Does Unlimited Government Spending Bring Prosperity?

Paul Krugman still is on his anti-austerity kick, which I guess is his economic flavor-of-the-week. His blog post on "austerity" and Ireland (among other countries), while clever, really does not answer the question he is asking, plus he inadvertently paints himself into a corner. Let me explain.

First, let us look at what Krugman writes:

...now the cause is fiscal austerity — and we keep hearing about supposed examples of countries that experienced a boom after tightening fiscal policy, supposedly demonstrating that austerity is good, not bad, for employment. First was Canada in the 1990s, which turns out to be a quite different story. Now we’re hearing about Ireland in the 1980s.

So, time for a little research. And whaddya know: this story is also not at all the way it’s being told (pdf). Yes, Ireland had fiscal austerity — but it also benefited from a devaluation and an inflationary boom in the UK.

Oh, and Irish interest rates fell sharply, which was possible because they were very high to begin with; that’s not much of a precedent for the United States today, which starts with very low rates.

So yes, you can boost your economy with fiscal austerity, as long as you also devalue your currency and sharply reduce interest rates; also, incantations will destroy a flock of sheep, if administered with a sufficient portion of arsenic.

We have to remember that Krugman is demanding that governments can bring back prosperity by (1) borrowing trillions of dollars for which there is no appreciable way to pay back the money unless they (2) repudiate the debt by printing money, which is what Krugman wants them to do.

There is nothing surprising here, when one is beholden to Keynesian orthodoxy. When interest rates (as set by the central bank) are at what Krugman calls "zero-bound," then the only entity that can spend freely is government, since it has a legal monopoly on "creating money."

However, Krugman's economic logic in this passage is wanting. First, what does he mean by an "inflationary boom," and why should he care? In Keynesian thinking, inflation is NECESSARY for bringing an economy to "full employment," at least until the economy reaches its highest levels of "capacity." Thus, when one holds to this way of thinking, ALL booms are necessarily "inflationary," as inflation is required for the boom to occur in the first place (and Krugman holds that booms are good).

Second, why did Ireland's interest rates fall? Krugman gives no causality; they just fell. Third, none of this explains why Ireland in the 1980s had a fundamental economic change in which the country went from a quaint, but poor nation that mostly exported people to a place that attracted new investment AND people who wanted to be part of what was happening.

With Krugman, the change just happened, but lots of places have currency devaluations and even lower interest rates, yet do not have paradigm shifts in the economy. In other words, Krugman really has no causality theory for what happened.

James Burnham in a 2003 paper in the Independent Review wrote about the Irish boom, and gives much more detail into what happened. Yet, Krugman, holding to his Keynesian orthodoxy, simply gives us one more example of post hoc ergo propter hoc.

Again, we are dealing with two very different paradigms. In the Keynesian way of thinking, spending is everything. This is very different than "demand" as we know it, economically speaking, in which demand reflects what people want and what they are willing to give up in order to obtain it. In other words, demand cannot be separated from opportunity cost.

In the Keynesian view, however, "demand" really means "aggregate demand," which exists when people have "purchasing power" fueled by money. Thus, when government prints more money, it creates new "purchasing power" and, therefore, new "aggregate demand." There is nothing purposeful about this whole scenario; in fact, there really is nothing economic about it, for real economics deals with opportunity cost, something that pretty much is missing in Keynesianism.

So, we really are arguing two very different views of the world, and I believe that the Austrian view, while hated by the Krugmans of the world, better explains economic phenomena than does Keynesianism. However, don't forget that the very first line of Carl Menger's ground-breaking Principles of Economics makes the important point: "All things are subject to the law of cause and effect." In other words, to Austrians, causality really matters.

We are left, then, with the question that I asked in the title of this post. Krugman assumes that government spending financed via borrowing and printing really exacts no opportunity cost. I cannot accept that view under any circumstances. The fundamental building block of economic thinking is opportunity cost, and to ignore it is to jettison economics in the whole.