Sunday, March 27, 2011

Dean Baker vs. Paul Krugman

I often tend to agree with Dean, and its no different this time around, but it should be remembered that Volcker not only caused pain domestically with unemployment, he caused the debt crisis by hiking interest rates to the stratosphere.

Dean is right that the US will not be Greece, and that common currencies, like the euro (or dollarization in Latin American countries like Ecuador or El Salvador) imply that external imbalances must be adjusted with lower levels of output growth and higher unemployment.   But it is important to note that the US will also not be Zimbabwe. Hyperinflation is not about monetization of public debt. The German and Latin American cases show that is about being unable to keep the external value of the currency when faced with a balance of payments crisis.

If the US monetizes debt, and the economy is not at full employment, the level of activity should increase. If hypothetically it gets to full employment, monetization of public debt may lead to private agents using money to repay existing debts, to some currency substitution, and to some excess demand (which would force business to invest to adjust capacity to demand).

The last two may lead to some demand inflation.  Certainly during World War II, when unemployment reached 1.2%, and in the late 1960s, when unemployment fell below 3.5%, some demand pull inflation forces were at work.  But Zimbabwe is not related to that at all!!!

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