Krugman’s parachute is full of holes Editor: This latest article from CMI Gold & Silver debunks the notion that the Federal Reserve has a credible exit strategy. Arch-Keynesian Paul Krugman believes that the Fed should be printing and spending even more money to support the US economic recovery. Crucially however, he also believes that when the time comes, the Fed will simply be able to unload the treasuries and other toxic debt that is rapidly building up on its balance sheet. This is not a view we share.

It is one thing to increase the supply of money and credit by taking newly created money and buying assets from commercial banks and other financial entities. However, it is quite another to sell those assets and destroy the money in order to bring the supply of money back down again.

The Fed’s balance sheet is already around $2.9 trillion, and is forecast to grow to almost $4 trillion by the end of 2013 (about 25% of nominal GDP). In the unlikely event that, in the face of rising taxes, a massive debt overhang and shifting demographics, the US economic recovery gathers pace and unemployment falls to the Fed’s new target of 6.5%, the plan is for the Fed to begin unloading the “assets” on its balance sheet.

The problem is, the US government bond market is already in a bubble, and if investors see the Fed dumping its Treasury bonds, they too are likely to head for the exits. This could easily trigger a jump in interest rates and huge losses throughout the banking system.

As a recent Kitco article concluded, “While the U.S. Fed and other global central banks did forestall another Great Depression, the second act of the play they need to direct may be even more difficult and challenging.”

The pure fantasy involved in Paul Krugman’s great scheme to save the economy jumped out in one of his recent blogs where he stated:

“It’s true that printing money isn’t at all inflationary under current conditions – that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end. At that point, to prevent a sharp rise in inflation the Fed will want to pull back much of the monetary base it created in response to the crisis, which means selling off the Federal debt it bought.”

So, this really appears to be the heart of the matter in a Krugman-planned economy. “Stimulate” the economy back to health by printing and spending as much money as needed. Once back on a robust trajectory – and before price inflation rears its ugly head – unload the Fed’s treasuries to sop up all of those extra dollars.  This is pure Keynesianism, which although proven a flawed theory as far back as the 1970s, is today the dominant theory in world economics.

What could possibly go wrong? Well for starters, what if the entire notion of deficit spending an economy back to health is based on a faulty premise? Four years and six trillion dollars of additional debt later, and we’re still wallowing in an economic malaise. There’s nothing that I can see in this great experiment that indicates a rosy economic future awaits us if we can just borrow ( and print) a few trillion more.

Here’s the real problem: What if a recovery doesn’t happen and price inflation does? Is selling the Fed’s treasuries Krugman’s only parachute once we’ve jumped out of the plane? If price inflation (dollar devaluation) starts to happen rapidly enough that the Fed feels the need to intervene, how will this possibly work?

The Fed currently monetizes more than 60% of the deficit. If the Fed is going to sell its accumulated treasuries to soak up dollars, then this monetization will have to stop. But who on earth (literally) is going to buy all of this debt and 60%+ of the deficit going forward? And even if such buyers did exist, at what price would they possibly be interested in buying near zero yielding bonds in an environment where the dollar is being rapidly devalued? The catch-22 is that the ability of these bonds to soak up dollars falls with the necessity to do so.

The reality is that Krugman’s Fed has painted itself into a corner. Once you start down the path of printing money in order to fund the government, inflation is inevitable. And once that inflation starts, it cannot be stopped. No, Mr. Krugman, I’m afraid that when the dollar ship begins to sink, the idea will be to get off as quickly as possible – not book an extended cruise. Only gold will be capable of soaking up those dollars, not treasuries.

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