Greek Default, And Krugman v. Krugman

Vex me!  Last week Megan McArdle opined on the possibility of rising credit default spreads on US Treasury debt, prompting a derisive response from Paul Krugman and inspiring a marvelous (yet unpublished!) post by Yours Truly.  A week later, Krugman has rebutted himself, which ought to spare me the trouble, but allow me to reflect on what might have been.

The subject was the question of whether rising yields on long term Treasury Notes foreshadowed a rising risk of default.  Here is Krugman from March 31 identifying high inflation as the likely pre-cursor to default:

More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se.

I now wish I had posted several points, rather than simply reviewing them with my cats.

First, the notion of hyper-inflation followed by default probably takes its inspiration from Weimar Germany and Latin America.  However, neither example is useful since they (like Greece, but unlike the US) were dealing with debt denominated in something other than their own currency.  In fact, as Krugman notes in the passage above, inflation is probably a substitute for formal repudiation of our debt.

However, Japan's Lost Decade provides a more relevant example - a long, grinding deflation could push the US into an untenable financial position.  And that might happen despite a sustained Fed policy of low interest rates and easy money.  Imagine that China maintains its link of the yuan to the dollar, so that easy dollars simply result in easy yuan, thereby stimulating employment and production in China (actually, that is pretty easy to imagine, since it has been the story of the last several years, although China's policy may change.)  The Fed will never achieve either inflation or robust growth here, since China swallows it up by buying dollars and selling yuan, and the US might be pushed to the brink.

But to the brink of what?  What might a US default look like?  Since we control our own printing presses, it is not that easy to picture logical scenarios in which we default on our debt rather than spinning the presses and printing the legal tender needed to pay off our bills, notes and bonds.  But we are talking about Washington, so why rely on logic?

An obvious irrational default scenario is simply that a Just Say No Congress plays chicken with the Treasury and the Administration, refuses to raise the debt ceiling, and delivers a train wreck on some maturing debt.  That may not tell us much about the US long-term ability to pay, but it will surely spook markets.  Even if the debt ceiling problem is quickly resolved, there will be repercussions throughout the global payments system as people who were relying on maturing Treasury debt to make other payments find themselves caught short.  Even though people would get their interest and principal in a near-timely fashion, US borrowing rates would be higher for years.  And as to whether inflation would be high or low when Congress acted out, who can guess?

And can we conjure a semi-rational default scenario?  Yes, but it depends on the meaning of "default".

Suppose the US becomes fed up with China maintaining a link to the dollar, thereby boosting their economy instead of ours.  Congress and the Treasury might dream up some arcane withholding tax that has the effect of keeping some of the interest and principal owed to China right here in the US (just for example, it could be dressed up as a concern that terrorists or drug cartels are investing in Treasuries through Chinese banks).

Since Chinese investors won't be receiving full and timely payment they might consider the US to have defaulted; other investors not subject to the targeted withholding may or may not not agree.  Chaos!  But one result would be a strong disinclination on the part of the Chinese to continue the cycle of supporting the dollar by buying US Treasuries.  That might free the Fed and boost the US economy.

My gist (had I posted this) would have been that deflation is probably more of a worry than inflation as far as a US default goes.  As a sidebar, I would have noted that the probability of default might be modeled separately from the probability of high inflation, since inflation is neither necessary nor sufficient to trigger a default.

But I let a week go by and now Krugman has beaten me to it!  Here he is, taking a lesson from Greece:

But what are the lessons for America? Of course, we should be fiscally responsible. What that means, however, is taking on the big long-term issues, above all health costs — not grandstanding and penny-pinching over short-term spending to help a distressed economy.

Equally important, however, we need to steer clear of deflation, or even excessively low inflation. Unlike Greece, we’re not stuck with someone else’s currency. But as Japan has demonstrated, even countries with their own currencies can get stuck in a deflationary trap.

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.

It's two columnists in one!  A week ago a rising risk of default should have been accompanied by a rising concern about inflation.  Now, a rising risk of default should be coupled with a rising fear of deflation.

Whatever.  For our friends on the left, Krugman was a genius each time.  For my money, he was right the second time.

REPEAT FOR EMPHASIS:  Here is a longer excerpt from Krugman I:

More broadly, on the risks-of-default thing: surely if investors were growing worried about US ability to honor its debts, they would be worrying about a breakout of inflation as well as or instead of default per se. But we can track that by comparing interest rates on ordinary bonds and inflation-protected bonds. What we see is that from 3/17 to 3/30 — the period that inspired all those recent scare stories — the nominal interest rate on 10-year bonds rose by 26 basis points; the real rate rose by 28 basis points. So expected inflation actually declined, marginally.

This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay. It is, on the other hand, exactly what you’d expect to see if markets slightly upgraded their hopes of recovery.

A week later, per Krugman II, a reduced perception of future inflation (assuming the 2 bp move is not just noise) is now consistent with an increased risk of deflation and default.  So "This is not at all what you’d expect to see if markets were pricing in fears about the US ability to repay" can be revised to read "This is exactly what you’d expect to see if markets were pricing in fears about the US ability to repay".

And since default can occur in either deflationary or inflationary scenarios, his basic notion that we can track it by comparing conventional and inflation-indexed bonds is now out the window.

It would be interesting to see Krugman's email inbox; if the flaws in Krugman I were obvious even to a primitive caveman righty such as myself, I'll bet he got pushback from others as well.

TO BE MORE SPECIFIC:  My original intended title had been "The Over-Excited (But Under-Specified) Paul Krugman".  Eventually I would have made the point that we have too few variables for the explanatory factors in play.  For example, rising optimism in a strong recovery could push up expected future real interest rates, or rising fiscal gloom could push up expected default premiums. In either case, all we mere mortals would observe is that nominal interest rates are higher.  And that would apply to both fixed and inflation-indexed bonds.

Comments

[Captain Hate]

TM, you have this persistent belief that Krugman will ever make sense....

[Ignatz]

Krugman is like one of those ordinary guys who one time in his life has a bright idea, patents it and makes a mint.
While every other aspect of his life and mind is a hopeless mediocrity, people continue to listen to him because for one short fortuitous moment in his life, long ago and never to be repeated, he wasn't a lunkhead.

[Clarice]

My head's spinning. what was your cats' take?

[Jeff]

gee, wasn't Krugman the Enron economist ?

How is it that the economist who oversaw one of the largest financial frauds in history is not wearing stripes ?

Just looking back at some of the more recent financial frauds (Enron, Fannie/Freddie) and you'll notice alot of liberals involved. Correlation is not causation but then again maybe it is ...

[RichatUF]

Congress and the Treasury might dream up some arcane withholding tax that has the effect of keeping some of the interest and principal owed to China right here in the US (just for example, it could be dressed up as a concern that terrorists or drug cartels are investing in Treasuries through Chinese banks).

Wouldn't this run afoul of WTO rules? Also, didn't the UST already have a problem with a "cartel" (ie North Korea) laundering proceeds from various activities through Macau and HK banks? I could also see China retaliate with a re-export tax that would clobber WalMart and Walmart's suppliers.

Imagine that China maintains its link of the yuan to the dollar, so that easy dollars simply result in easy yuan, thereby stimulating employment and production in China...

But isn't there a dimishing returns problem? The Chinese are heavily dependent on the US market and if the US economy sags, consumer spending sags, which would eventually cause employment in China to sag. The other is that doesn't a strengthening yuan (or easier convertibility) import inflation in the areas that China really doesn't want it-food and energy-and could potentially bring inflation into the areas that are already overheated-property, equities, plant?

More later...

[Like 'Climate Science' it's got numbers, but it ain't science.]

Dismal, yes he is.
=========

[RichatUF]

An obvious irrational default scenario is simply that a Just Say No Congress plays chicken with the Treasury and the Administration, refuses to raise the debt ceiling, and delivers a train wreck on some maturing debt.

Didn't we have a precursor to this during the government shutdown in the 1990's, where Clinton and Rubin went out and spooked the bond market and Gingrich obliged with his loud mouth.

And I seemed to have missed the plot of the post-sorry.

[The many faces of Evil.]

Rich, it's about The K not knowing or caring what he says because he's on the side of the Gods. Ditto the EcoFruck Friedman.
=============

[glasater]

RECOVERY?!? WHAT RECOVERY? THE U.S. IS COMPLETELY SCREWED!!! (Howard Davidowitz)

First time I've heard of this fellow--a retail analyst.....

[So far, it's the Mishigas Century.]

Yep, g, it's crazy. Like the climate business.
======================

[Jane]

Go Sarah go!

[Jane]

Oops! Wrong thread

[Melinda Romanoff]

glasater-

Howard is well known by others, and is very good at retail consulting and finance.

Very, very good.

And he likes David Rosenberg, my 2nd favorite economist.

[Tom Bowler]

Doesn't Krugman make you long for the days of TimesSelect! Oh well. I thought I caught him in a contradiction in his recent article on building a green economy, when he said,

"If there’s a single central insight in economics, it’s this: There are mutual gains from transactions between consenting adults."

Then he followed it almost immediately with,

"Free markets are “efficient” — which, in economics-speak as opposed to plain English, means that nobody can be made better off without making someone else worse off."

How was someone else worse off, when he just said the transaction was mutually beneficially? Silly me. I forgot all about the third world babies and polar bears dying from carbon dioxide inhalation. Tragically, it's all our fault as the conscience stricken liberal so frequently points out.

[Frau Steingehirn]

Didn't a JOMer suggest we always refer to him as "Enron Adviser Paul Krugman"? Always.

[glasater]

Mel--he's a straight talker and I appreciate that....

[DaDa da]

Shorting real estate is like the spread; short one side, long the other and a legal short as long as your long too so we should be okay.

[Obra la boca.]

You put your right foot in.
==============

[Jim Ryan]

my 2nd favorite economist

Mel, who's your most favoritest?

[Jack is Back!]

After watching Melinda's link to the Jim Grant explication of why Treasuries were losers and now reading this post and Krugman, I am reminded of something I learned from my 35 year business career:

An economist is a highly trained professional who's guess is as good as your's or mine.

[glasater]

Speaking of Jim Grant--here's a recent video:

Jim Grant Eviscerates Greenspan, The Foolish Ayn Rand Acolyte Who Just Wants To Be Loved

This is one of those--"Whoa" type videos.....

[Tom Maguire]

what was your cats' take?

My cats will listen to anything, until I feed them. But sometimes I glaze over during my explanation...

[Tom Maguire]

How was someone else worse off, when he just said the transaction was mutually beneficially?

In the first instance, Krugman is saying people mutually benefit from voluntary transactions.

In the second instance, Krugman is saying that coerced transactions (higher taxes to fund welfare payments) make some people better off and others worse off.

That's my guess, anyway.

[jimmyk]

Tom Bowler--Not sure of the context, since what you quote could have been said by Milton Friedman. The point is that free markets allow all those mutually beneficial transactions to take place, so that as a result, "nobody can be made better off...."

[Melinda Romanoff]

Jim-

The one who spent nearly four years, every day for six hours, on the phone training me about inflation and bond pricing. He's long retired, and wants his privacy. So II keep up my end of that request.

And I remain eternally grateful.

Other favorites? Neal Soss and Darwin Beck are two of my favorites from First Boston days.

[Ignatz]

--That's my guess, anyway.--

Assuming the quote is accurate and is about efficient "free markets" it's hard to see how he could be referring to taxes and welfare.

[MikeS]

I struggled to get through Econ 101, but it's my impression is that a few liberal elites spout economic gibberish. The rest, not wanting to appear ignorant, nod their heads in approval.

For example, the Libs claim that higher energy costs is a good thing, even though most of those higher costs go overseas. Conversely, they claim that higher medical costs are a bad thing. Most of that money stays in this country and pays for innovations as well as U.S. salaries and U.S. taxes.

Another bit of gibberish is the claim that spending $2.5 trillion more on healthcare will reduce the costs. They all nod when they hear that one. "Of course," they say, "the savings will come from doing more volume!"

Here's some common sense.

[Charlie (Colorado)]

By the way, just added this to the new PJM ticker as "Krugman debates Krugman, loses".

[Charlie (Colorado)]

My cats will listen to anything, until I feed them. But sometimes I glaze over during my explanation...

My old Siamese, Vashti, listened to me working through my notes for my doctoral comp, then explain and debate my whole dissertation. Probably the most mathematically sophisticated cat of her generation.

[Charlie (Colorado)]

First time I've heard of this fellow--a retail analyst.....

Now you know what it takes to get heard of, especially the first time.

[sbw]

As a non-economist, I need some help. Adam Smith distinguished between productive and service jobs where productive adds value and service is, well, like a servant. Smith valued the former more highly, for increasing GDP by a larger multiplier than simple service.

Have we metrics that have divided GDP into those types of jobs, typically private sector and voluntary, that accentuate division of labor vs. those jobs, typically government, that are service.

If I were redefining GDP I'd measure private sector created wealth minus public sector pseudo-wealth and call that GDP.

Any pointers to charts and graphs on this?

[Rick Ballard]

"Any pointers to charts and graphs on this?"

NIPA tables, not charts and graphs.

GDP Split

Income Split

The tables are actually more fun (stop looking at me like that) - you can generate graphs until your eyes cross. Be careful about those first derivatives though.

[Tom Bowler]

TM, jimmyk, and Ignatz,

Krugman was actually talking about "negative externalities" where evil free market consumers and producers crush innocent third parties - like the polar bears - when they engage in dastardly commerce. Buy a car, decimate the polar bear herd.

But what if a deal between consenting adults imposes costs on people who are not part of the exchange? What if you manufacture a widget and I buy it, to our mutual benefit, but the process of producing that widget involves dumping toxic sludge into other people’s drinking water? When there are “negative externalities” — costs that economic actors impose on others without paying a price for their actions — any presumption that the market economy, left to its own devices, will do the right thing goes out the window. So what should we do? Environmental economics is all about answering that question.

The point of Krugman's article was to promote cap and trade legislation.

[Melinda Romanoff]

sbw-

I would start here at the BEA and pull down the parts you're interested in.

Bearing in mind that service related jobs are broken out in the Establishment Survey of the monthly Employment Situation also known as the Unemployment Report, released on the first Friday of the month.

I'm happy to point you towards other statistics upon request.

Note that Government Payrolls are a separate category and are divided three ways, Postal, Federal, and State & Local Governments.

Good luck.

[Melinda Romanoff]

I agree, Rick. The tables are waaay better.

And first derivatives only hurt when they're traded OTC!

(Fozzy Bear is gape mouthed for that one!)

[glasater]

But Charlie..I've always loved retail...and wholesale..and better...cost...:-)

[Steve C.]

It's the 70s again. Rising oil prices will kill off growth and we will see deflation in things that don't use a lot of oil. Which means cheaper Iphones and that's about it.
It's funny, but 15 years ago we were told that it was useless to drill for oil in ANWAR because it would take 10 years to get into production.
THANKS CLINTON DEMOCRATS!

[Sharon says Obama sux]

Tonight, while hubby was clicking through channels came upon Katie Couric gushing about the Dow hitting 11000 today.
She then stated that it's the first time since 1999 that the Dow has gotten to 11000. HUH!!
I thought I heard it wrong but hubby heard it too.

[glasater]

alt="Price for 2010 US House of Representatives Control at intrade.com"
title="Price for 2010 US House of Representatives Control at intrade.com" border="0">
A fellow on Kudlow's show 'bought' at 22....

[Melinda Romanoff]

Steve C-

Small problem, crude prices are rising, supplies are rising, and demand for distillates is dropping.

What's the figure out of line?

[Melinda Romanoff]

OT, glasater, have you ever been to Lake Crescent Lodge in Olympic Nat'l Park?

Just curious, I had a digital camera and I thought I would run out of film...

[Clarice]

TM:"My cats will listen to anything, until I feed them. But sometimes I glaze over during my explanation..."

Mine won't listen unless I accompany the piece with some shaved dried bonito chips and use a flying Da Bird as a pointer with the charts.

[Charlie (Colorado)]

Melinda, I haven't looked at it much, but aren't the usual prices they quote the 30 or 60 day future price? If so, then this would indicate they expect a major ramp in demand and/or a major supply constriction.

Or, of course, an external event changing the price, like more CO2 restrictions, tariffs, or charges.

[Charlie (Colorado)]

By the way, I'm looking for more financial articles for PJM. Use charliem AT pajamas if you're interested.

[glasater]

Melinda--

Lake Crescent--was there on our honeymoon.......

It is lovely there and hope to get back soon.

[Manuel Transmission]

Hey Mel, looking forward to your pix. Currently laying about in a nice HI in Beijing until the second big wave of work starts Monday. The beds at the work site are so hard I get bruises, so this is heaven by comparison. We spent about six hours yesterday finding the only espresso machine in the country that takes those little packets for brewing. Want to keep my crew at top form to get things done quickly.

[matt]

they're playing Russian Roulette with a semi-automatic pistol.

Gold and Silver rising. Commodity prices rising...hmmm..what could ever be going on?

[Melinda Romanoff]

Chaco-

My query to Steve C was a set up.

Price theory implies that equilibrium of supply and demand determines price. I threw out that supplies were growing and demand was dropping, which they are, but prices were rising, which is also true. So, by price theory implications, the current price is wrong.

Yet, the price is.

Why?

On one part, the continued treatment of commodities, by Wall Street types, as an asset class, or more simply, a storage point for wealth (not a good, as in merchandise to be consumed). The second being the current Chinese demand for ALL commodities, and, more specifically, trying to guarrantee their continued supply.

These two are enough to distort, front month, crude oil prices and the resultant distillates, aka "the crack".

One last definition, "front month" commodities, versus "spot" commodities.

Originally, commodities traded on self-regulated exchanges in self-segregated, by delivery date, trading pits. Ignoring the importance of the organization of the exchanges for now, the distinction of standardazation of "delivery" of a commodity is what makes all the difference in its tradability. IF you can design a commodity contract for the following: WHAT, precisely, will be delivered (Grade, Quality, Purity, Interest Rate, what have you), WHEN it will be delivered, WHERE it will be delivered, and HOW it will be delivered; you will be left with only two things to decide, number of contracts and the price per contract.

The brokers and "pit" traders, via "open outcry" (MUST publicly yell how much, buy or sell, quantity, and price) determine the prices that these standardized contracts trade via customer orders and trading for their own nickels. The different contract delivery months are distributed about the pit by the members with the dominant position, "top step" given to the month just one further than the month closest to delivery. This is the "front month", which, to the traders actually trading it, are on the top step of the pit looking into the pit where the trading is happening, their clerks are looking out, where their orders are coming from via hand signals.

The "spot" month is the month that is TODAY's, deliverable, TODAY, as in right now! In the case of One Contract of CME traded West Texas Intermediate Crude Oil, which would be 1,000 barrels of qualifying crude, settled today at the price per barrel of $84.92, deliverable. today, all 42,000 gallons.

I hope that clears some things up.

I open the floor to questions.

And sorry for the pixel load, this stuff needs to be shared, and it's partly my fault for just keeping it as a personal tool.

[Manuel Transmission]

Nice lesson for us flatlanders, Mel. Now I can blend in the four phones and the card stock and the funny, ink stained jackets to get the whole image. ::grin::

[glasater]

As the terrific Rick Santelli says--You can't print corn.... :-)

[Rick Ballard]

The question of probability of default is not quite as abstract as it seems. Krugman, as the Democrats cheapest crack whore, will assume any position requested at a moments notice.

He knows that if comprehension of the Bank of International Settlements report cited above were possible for the majority, the complete criminal idiocy of HCR would cause every Democrat who voted for it to be driven not just out of office but into exile. He also knows that the free lunch of low interest rates that is presently being enjoyed by Turbo Timmy is getting down to the last crumbs on the dessert plate.

The BIS paper actually understates the severity of the problem facing the US because it incorporates rather rosy assumptions made by the CBO regarding tax collection which are already proving to be false. Air Taxes and a VAT are insufficient to plug the gaping hole in Uncle Sugar's bucket. I would also note that the shadow economy mentioned by the BIS is primed to expand to Greek/Italian levels here, with a very negative probable negative impact on tax collection.

Why on earth would any Millennial feel obligated to pay taxes with thieves such as Geithner heading Treasury and Rangel and Conyers chairing important committees in the House? It's far better to continue to collect extended unemployment benefits and pick up cash on the side.

[B Buckner]

I think you are missing the real danger here. We are not talking about a little inflation to solve the long term problem. We are on an unsustainable path with regards to spending and borrowing, and it can all come crashing down very quickly. A loss in faith that our debt will be repaid will stop the purchase of our bonds. Quickly thereafter foreign holders of dollars will sell them for more stable currencies and the value of the dollar will crash. At that point it will be obvious to all that we cannot repay our debt and we will default. Then, yes, we can print all the money we need to keep the ship afloat. But this is not a little printing, but massive printing that will lead to triple digit inflation and a very bad scene for a couple of decades. I wouldn't count on our ability to print money as an easy way out of the problem we have.

[Melinda Romanoff]

BBuckner-

There are two battles going on right now. Deflation is one (the BIG one), reckless fiscal actions are the second. The first is being tackled by the Fed, the second being created by Congress and the Administration.

The Fed is doing what it can. November can start the repair of the second.

As far as foreign replacements, do you want to bet Russia will honor repayment of their thirty year paper? The have a track record of doing otherwise, and the list goes on...

[sbw]

Thank you, Rick and Mel. What a community JOM is to have people like you able to answers to such curiosity at the flick of a mouse.

[Melinda Romanoff]

Maybe, but Rick's winning the links game, better quality.

I'll catch up.

[Rick Ballard]

Mel,

I agree with you regarding deflation being the larger problem. I would add that the demographics for this decade are going to greatly compound the problem. Boomers are exiting their most productive years and their consumption will decline as a result. The GenX cohort is substantially smaller (they're going to be substantially richer as well) and the Millennials are going to have a very rough time adjusting to an environment that is really not going to treat them in the manner to which they have quite foolishly become accustomed.

I find it difficult to come up with a scenario that allows the GDP to grow at more than 2% for the rest of the decade (aside from a touch of hyperinflation instigated by Helicopter Ben. That tiny .02 per hour in average earnings is rather troublesome. I've been watching help wanted ads for the bottom tier and I've seen a measurable drop in wages offered for semi-skilled manual labor. $12 is being offered for work that commanded $14 two years ago. The problem is that $12 will increase outlays for food stamps quite dramatically and accelerate down the spiral.

It's really getting to be Chinese curse "interesting times".

[w3bgrrl]

This post pwns the unpublished post.