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Monday, April 12, 2010

Paul Krugman and Lessons from the Greek Debt Crisis

Dr. Douglas O. Walker
Robertson School of Government

In an article published yesterday, Paul Krugman of the New York Times discussed the debt crisis in Greece and what he regards as its implications for the U.S. He pointed out the crisis in Greece seems to have reached the point of no return, as he put it, and this small country is going to pay a steep price for its past irresponsibility.

He also noted that while the U.S. also has a large and growing national debt, its policy options are very different from those before Greece and consequently the U.S. response to its problems of recession and debt should be very different from the harsh approach followed by the Greeks.

To Professor Krugman, the difficult situation Greece finds itself in is more than a problem of high debt. It is also a problem of policy inflexibility caused by the fact that Greece does not control its own currency and cannot conduct its own monetary policy. If Greece were not linked to the euro, he points out, its options for dealing with its debt would be more than steep spending cuts and large tax increases: It could inflate its currency, thereby reducing the real burden of its debt. In its present circumstances, however, leaving the euro would trigger terrible consequences, so Greece must endure severe austerity measures intended to sharply reduce its output and employment, with their painful social consequences.

For Krugman there are lessons in the Greek crisis for the United States. While he says "Of course, we should be fiscally responsible" and take "on the big long-term issues, above all health costs," he also seems to suggest that the way to become more fiscally responsible is to spend more money, incur more debt, inflate the currency, and only pay attention to the immediate problems before us. In his own words:

"What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off."

In short, the way to become more fiscally responsible is to become even more fiscally irresponsible and short-term oriented than we have been in the past.

We can do this because, unlike the Greeks, we "own" our own currency and therefore can use our monetary policy to support whatever fiscal policy seems opportune at the moment. It seems in his view we can also do this with no expectation of a response on the part of capital markets, even though we conduct our policy with the goal of manipulating our interest rate, money supply and exchange rate so as to reduce deliberately the real value of the debt we are incurring. Somehow, investors are not going to take into account in their purchase of Treasuries the impact of the policies the government says it is going to follow.

Moreover, it seems that in Professor Krugman's view we can continue to sell our escalating debt to American and foreign investors on the expectation that the economy will quickly return to rapid growth and the means to pay the higher debt will be strengthened. Supposedly, this rapid growth and stronger debt repayment capacity will be achieved even though he proposes we put in place high energy and health care taxes and remove more and more low-income households from the tax rolls.

I suppose anything is possible. But frankly I do not think many people would be encouraged to buy U.S. debt if they thought the government was simply going to be guided by short-run considerations divorced from the longer-term impact its policies will have on the economy's performance and its capacity to pay back the real value of its debt it owes.

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