Paul Krugman recently wrote an op-ed in The New York Times about the exit of Bill Gross from Pimco and why that happened because he didn’t understand that we’re in a deflationary or depression-like economy. He kept betting on interest rates rising on a lag from money printing or quantitative easing (QE) but that never happened and his massive bond fund suffered.
I don’t agree with Paul Krugman about too many things, but I do agree with one of his major points in that article.
He said that people like Gross and the gold bugs have a view of present government deficits that isn’t appropriate. The classic theory is that if the government borrows too much, it both tends to raise interest rates and to crowd out private borrowing.
And that does tend to be the case in most economic periods…
The Ups & Downs of an Economy
In boom periods, businesses begin to expand, higher rates occur and there is little interest in bonds, especially when stocks are doing well.
This would definitely be the case during an inflationary period similar to the one that occurred during the late 1960s through the 1970s. New investment is a necessity when there are shortages of capacity, goods and high inflation rates. In this scenario, high rates and heavy-handed government borrowing become strong deterrents.
And it’s here where Krugman is right.
After the fall bubble boom of 1983 to 2007, both businesses and consumers over-borrowed and over-invested. Even when central banks reduce short-term interest rates to zero and long-term rates near or below zero real returns, businesses aren’t lining up to borrow, nor are consumers (especially the older baby boomers who still dominate the economy).
Government deficits and increases in borrowing don’t compete with the private sector. The chart below shows how private debt has deleveraged or shrunk slightly since the crisis of 2008, while government debt levels have continued to soar.
Has inflation gone up with $4 trillion of money printing and $7 trillion and rising in deficits since 2008? No, it has actually fallen.
Has government borrowing crowded out business? Definitely not. They have just used most of what they have borrowed to buy back their own stock and increase earnings per share, as most don’t need more plant and capacity.
Deflationary periods occur once in a lifetime when debt bubbles cause over-expansion and financial asset speculation. When those bubbles deleverage and debt and wealth is rapidly destroyed, you have less money chasing the same goods which is the classic definition of deflation!
But that’s as far as I agree with Krugman.
Despite the fact that the Fed brought QE to an end, he still thinks the government should have run deeper deficits and had more money printing to offset the decline and debt deleveraging of the private sectors — classic Keynesian economics. That represents an even greater misunderstanding of the dynamics of the economy than the concept held by the gold bugs.
He, like most economists would like to see an economy that grows at 3% to 4% with 1% to 2% inflation and with no recessions — ever!
He, who has never run a business, doesn’t understand that the innovation that underpins free-market capitalism is driven by the play of the opposites of many factors, like boom and bust, inflation and deflation, innovation and creative destruction, success and failure.
The greatest innovations come in challenging periods of busts and high inflation or deflation — NOT in economists’ dream economy of 3% growth and 2% inflation.
It’s human nature to overdo and over shoot everything. That’s why the economy and markets have natural mechanisms for re-balancing. Inflation stimulates investments that bring inflation down and then benefit the economy for decades to come — the killer apps like the assembly line in 1914 and the PC in the late 1970s.
Deflation is where you see the most radical long-term innovations from autos, electricity and phones in the late 1800s to TVs, automated appliances the computer and jet engines in the 1930s and 1940s. Excessive debt needs to be washed out when it’s no longer useful for the future and was largely built around speculation, not productive capacity.
At least the gold bugs understand that you don’t get something for nothing and that you can’t borrow your way out of a debt crisis. They just don’t get the impacts from much farther back in history (1930s) of what actually happens when a debt and financial asset bubble deleverages.
But Krugman and most economists don’t understand the most fundamental dynamics of the economy… at all!
If Krugman had his way with endless money printing, the economy will never rebalance and we would have gone into a coma economy like the one the Japanese have been in for 25 years now and not yet come out of it.
I have faith and strongly predict that the markets are going to win in the next five or more years and we’ll get a great reset or depression that deleverages the whole system and lays fertile ground for the next spring boom from 2023 into 2036 forward.