Paul Krugman is Wrong on Inflation
A major point made by others and me is that a high ratio of national debt to GDP creates a substantially elevated risk of inflation. Furthermore, I suggest that this may lead to a conclusion by decision-makers that the only policy response that can reduce this dangerous ratio of public indebtedness is to allow high levels of inflation, which in turn “grows” the nominal GDP not through higher output of goods and services, but through reduction of the constant value of the currency. Professor Krugman is dismissive of this point, making reference to the United States having a level of public debt that exceeded the GDP right after World War II, without severe consequences.
Let us look at the facts. The United States ended World War II with a labor force, including a substantial military, which was fully employed but had been restricted in the opportunities to spend disposable income. This was due to rationing on basic commodities such as foodstuffs, and the termination of production of major consumer durables such as automobiles owing to industrial mobilization in support of the war effort. After VJ day the pent-up consumer demand exploded, while consumer goods remained in short supply in the immediate post-war period. The result was a combination of real growth and high inflation, both dynamics contributing to the attenuation of the public debt to GDP ratio. Thus in 1946, the national debt ratio reached its highest level, 121%. By 1948, that ratio had declined significantly, at 93.7%. Now, let us observe the inflation rate during this period: 8.3% in 1946, a staggering 14.4% in 1947 and 8.1% in 1948. These figures clearly demonstrate that having a level of public debt exceeding 100% of the GDP does have inflationary consequences, and suggests that inflation in turn reduces the real value of the nominal public debt as a proportion of national GDP.
Perhaps the most disturbing aspect of Paul Krugman’s piece, beyond superficial and trivializing dismissal of those he disagrees with on the question of high levels of deficit spending, is his marginalization of those he disputes by resorting to rhetorical generalizations. Thus, he issues this inexplicable diagnosis of those who hold economic views that are contrary to his own: “But it’s hard to escape the sense that the current inflation fear-mongering is partly political, coming largely from economists who had no problem with deficits caused by tax cuts but suddenly became fiscal scolds when the government started spending money to rescue the economy. And their goal seems to be to bully the Obama administration into abandoning those rescue efforts.”
One of the inflation fear mongers is a supporter of President Obama’s stimulus spending program, NYU economics professor Nouriel Roubini. This is what he had to say at a recent symposium on the economic crisis, which Professor Krugman also participated in: “…we have to worry about the long run. If we’re going to finance budget deficits by printing money, we may have high inflation, even risk of hyperinflation in some countries. That’s what happened in Germany in the 1920s during the Weimar Republic. We are having large budget deficits and increasing the public debt, we don’t know whether it’s going to be $5 trillion or $10 trillion of more debt. But there are only a few ways of resolving that debt problem: either you default on it as countries like Argentina did; or you use the inflation tax to wipe out the real value of the debt; or you have to raise taxes and cut government spending. And given the size of the deficits, over time that’s going to be a painful political choice to make. So we need the stimulus in the short run, but we need to restore medium-term fiscal sustainability.”
Another supporter of President Obama’s economic policies, who also opposed George W. Bush’s deficit-financed tax cuts, is billionaire investor Warren Buffet. This is what the oracle of Omaha had to say about the linkage between high public debt to GDP ratios and the risk of inflation: “A country that continuously expands its debt as a percentage of GDP and raises much of the money abroad to finance that, at some point, it’s going to inflate its way out of the burden of that debt.”
In writing off those observers who are concerned about the inflationary dangers emerging from the exploding national debt, Paul Krugman resorts to paraphrasing Franklin Roosevelt, claiming the only thing we have to fear about inflation is the fear of inflation itself. It seems, however, that there is one authority that is of like mind with Professor Krugman. In December 2002, Treasury Secretary Paul O’Neill, about to be fired for opposing the Bush tax cuts, had a meeting with Vice President Dick Cheney. In response to O’Neill’s warning of the long-term implications for the nation’s economic health of escalating federal deficits, Cheney told the soon-to-be but prescient ex-Treasury Secretary, “You know, Paul, Reagan proved deficits don’t matter.”
I never thought I would witness the day when Paul Krugman and Dick Cheney agree on economic policy.