, the economy will grow and grow, thus raising the tax base! And it really doesn't matter that there is currently $11.66 trillion (11,600,000,000,000) of "consumer" debt according to the Federal Reserve. Unlike government debt, which need never be paid off, that's household debt which must be paid off, as Krugman himself pointed out. And it really doesn't matter that 147,000,000 Americans are living at subsistence levels. And why not? Because our "borrowing" (IOU printing) costs are low!

And why are interest rates on our IOUs low? Because all the other developed countries (currencies) are even more screwed than we are. Among the "advanced" economies, we are the Smartest Kid with Down's Syndrome. This is called the "flight to safety." And the dollar is the world's reserve currency, so central banks must recycle dollars. And our very own central bank, the Federal Reserve, is the largest holder of U.S. debt. And the central bank lets other Big Banks borrow money at nearly zero percent, and they in turn get a higher rate of return on that "free" money by buying government IOUs. And finally, the near zero interest rates set by the Fed lowers interest rates for savers (with bank accounts or in money markets), which makes buying government IOUs attractive.

All of this, especially that last part, sounds a little fishy to me, but I'm not as smart as Paul Krugman. He teaches at Princeton! He writes for the New York Times! He has a Nobel Prize in economics! Who am I to question all this? I'm nobody.

So, it's as simple as 1-2-3 if you remember to include 4-5-6-7-8-9-10 and 11. But really, looking back on this exercise, I could have just put up that graphic above and left it at that.

And be sure to read my comment on this post.

Bonus Video — "Killing The Dollar" with Kyle Bass. (You may have to crank up the volume.)