Friday, May 11, 2012

Where Prof. Krugman is wrong!

Just like Ron Paul is totally consistent in his critique of "big government", Prof. Krugman is totally consistent with his message that austerity will kill Europe and only spending can save it.

Prof. Krugman wouldn't be a Nobel Prize winner if he meant by "spending" nothing other than undifferentiated government spending. He certainly knows that it depends on what money which has been borrowed from lenders is spent on. If it is spent on something which generates a return greater than the cost of borrowing, spending is a wonderful idea --- that idea is called investment.

Still, even undifferentiated spending might help to lessen the pain of a recession. I believe it was Keynes who suggested that in a recession it might be smart to pay a fellow for digging a hole and then pay him for filling it up again. As long as he spends his income in the domestic economy, that might generate some benefit. More examples could be given.

Prof. Krugman - when talking about sovereign debt and when suggesting that countries could easily borrow a lot more - hides one fact from the public. That fact can be summarized in one expression: debt capacity.

Every borrower - be it an individual, a company or a state -  has a debt capacity. One doesn't really know beforehand what the limit of that debt capacity is but when one reaches it, one finds out brutally quickly that it has been reached.

Maastricht defined debt capacity as 60% of GDP. Greece has increased that definition to 120%. Japan is closer to 200%. I don't know where the limit is but it is somewhere!

Once the debt capacity has been reached (as percentage of GDP), additional debt is limited to the percentage increase in GDP (i. e. growth). It's great fun to go from 0% to 60%, from 60% to 120% or from 120% to 200%, but it's not a lot of fun having to stay at 200% when GDP growth is only 2%.

There is allegedly no such thing as a free lunch. Except: the debt capacity is indeed a free lunch, a free lunch which is also a scarce resource. The question is who should be allowed to use this scarce resource over what period of time.

If the debt capacity is at 200% of GDP and a society goes in one generation from 0% to 200%, this generation has eaten up the entire free lunch and there is only little left for next generations. There is no way the US debt as a percentage of GDP can increase forever at the rates at which it has increased in the last generation.

So Prof. Krugman, shouldn't one leave at least a bit of the fun for the next generation?


  1. I think I understand the point about the debt capacity in general.But two questions come to my mind: as long as a country borrows from private lenders, who can decide whether to lend more or not, then it will sooner or later run up against such a limit; people won't lend to you even at high interest rates. But when you can convince (or bully) your central bank to continue lending more - directly or indirectly -, is there still a limit then? It seems to me that in Europe this way out is being tried; let us hope that the ECB will at some time resist.

    On the other hand, once private lenders feel the debt capacity is exhausted and are no longer ready to lend more, I assume that they may not even be ready to roll over existing debt, so that - without an accommodating central bank- debt capacity would actually come down, and unless other governments feel compelled to help out - as in the euro zone - the country would be bankrupt.
    Do y<ou see that in the same way?

    1. First, you are completely right (and Greece is the best example) that no one is ever informed that the debt capacity has been reached. Instead, borrowers find out that they have exceeded it and then everyone tries to grab for the cookie jar, i. e. the private creditors don't stay where they are but, instead, try to reduce their exposures.

      Once Central Banks get into the picture, they act as the lender of last resort, i. e. no one else is lending any longer. At this point, the debt capacity has already been exceeded. In the case of Greece, I would say that this point occurred in late 2009.

  2. Isn't everything relative?

    It seems to me that certain economies stopped growing precisely because credit expansion stopped, only it was private credit expansion that was driving these economies, and after it's collapse governments and central banks didn't replace it with government credit expansion due to ideological reasons.

    Japan did the same at first, but then resorted to what we know works when the private sector refuses to borrow: public expenditures. It's government debt has been increasing since, with no sings of reaching that debt capacity.

  3. My article has nothing to do with analysis as to why economies grow, don't grow, etc. My point is: every state has a debt capacity, even Japan. Japan's is perhaps higher than that of other countries because they can place so much of their sovereign debt domestically.

    No one knows beforehand where that debt capacity is. You only find out when you have over-reached it and then things become very difficult.

    Not too long ago, everyone seemed worried that the US might not be able to borrow so much longer at favorable rates. Since then, they have been borrowing like it was going out of style and at very attractive rates. So the US' debt capacity at the time was underrated.

    When I was in school (50 years ago), Austria had virtually zero sovereign debt. Today it stands, I believe, at around 80%. Who knows? Perhaps Austria's debt capacity is 160%. If so, my sons can enjoy in their lifetimes the same pleasures of government spending as my generation did. If not, their pleasure will be a lot less.

  4. Why do you put so much emphasis on sovereign-debt? A lot of countries have private-debt well over 400% of GDP and nobody seems to care.

    Anyway, I don't think there's a debt capacity when the central bank is financing your deficit. The adjustment happens through the currency-rate instead.

    I think that the current method is going to fail because the required re-balancing of trade won't happen no matter how much austerity you impose on the deficit country. The surplus country won't change it's bias towards saving, and the deficit country will be forced not to spend, so there's going to be a recession for all involved.

    De-globalization makes more sense to me. Relative trade barriers will favor consumption of domestic goods, will drop unemployment rates, and each country is going to have a standard of living that is compatible with it's productivity.

  5. I put the emphasis on sovereign debt because this is what the entire current discussion is all about (I would agree with you that it is a very limited way of looking at national wealth and/or indebtedness). The growth-camp wants the government to borrow more to spend more. The austerity-camp wants the opposite.

    As I replied to another comment, once the Central Bank has to finance, it means that the debt capacity has already been over-reached. My point is not to make an academic discussion about debt capacity. I just want to point out that the ability of a government to take up debt is limited. We don't know exactly where that limit is but it is there. Like with any other scarce resource, the question is who gets it and how much of it for how long. Our generation seems to have used up an awful lot of this scarce resource (to the disadvantage of future generations).

    The other subject you raise is in my opinion THE key subject. Cross-border debt can only exist when there are current account imbalances. If one wants to get cross-border debt under control, one has to re-balance the flow of products and services. I have written innumerable articles on current accounts (see my blog inventory). Perhaps you are interested in this one.