Paul Krugman has a blog on the New York Times Website. He’s a professor at both Princeton and the London School of Economics (LSE). And in 2008, he won a Nobel Price for his work on New Trade Theory and New Economic Geography*.

He did not, however, win a Nobel Prize for his work on liquidity traps in Japan. But I have listened to him give an LSE lecture on macroeconomic policy – and I totally thought that it was this work that got him the recognition. Also: this self-congratulatory blog post (Smuggish Thoughts: Self Indulgent).

Some background:

• In the 1990s, following the collapse of a giant asset-pricing bubble, Japan turned from a rapidly growing economy into a stagnant one;
• High land values and low interest rates had fueled excessive amounts of borrowing (which had resulted in higher land values, which resulting in more borrowing…)
• The Japanese Finance Ministry realized that this bubble was unstable, and hiked interest rates, causing the bubble to burst.
• Which was probably too dramatic a reaction
• Because the stock market crashed
• Followed by crisis in the banking sector, during which the government had to bail out the banks who were failing under a mountain of bad debt**.
• And the economy has never really since recovered.

Paul Krugman has argued that Japan fell into a Keynesian Liquidity Trap: where Japanese consumers and firms were saving too much money overall, which caused the economy to slow. The solution to a Keynesian Liquidity Trap is for the government to pump as much stimulus as possible into the system – hopefully breaking this cycle of frugality***.

[Sidebar: interestingly, PK talks about the 1990s as a time when he and three of his academic buddies were the only Harvard/Princeton folk who were really concerned about Japan and its liquidity trap situation: one of those buddies was Ben Bernanke.]

Today, a simplified version of Krugman’s public commentary is that the US and Europe are stuck in the same type of Liquidity Trap; and that the current political stance of austerity and deficit-reduction is so very very wrong****.

And he is also so very very tired of pointing that out.

As to whether he’s right – America and the West face high unemployment coupled with low inflation. Which is exactly the kind of issue that Keynes was responding to in the aftermath of the Great Depression when he developed the General Theory. So Paul Krugman isn’t being so much controversial as he is being verbatim-textbook. He also likes to quote the fact that the US has less relative debt today than it did at the end of the World Wars. And “Where is the dramatic inflation that the austerity-proponents have been predicting?!”

If I’m to venture a counter-argument here (daring, I know – he’s got a Nobel Prize!), I would say this:

• Inflation is a function of money supply;
• As is the relative exchange-rate value of the currency itself;
• In most countries, where the demand for the currency is driven by the imports/exports market – inflation and exchange rate devaluation would occur hand-in-hand;
• But the US dollar functions as more than just a medium-of-exchange for US trade;
• It also functions as the store of value for the world.
• There is therefore a demand for dollars by foreigners that is independent of trade
• It’s therefore theoretically possible for the rest of the world to carry the brunt of US expansionary monetary policy without impacting the US domestic price level, provided that there is sufficient external demand to soak up the extra liquidity being created by the Fed.

I refer you to this article from back in June: http://www.bloomberg.com/news/2012-06-18/dollar-shortage-seen-in-2-trillion-gap-says-morgan-stanley-1-.html

This is talk of a $2 trillion shortfall of dollars in the foreign markets.

In which case, the question then becomes: if there is such excess demand for dollars, why is the currency not appreciating? Traditional rules of demand and supply tell us that if there is excess demand, the only way that the price won’t change is if the demand is met with an increase in supply. And the supply of dollars is increasing: through quantitative easing.

Thus, arguing that inflation is not happening is a question of semantics: because there is a rapid dilution of the value in the US dollar holdings of the rest of the world*****, which is inflation in effect if not in name.

It’s just not so obvious: because what everyone is losing is the appreciation in the value of their holdings that should have been taking place.

*Thank You, Wikipedia.

**Sound familiar?

***Lest we forget: frugality is actually a moral evil and an economic vice – to be preached against at all literal cost.

****A less simplified version of his argument would have used multiple variations of the phrase “as those of us who are right have predicted all along”. Also, somehow, he would have worked in an observation about the Republican Party being insane.

*****Always remembering that the bulk of the world’s money wealth is held institutionally, by pension funds and the like. These funds will have investment mandates and regulatory requirements that force them to invest given portions of their portfolios in fixed income instruments (like bonds) of a given rating (AAA or AA)… This doesn’t leave many options other than the US and a few of the smaller Western Nations. And the pension funds will still be getting monthly deposits from the still-employed, meaning that every month there is money that needs to be invested somewhere. All of which translates into strong, and even growing demand for dollars (as each country drops a credit rating…).