Austerity or Reckoning? We Cannot Print Our Way Out of the Crisis

While attending the 2001 ASSA meetings in New Orleans, I was jogging one morning and found myself in the company of a Yale economics professor who taught monetary economics. We had a discussion of approaches, and I explained that I went with the Austrian view, in which one teaches monetary theory from a marginal utility angle. In other words, money is a specialized good used specifically for exchange that is subject to the same laws of economics as any other good.

The Yale prof listened intently and sounded interested. Given that he taught monetary theory from a quantity view of money approach, my viewpoints were foreign to him, but he was not dismissive of what I was saying. Instead, he told me that he was interested and that he had not even thought of looking at money that way. Whether or not I planted a seed of interest, I read today from another Ivy League economics professor, Paul Krugman, that money is so "other worldly" that we really cannot apply economics at all.

Now,Krugman does not give a direct approach of monetary theory in his blog or columns, but it is there in default. Like all Keynesians, he believes that as long as an economy is not running at "capacity," and if interest rates (as set by government monetary authorities) are at or near zero (which Keynesians call a "liquidity trap"), then the only thing that can drive an economy to "full employment" of all resources is "fiscal policy," in which governments borrow and print money in order to push enough spending to those full-employment limits.

This viewpoint also holds that the key to a healthy economy is the rate of unemployment, not just of labor, but of all resources. For example, the "full-employment" of World War II is seen as an economic triumph because anyone who wanted to find work could get a job (provided he or she moved to the population centers where the factories and administrative offices were located). Farmers had huge markets for their crops, and people suddenly had money in their pockets. The fact that the government rationed goods, including food and fuel, is ignored, since people had jobs, and that was the only thing that mattered.

I don't believe that I am misrepresenting Krugman's views here, as they are pretty much standard modern-day Keynesian. The problem, however, as I noted in my post containing Robert Higgs' assessments of Keynesianism, is that this viewpoint has some very unreal assumptions, the most important being that all assets are homogeneous, so it does not matter what is being produced, be they bombs or bagels, as long as labor is being used. Furthermore, the assumptions also rest upon a pure quantity theory of money in which prices themselves are irrelevant, being subservient to a government-calculated "price level."

Another false assumption from this viewpoint is that consumer spending is nothing more than "buying back" the products they created as workers. There is no purposeful behavior here, just a circular motion of production and purchases. As long as consumers have jobs and income, they can continue this circular pattern and the economy will be operating at "full employment." Thus, World War II in this analysis would be a period of "good times."

Professor Higgs, however, takes down even the "war prosperity" myth in this paper. I think a reading of this will change one's viewpoint considerably about the views economists have about World War II.

Unfortunately, this is a very stilted and inaccurate way of looking at the economy, as there really is no plan or purpose on behalf of individuals. Instead, they simply produce, purchase, and consume in a rather mindless fashion, yet that is what Keynesians believe is a "thriving" economy. In Krugman's view, because we are in a "liquidity trap," the only thing that can rescue the economy is government borrowing and spending.

In today's post, Krugman gives what I would call his classic viewpoint of what I have described. Furthermore, in his theoretical world, any spending cutbacks will create needless disaster. After all, if assets are homogeneous, and governments can borrow and print just as long as the economy is operating "below capacity," then it is foolish to stop and engage in "austerity." He writes:

Some thoughts on the fiscal austerity mania now sweeping Europe: is anyone thinking seriously about how this affects the rest of the world, the US included?

We do have a framework for thinking about this issue: the Mundell-Fleming model. And according to that model (does anyone still learn this stuff?), fiscal contraction in one country under floating exchange rates is in fact contractionary for the world as a hole. The reason is that fiscal contraction leads to lower interest rates, which leads to currency depreciation, which improves the trade balance of the contracting country — partly offsetting the fiscal contraction, but also imposing a contraction on the rest of the world. (Rudi Dornbusch’s 1976 Brookings Paper went through all this.)

Now, the situation is complicated by the fact that monetary policy is up against the zero lower bound. Nonetheless, something much like this transmission mechanism seems to be happening right now, with the weakness of the euro turning eurozone fiscal contraction into a global problem.

Folks, this is getting ugly. And the US needs to be thinking about how to insulate itself from European masochism.

However, if assets are heterogeneous, and if money is a good subject to the laws of economics, and if the Europeans must be able to produce real goods in order to pay for their welfare states, then Krugman is uttering foolishness. For the past three years, governments have been boosting their spending to irresponsible levels (at Krugman's urging) and printing money like mad in order to try to "spend" their way back to prosperity, and we are seeing the results: unemployment is at double-digit levels and all of this spending has created zombie financial institutions that on paper are "solvent" but in reality are on the brink.

Furthermore, the wave of government debt creates real liabilities that reflects the perilous situation that exists today. Instead of creating "full employment," these policies have furthered the malinvestments that are at the heart of this downturn. Unfortunately, Krugman refuses to see this point, so he will continue to demand that governments create even more malinvestments, all in the name of "fighting the depression."

At the heart of this matter is the Keynesian myth that money is something extra-economic, and that printing more of it (provided the economy is at less than full employment) will put us back to work and create prosperity. Instead, the current policies of the U.S. and European governments are digging the hole deeper, and Krugman is claiming that the only thing that will work is for us to use bigger shovels.