What Creates This “Incredible Credibility”?

Paul Krugman wrote a good post yesterday regarding the low interest rates in many nations.  His conclusion will sound familiar to readers here:

“Let’s unpack this a bit. It’s very hard to come up with any reason why either the US or the UK might default, since they can simply print money if they need cash. And given the absence of real default risk, long-term interest rates should be more or less equal to an average of expected future short-term rates (not exactly, because of maturity risk, but that’s a fairly minor detail).

So if you expect the US and UK economies to be depressed for a long time, with the central bank keeping rates low, long rates will be low too — end of story.

But won’t that money printing cause inflation? Not as long as the economy remains depressed.”

Alan Greenspan and Warren Buffett have been saying this same thing for years.  A nation whose debt is denominated entirely in a currency it can create, will not default.  That should be obvious.  And as I’ve explained many times, bond traders in the USA don’t fret about getting paid when Treasury bonds mature because the US government doesn’t “run out of money” it can essentially create.  Good bond traders know that.  So they worry about inflation and not solvency.  Further, the structure of the US monetary system is such that the US government procures funds via taxes and sells bonds by requiring the banking system to bid at Treasury auctions (see here for more on this).  In other words, the banking system, political system and Fed system is cohesive in a way that Europe is not.

But underneath all this is a massive economy built primarily on private production.  Ultimately, the glue that binds the monetary system is not the government or the Fed or the banks.  The glue that binds is the output of the nation.  This is very important to understand because I don’t think Dr. Krugman’s story is quite as simple as he implies.  After all, there’s more than one way for inflation to ravage an economy.  Aside from obvious cost push issues (which are usually temporary – think 70’s style USA inflation), you can see demand pull inflation in two very different environments where spending exceeds productive capacity.  The more common type is a benign growth inflation.  That is, the economy grows and demand simply outstrips supply.  This is basically your standard business cycle effect to some varying degree.  I’ve previously described this like eating chocolate cake.  It’s bad, but it’s also kind of good.  You just don’t want it to be prolonged or excessive.

But there’s a very different type of environment that can be catastrophic.  That’s the case when production collapses and spending exceeds productive capacity for very different reasons than the aforementioned.  This is often consistent with hyperinflation and tends to occur in extremely rare environments (see my hyperinflation paper here).  This is often the result of political incompetence and politics (among other things).  And I think that’s what many conservative economists really fear when they discuss the dangers of excessive government spending and influence over the way output is generated.  So it’s not quite as cut and dry as many would like to think.

Still, I think Dr. Krugman is mostly right here.  The USA is not going to suffer some colossal collapse in output and as long as demand remains weak we’re likely to see low growth, low inflation and therefore low interest rates.  In other words, the really bad kind of inflation induced via output collapse, is highly unlikely.  But that doesn’t mean it can’t happen at all.  The ability to create your own currency is a very powerful advantage that eliminates a solvency constraint (but NOT the inflation constraint), but it’s no substitute for the greatest power of all – like having 23% of the entire globe’s output.