We Already Went Over the Fiscal Cliff

The U.S. government is insolvent, and Paul Krugman's remedy means inflation

By ROBERT P. MURPHY

The hemming and hawing over the looming “fiscal cliff” is akin to passengers fighting over who gets to sit in the first class seats in a jumbo jet that just ran out of fuel. The U.S. government already sent the country over the cliff years ago; it’s just taken this long to (possibly) acknowledge reality. Legislators may strike a “compromise deal” that will postpone the crisis yet again, but soon enough it will return and with greater vengeance.

When people speak of “the national debt,” they usually have in mind the official Treasury securities held by the public. This figure is currently about $11.45 trillion (72% of GDP). However, this is just a small portion of the total indebtedness of the federal government, once we include all of the implicit obligations in the current benefit schemes for Medicare, Social Security, and other social insurance programs. Using GAAP procedures the way they would be applied to a corporation that had pension obligations for its employees, the federal government could be in the hole more than $70 trillion. Even the government-approved Social Security Trustees reported earlier in 2012 that the “unfunded liabilities” (i.e. benefit payments that will exceed incoming payroll tax receipts) of the major federal social insurance programs over the next 75 years have a present-discounted value of $38.6 trillion.

Another way of assessing our current, unsustainable trajectory is to look at the Congressional Budget Office (CBO) forecasts of the official Treasury debt/GDP ratio. As time passes, the unofficial indebtedness of Social Security and Medicare will show up as “official” debt when Uncle Sam has to enter the bond markets to cover the shortfall between beneficiary payments and incoming payroll taxes. When CBO plugged into its model the assumptions that the federal government would continue with its recent behavior in terms of maintaining tax rates, continually exempting large groups of Americans from the Alternative Minimum Tax, postponing reductions in reimbursement rates for doctors, and so on, then the federal debt held by the public exceeds 200% of GDP in the year 2038.

Clearly, at some point the U.S. federal government will need to slash its spending—including the benefits it currently promises to Social Security and Medicare recipients—and/or sharply raise tax revenues. This necessity is baked into the unsustainable fiscal trajectory on which our government finds itself. The longer this adjustment is postponed, the deeper the government sinks into (official) debt and the more tax revenue each year that must be earmarked purely to pay interest on the growing debt. With each passing day, the government paints itself into a tighter and tighter corner.

In all of this debate, there are those like Paul Krugman who claim the fears of a debt crisis are fantasies of right-wing idiots or liars. To take just one example from dozens of his blog posts and articles, he recently wrote:

You’ve heard the story many times: Supposedly, any day now investors will lose faith in America’s ability to come to grips with its budget failures. When they do, there will be a run on Treasury bonds, interest rates will spike, and the U.S. economy will plunge back into recession.

This sounds plausible to many people, because it’s roughly speaking what happened to Greece. But we’re not Greece, and it’s almost impossible to see how this could actually happen to a country in our situation.

For we have our own currency—and almost all of our debt, both private and public, is denominated in dollars. So our government, unlike the Greek government, literally can’t run out of money. After all, it can print the stuff. So there’s almost no risk that America will default on its debt…

But if the U.S. government prints money to pay its bills, won’t that lead to inflation? No, not if the economy is still depressed.

In the first place, even if everything Krugman said above were true, it would hardly be reassuring. If a dollar/Treasury crisis did break out—so that investors the world over dumped dollar-denominated bonds because they feared either an explicit default or a stealth default via inflation—it would not be the type of thing that could be turned around on a dime.

In other words, even if Krugman were right and the falling dollar did give a boost to US exports and thus reduced unemployment, it’s not as if world investors would suddenly become bullish on dollars right when the economy recovered. No, it’s very likely that there would be an overhang, where the large price inflation—which Krugman welcomes as a way to induce more spending—would lead to a prolonged period of wariness for Treasuries. In that scenario investors would be wise to think like this guy:

[L]ast 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.

… [W]e’re looking at a fiscal crisis that will drive interest rates sky-high….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.

… How will the train wreck play itself out? … [M]y prediction is that politicians will eventually be tempted to resolve the crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.

The above deficit-scold was none other than Paul Krugman, writing in 2003.

Yet there is an even more fundamental problem with Krugman’s more recent analysis: He is simply wrong when he says a government that issues its own currency, and has debts denominated in it, can’t experience anything like the Greek crisis. For this is exactly what happened to the United Kingdom in 1976, when speculators began attacking the pound. The U.K. government actually sought a then-record-high loan from the IMF, which it only obtained after agreeing to spending cuts. The situation sounds eerily like that faced by Greece today, even though the U.K. (like the U.S.) is a country that Paul Krugman thinks is immune from this type of thing.

The escape hatch Krugman has provided himself is to say that the threat of a bond strike, and the ensuing inflation, will help our depressed economy; it could only lead to trouble once unemployment has been solved. Yet this view is hard to reconcile with the British experience. According to this website, U.K. inflation was 9.2% in 1973, rose to 16.0% in 1974, rose again to 24.2% in 1975, fell to 16.5% in 1976 (when the IMF agreed to an austerity loan to rescue the falling pound), and steadily fell back down to 8.3% by 1978. Looking at those figures, armed with Krugman’s worldview, one might suppose that U.K. unemployment fell from 1973 through 1975 and then began rising, and that unemployment in 1976 was lower than in 1974 (because of the higher inflation rate).

Yet the actual data show a different story. It’s true, U.K. unemployment fell steadily (and slightly) from January 1972 through January 1974. But then it steadily rose, and in 1975 it accelerated upward—precisely when inflation was at its highest. Furthermore, the unemployment rate was higher than 5 percent throughout 1976, whereas it had been below 4 percent throughout 1974. In summary, the U.K. experience with unemployment and inflation in the 1970s is arguably the exact opposite of what Krugman is telling us would happen with the United States, if it suddenly faced a debt crisis.

Now in fairness, I’m sure that Krugman or his defenders could look at the same chart of U.K. unemployment in the 1970s and “see” their theory confirmed: The U.K. obviously wasn’t in a bad slump (since unemployment was relatively low compared to today’s levels), and unemployment was higher after the IMF austerity package than before. This is part of the problem with using historical episodes to “test” economic theories; there are so many moving parts that everybody walks away claiming victory.

What should be beyond controversy, however, is that the U.K. experience in the 1970s showed that even “safe” governments can incur the wrath of currency and bond speculators. The so-called Phillips Curve, which charts the alleged unemployment/inflation tradeoff, can shift when people’s expectations change. Even if Krugman were right, and a moderate dose of (price) inflation is just what our economy needs right now to knock off two percentage points of unemployment, he still can’t control the fact that once that genie is out of the bottle, suddenly Americans will have to tolerate much higher price inflation just to avoid a new recession.

This insidious logic of how an inflationary spiral feeds on itself is what Hayek dubbed having “a tiger by the tail.” The U.S. government is insolvent—bankrupt—according to standard accounting principles. Rather than heeding the advice of Krugman and others to simply print our troubles away and/or raise taxes on “the rich,” the responsible thing to do is cut spending. This is the best solution to a government debt crisis, as the Canadian experience in the 1990s showed, and as mainstream surveys of numerous case studies document.