In his latest column, “Money for Nothing”, Paul Krugman dismisses warnings about the U.S. government running such a large budget deficit, writing:
For years, allegedly serious people have been issuing dire warnings about the consequences of large budget deficits — deficits that are overwhelmingly the result of our ongoing economic crisis. In May 2009, Niall Ferguson of Harvard declared that the “tidal wave of debt issuance” would cause U.S. interest rates to soar. In March 2011, Erskine Bowles, the co-chairman of President Obama’s ill-fated deficit commission, warned that unless action was taken on the deficit soon, “the markets will devastate us,” probably within two years. And so on.
He goes on to pooh-pooh such warnings, which instantly reminded me of something he wrote years ago that I included in my book Ron Paul vs. Paul Krugman: Austrian vs. Keynesian economics in the financial crisis. I found what I was looking for on page 38, where I quote Krugman from a May 20, 2005 column, in which he wrote (emphasis added):
And there’s no sign that anyone in the administration has faced up to an unpleasant reality: the U.S. economy has become dependent on low-interest loans from China and other foreign governments, and it’s likely to have major problems when those loans are no longer forthcoming….
Dollar purchases by China and other foreign governments have temporarily insulated the U.S. economy from the effects of huge budget deficits. This money flowing in from abroad has kept U.S. interest rates low despite the enormous government borrowing required to cover the budget deficit….
Here’s what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise…. And we’ll suddenly wonder why anyone thought financing the budget deficit was easy.
So Krugman can include himself among those who have issued dire warnings that the deficit could or would eventually result in rising interest rates, making it difficult, if not impossible, for the U.S. to finance its debt through even more borrowing.
Now, before continuing with his “Money for Nothing” column, we need to put that 2005 article in its proper context. You can get the full context by reading my book, but in a nutshell: By that time, Krugman realized that artificially low interest rates had created a housing bubble. This was a problem for him because he had up until 2005 been calling on the Fed to lower interest rates specifically in order to create a boom in housing. That is, of course, precisely what the Fed did, but it wasn’t enough for Krugman, who perpetually wanted even lower rates.
Unwilling to acknowledge that this policy he advocated was a mistake, he sought to place the blame for the housing bubble elsewhere. So where to aim his sights?
Over the last few years China, for its own reasons, has acted as an enabler both of U.S. fiscal irresponsibility and of a return to Nasdaq-style speculative mania, this time in the housing market….
And there’s no sign that anyone in the administration has faced up to an unpleasant reality: the U.S. economy has become dependent on low-interest loans from China and other foreign governments, and it’s likely to have major problems when those loans are no longer forthcoming.
And that is where the previously quoted observation about the budget deficit and eventual rise in interest rates comes in. After the above-quoted sentence about “money flowing in”, Krugman stated (emphasis added):
Low interest rates, in turn, have been crucial to America’s housing boom. And soaring house prices don’t just create construction jobs; they also support consumer spending because many homeowners have converted rising house values into cash by refinancing their mortgages.
Restoring more of what I omitted above, Krugman wrote (emphasis added):
Here’s what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies. And we’ll suddenly wonder why anyone thought financing the budget deficit was easy.
Aha! So it was these “low-interest loans from China and other foreign governments” that enabled the “speculative mania” of the housing boom, and if the bubble burst, it would be because China stopped lending so cheaply to the U.S.!
If you read my book, you’ll see how laughably transparent Krugman is being here, attempting to shift attention away from the role of the Fed in creating the housing bubble by keeping interest rates artificially low (that is, lower than what they would be under free market conditions). First, he tried to deny that he had called for lower interest rates to create a housing bubble, which denials I discuss in my book, from which I’ll quote the following paragraph (p.54):
When Krugman wrote, “let’s have at least one more rate cut, please” (May 2, 2001), he was not advocating cutting interest rates? When he wrote that creating a demand for “housing, which is highly sensitive to interest rates, could help lead a recovery” (August 14, 2001), he was not advocating lowering interest rates to create demand for housing? When he expressed that he was “a little depressed” because “long-term rates haven’t fallen enough to produce a boom” in housing (August 2, 2001), it did not qualify as advocacy for cutting interest rates to spur a housing boom? When he wrote that, to “reflate the economy”, the Fed had to increase demand and that “housing, which is highly sensitive to interest rates, could help lead a recovery” (August 14, 2001), he wasn’t advocating that the Fed cut interest rates? It was not policy advocacy when he wrote that “economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer” (October 7, 2001)? It would be superfluous to continue. The fact is that Krugman did advocate a policy of creating a housing bubble to replace the dot-com bubble, his disingenuous protests to the contrary notwithstanding.
Apart from trying to blame China’s lending habits, Krugman also later tried to explicitly deny that the Fed policy he advocated created the housing bubble. Again from my book (pp.56-57):
Yet how could Krugman reconcile his argument here that the Fed was not “wholly, or even in large part” responsible for creating the housing bubble with his earlier arguments that the Fed should lower interest rates to spur investment in housing? How could he reconcile this argument with his earlier statement that “Millions of Americans have decided that low interest rates offer a good opportunity to refinance their homes or buy new ones” (May 2, 2001)? Or with his observation that “those 11 interest rate cuts in 2001 fueled a boom both in housing purchases and in mortgage refinancing” (October 1, 2002)? Or with his acknowledgment that it had been “the Fed’s dramatic interest rate cuts” that had “helped keep housing strong” (December 28, 2001)? Or his statement, “Repeated interest rate cuts encouraged families to buy new houses and refinance their mortgages” (December 22, 2002)? Or his remark that “Mortgage rates did indeed fall briefly to historic lows, extending the home-buying and refinancing boom that has helped keep the economy’s head above water” (July 25, 2003)? Or, “Low interest rates … have been crucial to America’s housing boom” (May 20, 2005)? Or, “interest rate cuts led to soaring home prices, which led in turn not just to a construction boom but to high consumer spending, because homeowners used mortgage refinancing to go deeper into debt”(May 25, 2005)? Or, “A snarky but accurate description of monetary policy over the past five years is that the Federal Reserve successfully replaced the technology bubble with a housing bubble” (August 7, 2006)? Or, “Back in 2002 and 2003, low interest rates made buying a house look like a very good deal. As people piled into housing, however, prices rose—and people began assuming that they would keep on rising. So the boom fed on itself” (July 27, 2007)?
What can explain Krugman’s self-contradictions? When he thought the housing bubble was a good thing, the road to recovery, he was all for it, lavishing the Fed with praise for single-handedly rescuing the economy from the much more painful recession that otherwise would have occurred without it. Once the devastating consequences of the housing bubble became clear, however, he changed his story, denying that he had ever called for a bubble and even denying that the Fed was responsible for having created it.
Okay, now, with that background and context, let’s get back to “Money for Nothing” (can I also get some chicks for free with that, please?):
Well, I guess Mr. Bowles has a few months left. But a funny thing happened on the way to the predicted fiscal crisis: instead of soaring, U.S. borrowing costs have fallen to their lowest level in the nation’s history. And it’s not just America. At this point, every advanced country that borrows in its own currency is able to borrow very cheaply.
Now, why is that, do you think? Could it be that central banks, by running the printing presses and creating money from nothing are keeping interest rates artificially low, thus enabling governments to borrow cheaply, but creating only an illusion of wealth (since you can’t really get chicks for free… I mean, money for nothing) and financial bubbles in some sector of the economy or another (e.g., tech stocks, housing, bonds…)?
[L]et’s talk about those low, low borrowing costs — so low that, in some cases, investors are actually paying governments to hold their money.
For the most part, this is happening with “inflation-protected securities” — bonds whose future repayments are linked to consumer prices so that investors need not fear that their investment will be eroded by inflation.
So you’re sayin’ the U.S. government has a financial incentive to rig the consumer price index (CPI) below the true rate of inflation?!
Even with this protection, investors used to demand substantial additional payment. Before the crisis, U.S. 10-year inflation-protected bonds generally paid around 2 percent. Recently, however, the rate on those bonds has been minus-0.6 percent. Investors are willing to pay more to buy these bonds than the amount, adjusted for inflation, that the government will eventually pay in interest and principal.
So investors are, in a sense, offering governments free money for the next 10 years; in fact, they’re willing to pay governments a modest fee for keeping their wealth safe.
Now, why would anyone pay the government to spend their money for them? Isn’t the whole point of buying Treasury bonds to get a modest return on a safe investment? This is crazy! What can explain this? Tell us, Krugman, tell us!
Now, those with a vested interest in the fiscal crisis story have made various attempts to explain away the failure of that crisis to materialize.
Krugman, of course, has no vested interest in this story, like, say, to defend the policies had has advocated. Next sentence:
One favorite is the claim that the Federal Reserve is keeping interest rates artificially low by buying government bonds.
There it is! Can you believe it? People actually think the Fed is keeping interest rates below where they would be under free market conditions? What a bunch of silly fools.
But that theory was put to the test last summer when the Fed temporarily suspended bond purchases. Many people — including Bill Gross of the giant bond fund Pimco — predicted a rate spike. Nothing happened.
What is Krugman talking about? He’s talking about how in June of last year, the Fed’s second round of “quantitative easing” (i.e., money printing), or “QE2”, came to an end, after it had completed its purchases of the target $600 billion in bond purchases. But as Bloomberg reported (emphasis added):
The Federal Reserve will remain the biggest buyer of Treasuries, even after the second round of quantitative easing ends this week, as the central bank uses its $2.86 trillion balance sheet to keep interest rates low.
While the $600 billion purchase program, known as QE2, winds down, the Fed said June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. That could mean purchases of as much as $300 billion of government debt over the next 12 months without adding money to the financial system.
The central bank, which injected $2.3 trillion into the financial system after the collapse of Lehman Brothers Holdings Inc. in September 2008, will continue buying Treasuries to keep market rates down as the economy slows. The purchases are supporting demand at bond auctions….
A total of $112.1 billion of the Fed’s government bond holdings will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account, known to traders as SOMA. Replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012.
Doh! Krugman forgot to tell us any of that! Actually, he didn’t just forget to inform us, he just lied. That’s right. He lied. Now, why did he lie? Ultimately, to cover his own ass for having advocated for the policy of keeping rates artificially low to produce a housing bubble in the first place, and to justify his policy prescriptions for getting out of the mess his policy prescriptions got us into.
Krugman also said this fictional suspension of Treasury purchases was “temporary”. Fed Chairman Ben Bernanke had pledged to keep interest rates low after QE2 ended. In July, Bernanke again said that the Fed was “prepared to respond should economic developments indicate that an adjustment of monetary policy would be appropriate”—such as if interest rates rose above their target low rate of between zero to .25 percent. By September, the Fed was once again taking measures above and bond this run-of-the-mill bond buying, and began “Operation Twist”, announcing a plan to buy $400 billion in longer-term Treasury securities as short-term securities matured, which, the Fed said in a statement would “put downward pressure on longer-term interest rates”. The Fed extended “Operation Twist” just last month, to “put downward pressure on longer-term interest rates”.
Krugman would have you believe that if you think interest rates are low because of the Fed’s purchases of Treasuries, you are clueless. The truth is that Krugman himself is a gigantic fraud who likes to insult his readers’ intelligence.
So what is Krugman’s alternative explanation for the government’s ability to cheaply finance its debt?
So what is going on? The main answer is that this is what happens when you have a “deleveraging shock,” in which everyone is trying to pay down debt at the same time. Household borrowing has plunged; businesses are sitting on cash because there’s no reason to expand capacity when the sales aren’t there; and the result is that investors are all dressed up with nowhere to go, or rather no place to put their money. So they’re buying government debt, even at very low returns, for lack of alternatives.
But buying government debt “at very low returns” is one thing. Krugman still hasn’t explained why “investors are actually paying governments to hold their money”! He has no alternative explanation for this. He is trying to say that interest rates are low because of the market, because those low rates are justified by the real market demand for government bonds, simple supply and demand. But as Paul Craig Roberts and Nomi Prins write in their article “The Real Libor Scandal”:
The question is, why do investors purchase long term bonds, which pay less than the rate of inflation, from governments whose debt is rising as a share of GDP? One might think that investors would understand that they are losing money and sell the bonds, thus lowering their price and raising the interest rate.
Why isn’t this happening?
Paul Craig Robert’s June 5 column, “Collapse at Hand,” explained that despite the negative interest rate, investors were making capital gains from their Treasury bond holdings, because the prices were rising as interest rates were pushed lower.
What was pushing the interest rates lower?
The answer is even clearer now. First, as Dr. Roberts noted, Wall Street has been selling huge amounts of interest rate swaps, essentially a way of shorting interest rates and driving them down. Thus, causing bond prices to rise.
Secondly, fixing Libor at lower rates has the same effect. Lower UK interest rates on government bonds drive up their prices.
In other words, we would argue that the bailed-out banks in the US and UK are returning the favor that they received from the bailouts and from the Fed and Bank of England’s low rate policy by rigging government bond prices, thus propping up a government bond market that would otherwise, one would think, be driven down by the abundance of new debt and monetization of this debt, or some part of it.
How long can the government bond bubble be sustained? How negative can interest rates be driven?
In “Collapse at Hand”, Dr. Roberts explained:
Ever since the beginning of the financial crisis and Quantitative Easing, the question has been before us: How can the Federal Reserve maintain zero interest rates for banks and negative real interest rates for savers and bond holders when the US government is adding $1.5 trillion to the national debt every year via its budget deficits? Not long ago, the Fed announced that it was going to continue this policy for another 2 or 3 years. Indeed, the Fed is locked into the policy. Without the artificially low interest rates, the debt service on the national debt would be so large that it would raise questions about the US Treasury’s credit rating and the viability of the dollar, and the trillions of dollars in Interest Rate Swaps and other derivatives would come unglued.
In another follow-up article, “The Libor Scandal in Full Perspective”, Dr. Roberts further explains:
The Federal Reserve’s purchases are often misread as demand arising from a “flight to quality” due to concern about the EU sovereign debt problem and possible failure of the euro.
Another rationale used to explain the demand for Treasuries despite their negative yield is the “flight to safety.” A 2% yield on a Treasury bond is less of a negative interest rate than the yield of a few basis points on a bank CD, and the US government, unlike banks, can use its central bank to print the money to pay off its debts.
It is possible that some investors purchase Treasuries for these reasons. However, the “safety” and “flight to quality” explanations could not exist if interest rates were rising or were expected to rise. The Federal Reserve prevents the rise in interest rates and decline in bond prices, which normally result from continually issuing new debt in enormous quantities at negative interest rates, by announcing that it has a low interest rate policy and will purchase bonds to keep bond prices high. Without this Fed policy, there could be no flight to safety or quality.
It is the prospect of ever lower interest rates that causes investors to purchase bonds that do not pay a real rate of interest. Bond purchasers make up for the negative interest rate by the rise in price in the bonds caused by the next round of low interest rates. As the Federal Reserve and the banks drive down the interest rate, the issued bonds rise in value, and their purchasers enjoy capital gains.
As the Federal Reserve and the Bank of England are themselves fixing interest rates at historic lows in order to mask the insolvency of their respective banking systems, they naturally do not object that the banks themselves contribute to the success of this policy by fixing the Libor rate and by selling massive amounts of interest rate swaps, a way of shorting interest rates and driving them down or preventing them from rising.
Just as the Fed created the housing bubble, it has now inflated a bond bubble. This is the fundamental underlying reality that Krugman wants you to not recognize. Why? Because he’s a Keynesian, that’s why. He has perpetually argued that the government needs to borrow more and spend more in order for there to be an economic recovery, which is exactly what he proceeds to do in this column, and recognition that the Fed has created a bond bubble would pop a big hole in his whole economic ideology. I’ll spare you the details of his prescription of more borrowing and spending, but then he comes to this:
That said, you should be a Keynesian, too. The experience of the past few years — above all, the spectacular failure of austerity policies in Europe — has been a dramatic demonstration of Keynes’s basic point: slashing spending in a depressed economy depresses that economy further.
So it’s time to stop paying attention to the alleged wise men who hijacked our policy discussion and made the deficit the center of conversation. They’ve been wrong about everything — and these days even the financial markets are telling us that we should be focused on jobs and growth.
That’s certainly a mouthful coming from the guy who advocated that the Fed create a housing bubble, the bursting of which precipitated the financial crisis and “Great Recession” we still find ourselves in precisely because policymakers have been heeding the kind of advice Krugman likes to give.
It’s time to stop paying attention to the alleged wise economist named Paul Krugman. The curtain has been peeled back. The great wizard has been exposed as a fraud. Or, to borrow from a different tale: the economist has no clothes.
