Krugman Draws Wrong Lesson From History
Paul Krugman, like many others, cites the U.S. experience after WW II as illustrative of how proportionately large amounts of government debt can be reduced as a percentage of GDP without major trauma (Click here to view "Learning from Greece" NY Times April 8, 2010).
For example, in 1946, the United States, having just emerged from World War II, had federal debt equal to 122 percent of G.D.P. Yet investors were relaxed, and rightly so: Over the next decade the ratio of U.S. debt to G.D.P. was cut nearly in half, easing any concerns people might have had about our ability to pay what we owed. And debt as a percentage of G.D.P. continued to fall in the decades that followed, hitting a low of 33 percent in 1981.
Drawing comfort from this analogy, I contend, is misleading.
What the gross numbers fail to reveal is the distribution of ownership U.S. government debt in the post-war period. Because consumer spending was rationed during the war, and Armed Forces personnel didn’t have much opportunity or need to spend their pay, American households had little alternative but to buy war bonds. Wealthy individuals, subject to confiscatory wartime taxes in excess of 90% were constrained from accumulating disproportionate amounts of government debt. Foreigners in those days were net borrowers due to the need to underwrite their costs of the war, leaving America in the enviable position of net creditor. Therefore, war’s end found the average American household with large savings, little debt, and huge pent-up demand.
Accordingly, American industrial capacity was reorganized to produce consumer goods to meet a broad-based consumer spending spree funded by widely held government bonds. Every sector benefited: households stocked up on previously rationed consumer goods; industry kept busy supplying those needs and employing the returning vets; government serviced the debt with taxes on the incomes thus generated. The widespread fear of a post-war return of the Great Depression quickly evaporated and the U.S. economy doubled in size in the course of a decade, as Krugman states.
The situation today is much different. While the ratio of government debt to GDP is much lower today compared to the post-war period, ownership of that debt is wildly skewed in favor of the wealthy and of foreigners, thanks to the upward-redistribution of wealth commencing with Reagan and the accumulation of vast surpluses by foreigners with deliberately undervalued currencies. The average American household has scant savings (and even scanter government bonds) and a much larger debt load thanks to the ubiquity of mortgages and credit cards.
Consequently, the post-war dynamic of a consumer-driven economic boom does not exist in the U.S. presently. With over-leveraged households intent on trimming spending, increasing savings and paying down debt, domestic consumer spending cannot be counted on as the engine of economic growth. Consumer spending by the wealthy — even with their tendency toward conspicuous consumption — isn’t enough to drive the economy. The absence of robust consumer demand dampens the need for business investment to serve domestic needs, so we can’t look to domestic business investment as an economic driver. The wealthy, who hold the bulk of government debt not owned by foreigners have little alternative (in the absence of a vigorous business investment sector) but to leave their savings idle in government obligations earning less than 1 percent on the short end of the yield curve, and around 4%-4.5% at the long end. From a strictly domestic standpoint, therefore, we lack the broad-based distribution of savings we had after WW II, needed to gin up the economy with robust domestic consumer spending fueling vigorous business investment and employment growth. Accordingly, expectations of lowering government debt as a percentage of GDP through robust domestically driven growth, as in the post-war period, are misguided.
The best hope for a sustained, robust economic recovery lies with foreigners, who are the modern-day equivalent of post-war American households in that they hold vast amounts of savings in the form of U.S. government (and corporate) debt and have pent-up demand for American exports. All foreigners need to unleash a spending spree on American exports is the inducement of lower prices to be achieved by further devaluation of the dollar. Such devaluation can be expected to occur over time through the interaction of supply and demand in the marketplace. The vast supply of dollars in the hands of foreigners, combined with their need to repatriate chunks of their surpluses to sustain their own economies, should bring about a resumption of the dollar devaluation commenced in 2002, once international investors stop taking refuge in the dollar as a ‘safe haven.’ The obvious sticking point in the process is China, which has pegged its currency to the dollar since mid-2008 in hopes of sustaining their export sector. However, there are rumblings of a sea change in China’s foreign exchange policy, which should break the logjam, helping the U.S. export sector to become the driving force for the U.S. economy.
Unless or until that happens, the growing accumulation of debt by the U.S. government poses a serious risk of runaway inflation, if the debt is monetized, or depression/deflation if it is not. Even with a robust U.S. export sector, there is no guarantee that we will avoid these risks if the government continues to overspend and under-tax.