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Paul Krugman - The Third Depression


Parsad
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This is setting up as a teutonic intellectual contest between Krugman on the one hand ("we need to spend our way out of this problem and we'll worry about the debt later") and Niall Ferguson on the other ("we've seen this movie before and it always has a bad ending").

 

I read them both and I don't know what to believe.  Maybe the answer is somewhere in the middle?  On the other hand, maybe the "problem" has no solution.

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This is setting up as a teutonic intellectual contest between Krugman on the one hand ("we need to spend our way out of this problem and we'll worry about the debt later") and Niall Ferguson on the other ("we've seen this movie before and it always has a bad ending").

 

I read them both and I don't know what to believe.  Maybe the answer is somewhere in the middle?  On the other hand, maybe the "problem" has no solution.

 

He won't admit it, but I believe Krugman advocates massive government spending because he knows that the inevitable devaluation of the currency will provide a backdoor solution to his wealth re-distribution goals.  With devaluation, those with cash will loose, and those without it (or even better, those in debt) will win.

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I don't know if I buy the argument that those with cash will lose while those with debt will win. Inflation is no picnic for anybody, look at the 1970s. No picnic for businesses, no picnic for individuals. The argument is that retirees depend on bond income. But those same retirees, presumalby have not been sold 10 year bonds, so they can easily take their cash and put it in a bank account paying interest.

 

I did a study that showed that simple interest on short-term government bonds returned 2x the inflation rate so few have lost money except the mattress holders.

 

 

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On the other hand, maybe the "problem" has no solution.

 

That's exactly what I think: it might be way too late and the system might be way too saturated to do anything about it.

 

Lets look at the options available: on one hand the government spends massive amounts of money in the hopes that the stimulus will eventually help generate economic recovery and reduce high unemployment and underemployment. This is done by spending trillions of dollars we don't have, leading to a devalued currency, higher (hyper?) inflation and finally high interest rates after running up the largest total government debt in history. Add to that the matter of funding medicare and social security.

 

On the other hand, our other option is the government stops spending and raises taxes to reduce the deficit, this depresses the economy, leads to higher unemployment and ultimately causes a depression. I don't know what the proper course of action is but I know it is not going to be pretty.....

 

cheers

Zorro

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Though I think him, Hoisington, and Rosenberg all make good arguments for deflation, and would be right in the absence of policy interference, I think I am beginning to side more with Jim Grant here. 

 

At the end of the day "Helicopter Ben's" idea that a persistent government can always beat deflation has merits.  Not that he will literally dump cash from a helicopter, but what about a $5,000 tax credit for every citizen?  Consensus is worried that the gov has run out of ammo...I wouldn't underestimate Bernanke though.

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I don't know if I buy the argument that those with cash will lose while those with debt will win. Inflation is no picnic for anybody, look at the 1970s. No picnic for businesses, no picnic for individuals. The argument is that retirees depend on bond income. But those same retirees, presumalby have not been sold 10 year bonds, so they can easily take their cash and put it in a bank account paying interest.

 

I did a study that showed that simple interest on short-term government bonds returned 2x the inflation rate so few have lost money except the mattress holders.

 

 

 

Sorry, "cash" was a poor word choice.  I meant to convey that generally currency devaluation and inflation transfers wealth from the older rich (usually they are net lenders) to the younger poor (usually they are net borrows via credit cards and mortgage debt).  For those who have cash, I hope they read your study!!

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Guest Dazel

 

Marc Faber has called Krugman's ideas insane in public...he has also referred to "helicopter" Ben as the same way. Krugman was calling for China to become the next Russia in 1993. Having said that I respect his point of view (I read his column daily). I think that Ben and Obama need a real good reason to do something substantial....and they are and will continue to get it...and they will do something soon.

 

question?

TARP is now expected to cost about $150 billion. I have not read anywhere....the fact that $600 billion will be saved...as everyone still counts it as stimulus...there has to be a plan B....and deflation ain"t it. TARP may be the most successful government plan ever implemented. Yet because of the political bullshit in the U.S no credit was given (pardon the pun). The American system as Buffett has put it...has worked better than any other system. Get the government the hell out and give the stimulus to the private sector and they will continue to prosper.

 

Dazel.

 

 

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I watched Niall's CFA conf speech yesterday and it was incredible.  The more I learn about history the more I realize things never change.  Krugman is a political hack disguised as an economics professor - I see him on as more political pudit shows than commenting on economics.  He and Koo seem to talk about this continued spending without considering the exit.  Pretty ironic that Krugman would be against going into Iraq without an exit strategy but not his own economic ideas. 

 

History of exit strategies from too much gov't debt tells us there are three ways out: 1) default (which may actually happen - rescheduling of the debt with lower interest rates over a longer period of time ala Argentina) , 2) inflation (printing money - this may happen but with velocity falling due to savings this is currently being counteracted), 3) growth or some combo of above.   

 

Growth is a nice in theory answer but the odds are stacked against this option.  There are 2 historical situations out of 100s were growth was either the driver for debt reduction or used with inflation.  The first was after the Napolianic wars where the UK was able to grow its way out of its debts (this was due it dominance in industry and the merchants ran the country).  The other time was the US (growth & inflation) after WWII.  Again the US was the only country standing.  Therefore, I think some combination of default and inflation will be the least painful answer.  I just do not know how you force feed folks dollar (to cause inflation) when they are pulling back so much.

 

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In his op-eds, which I would say are generally way over the top, Paul Krugman functions as an advocate, not as an academic.  He is trying to sway public opinion and have an effect on what policy decisions get made.

 

I think it's hilarious that Marc Faber, of all people, is calling Krugman insane.  Because Marc Faber is the epitome of measured rationality -- right.

 

Both Krugman and Koo, I think, know what the "exit strategy" is: reduced spending, increased taxes, and debt monetization over the long run.  They are fine with that because they view full employment as the best outcome even if the overall purchasing power of Americans declines and the wealthy get disproportionately affected.  That is not a crazy philosophical viewpoint to have, though many folks will disagree.

 

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But has there been one case where that "Exit" strategy has worked outside of post-war patriotism that has helped to reduce the debt?  I think the viewpoint may in theory be valid but it has never in reality worked in the real world (as shown by history).  This is where Niall Ferguson has a better argument because it is based upon history (reality) versus some theoretical case that has never worked before but has facilitated poor economic policy - spending, when you know that these same folks will not stop spending.

 

If full employment is the test of when to stop spending, we will all default before that occurs.

 

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I wish I could watch Ferguson's speech.  Is it available for public consumption, or do you have to be a member of the CFA Institute to watch it?

 

Full employment will not be achieved through stimulus alone, but stimulus is needed to keep the economy from getting markedly worse, i.e. lapsing into a deflationary spiral, in which case unemployment would go much higher.  I can't counter Ferguson's historical arguments without understanding what periods of time Ferguson is referencing.  However, I do believe that Japan's Lost Decade and the Great Depression serve as historical examples of why stimulus is necessary in this case.  If Japan hadn't taken the measures they did, I think we would be talking about the Japanese Great Depression instead of the Japanese Lost Decade.  And in the counterfactual case, Japan's national debt would be even worse than it is now.

 

Ultimately, the case for stimulus is premised on the notion that we are in a balance sheet recession.  If we were in any other recession, I would say "no" to stimulus spending.

 

I don't think we, the US, will default.  We will solve the debt problem primarily through monetary inflation.  That is the price we must pay for our past sin and folly.

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I think all investors have to read (or re-read) Bernanke's 2002 speech called "Deflation: Making Sure "It" Doesn't Happen Here". It's a crucial reading to understand what might happen next, a blueprint of Bernanke's thinking.

 

Key extract:

 

"the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

 

I suspect QE2 will start soon...

 

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

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Unfortunately, it is not publicly available.  You can see Niall's "Ascent of Money" on PBS though.  Since he is a historian, his approach I think is quite an additional to the background of booms and busts. 

 

Another consideration for Japan is that when Japan was going through it the rest of the world was booming which I think had an effect on the recessions depth.  I think giving all/most credit to spending is misplaced because if that was the case then historically we would have seen more spending successes which we have not.  If the world was not booming, they may have fallen in a depression.  We have not seen the end game of this spending which is probably going to wipe out the savings of the pensioners and citizens who paid for the spending via inflation/default.  I think Jim Rogers has it right.  You either pay for it now, with a severe recession and move on or stretch out the pain. 

 

I also question the logic of spending to spend.  If you have what you think are positive NPV projects fine (but even there I think calculating your borrowing costs can be misleading as the cost today may be very different from when the projects are completed if the markets have lost faith or you are forced to partially default).  High-speed rail outside the high-density corridors is an example.  In Upstate NY, they are putting in a high-speed rail line that is uneconomical and will have to be subsidized the rest of its life.  What sense does that make?  I think the spend today mindset leads to wasting money that would never have been spent other than for a gov't subsidy.  Do you like the idea that your money is being spent on a big white elephant where most of the technology is going to be purchased from other countries? 

 

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You guys should go to CNBC.com and listen to Gov. Chris Christie of New Jersey who was on Squawk Box just a few minutes ago.

 

I did not know that there still was any politician left with courage and common sense. He will be hated by public servants and unions, but I guarantee you that within a few years that New Jersey will be able to repay its debts, will have one of the lowest cost of debt in the U.S. and will be growing fast.

 

If you look at all the problems that the U.S. is facing now, I could probably identify 90% as being rooted in bad policy decisions. The biggest of all is Fannie and Freddie who in later years were setup to artificially lower the cost of home ownership. A Mac mension for all! Eventually, what could be reset to the real level by the market was and what has not will be borne by the American tax payer. Subsidy on a grand scale massively used by both Clinton and Bush to push the economy and garner votes.

 

Government spending could work if it was allocated properly with arm's length type transaction and a market type rate of return. The incentives are simply not built as such.

 

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Unfortunately, it is not publicly available.  You can see Niall's "Ascent of Money" on PBS though.  Since he is a historian, his approach I think is quite an additional to the background of booms and busts. 

 

Here is a link to his book,  "Ascent of Money". 

 

http://www.amazon.com/dp/1594201927/?tag=googhydr-20&hvadid=2670571435&ref=pd_sl_6yftfm0z07_b

 

Good for anyone wanting a historical perspective of money and markets.

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I like the added value that Ferguson brings as an economic historian, but I would also note that Bernanke is a historian of the Great Depression.  We often fail to give him credit in that regards, and some would say it hasn't born fruit at all in terms of the policy decisions he has made (I wouldn't say that, though).

 

Japan is also different because they mostly owe money to themselves, and as I understand it, their currency is still overvalued.  Think about what would have happened to their economy if the yen had properly devalued.  They would have even more of a trade surplus against the rest of the world, and they could have used such surplus to pay off some of their debt by raising taxes.

 

The problem I have with Jim Rogers and Austrians' arguments is that they believe that if we get to a place with 25% unemployment, we will again start climbing back towards an economic equilibrium to where we have lower unemployment and lower debt.  But I don't buy that.  I think it's much harder for the economy to recover from a devastating depression than they think and that people truly suffer during that period.  Furthermore, political instability can easily result with revolutions and whatnot occurring.

 

Ultimately, if we're looking to place blame, we can also say that the vast income inequality that has arisen out of the US's second Gilded Age helped precipitate the financial crisis.  Raghuram Rajan, one of the few economists who warned of a financial crisis, believes that wage stagnation that has occurred over the last few decades meant that those worst off were force fed credit by marketers, policymakers, and creditor nations in order to obscure the fact that things have gotten worse for them in times of supposed prosperity.  And that's only wage stagnation we're talking about; what about increased work hours, less job stability, unsecure pensions, skyrocketing costs of education, rent, and health care?  People, most of whom are unsophisticated investors, were told that their homes were a store of value that would appreciate and then were given crazy interest rates and shady loans.  They were given usurious credit cards by supposedly sophisticated lenders who were really just looking to sell their shit to institutional investors.  They were also told to allocate their hard earned wealth into financial assets without regards to price. 

 

Policymakers are certainly to blame, but I don't think it was their caring about the worst off that made the financial crisis happen; it was the exact opposite, in fact.

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I'm no economist, just a self-taught student of economic history.  But from what I've read, Weimer Germany likely got hyperinflation because the money they were printing was going to pay off speculators and reparations to other countries.  In other words, it seems to me that hyperinflation is caused by a fundamental lack of confidence in the value of a fiat currency.  The upshot of this is that WHAT you spend the money on is as important as how much you are printing.

 

In other words, if you are creating real infrastructure value that then backs up the currency, people would still continue to have confidence in the currency.  If you spend it on paying off the casino operations of the currency speculators, or bailouts to pay off bad debts, you undermine the currency.  Undermine it enough, and you're likely to have people consider your currency worthless, at which point inflation and if bad enough hyperinflation. 

 

Am I wrong about this?  Probably way too simplistic, I know, but seems generally correct to me. 

 

 

Government spending could work if it was allocated properly with arm's length type transaction and a market type rate of return. The incentives are simply not built as such.

 

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I like the added value that Ferguson brings as an economic historian, but I would also note that Bernanke is a historian of the Great Depression.  We often fail to give him credit in that regards, and some would say it hasn't born fruit at all in terms of the policy decisions he has made (I wouldn't say that, though).

 

Japan is also different because they mostly owe money to themselves, and as I understand it, their currency is still overvalued.  Think about what would have happened to their economy if the yen had properly devalued.  They would have even more of a trade surplus against the rest of the world, and they could have used such surplus to pay off some of their debt by raising taxes.

 

The problem I have with Jim Rogers and Austrians' arguments is that they believe that if we get to a place with 25% unemployment, we will again start climbing back towards an economic equilibrium to where we have lower unemployment and lower debt.  But I don't buy that.  I think it's much harder for the economy to recover from a devastating depression than they think and that people truly suffer during that period.  Furthermore, political instability can easily result with revolutions and whatnot occurring.

 

Ultimately, if we're looking to place blame, we can also say that the vast income inequality that has arisen out of the US's second Gilded Age helped precipitate the financial crisis.  Raghuram Rajan, one of the few economists who warned of a financial crisis, believes that wage stagnation that has occurred over the last few decades meant that those worst off were force fed credit by marketers, policymakers, and creditor nations in order to obscure the fact that things have gotten worse for them in times of supposed prosperity.  And that's only wage stagnation we're talking about; what about increased work hours, less job stability, unsecure pensions, skyrocketing costs of education, rent, and health care?  People, most of whom are unsophisticated investors, were told that their homes were a store of value that would appreciate and then were given crazy interest rates and shady loans.  They were given usurious credit cards by supposedly sophisticated lenders who were really just looking to sell their shit to institutional investors.  They were also told to allocate their hard earned wealth into financial assets without regards to price. 

 

Policymakers are certainly to blame, but I don't think it was their caring about the worst off that made the financial crisis happen; it was the exact opposite, in fact.

 

I agree with TX. The problem seems to be unsolvable. Household income needs to go up. We are all out of tricks. First wives went to work, then credit cards, then homes as atms. If Americans all of a sudden get prudent, and everyone else stays prudent (Germans, Asians) or broke (ROW) then aggregate demand will free fall.

 

I tend to agree with Krugman, Stiglitz, and Roubini. The Economist's special report was on this and talked about Koo also.

 

Roubini says the Austrians are cruel and wrong in the short run but will be proven correct in the long run.

 

The way I see it is you can cut spending, have unemployment spike, and have the paradox of thrift destroy the governments balance sheet and ability to repay debt.

Or you can keep spending till the economy rejuvenate then inflate away the debt.

 

Neither option has a good exit policy, but the Austrians dont really have a plan, and their medicine wont reduce the deficit. If unemployment spikes higher then the deficit will go up due to less receipts to the government. It will also be a political nightmare. Spending + inflation seems to be the sanest way to deal with this.

 

It seems like the optimal solution is a well designed high return spending program, combined with reduced military spending / global retrenchment to reduce the debt. Too bad no one is talking about that.

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Keep in mind that its very desirable & extremely easy for the G8 (& US) to inflate.

 

All that need do is globally relax the tax regimes that keep Euro $,Yen,Sterling, etc offshore. The offshore markets would immediately collapse onshore, producing a flood of new currency, & giving each central bank full control. Redistribute the inflation gain into debt write-offs & a whole lot of good will occurr very quickly.

 

SD

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let's talk real returns not nominal. If inflation is very low, as it is now, then whatever return your business gets is a real return - as low as that may be. 10% return is real in a zero inflation world. It is actually 11% in 1% annual Deflation. So sure your assets may come crashing down (they already have) but you can build them up again. If inflation is higher, then you have to substract it from your real return and your assets, while higher in price, also buy less. In the end, what matters is your real return, everything else is noise.

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