Monday, March 11, 2013

The Federal Deficit is a Symptom, Not a Disease

Member of Congress are infamous for attacking symptoms of a problem instead of going straight to the heart of the disease, and the current "discussion" on the massive federal deficits are yet another case in point. While I do find myself in some agreement with Paul Krugman on the issue of deficits in his most recent column, nonetheless I also find that once again Krugman sets up the straw man argument and falsely portrays himself as a lonely voice of sanity.

I will say it again; the federal budget deficits are symptoms of the larger problem of federal spending and lawmakers and economists should not be fixated upon them while ignoring more important issues. While I agree with Krugman that as the economy improves, deficits will grow smaller, I contend that the Keynesian prescription -- spend like crazy during the recession -- actually has made the economy worse and has prevented a more robust recovery.

Then there are following statements like this that make me scratch my head in disbelief:
What’s really remarkable at this point, however, is the persistence of the deficit fixation in the face of rapidly changing facts. People still talk as if the deficit were exploding, as if the United States budget were on an unsustainable path; in fact, the deficit is falling more rapidly than it has for generations, it is already down to sustainable levels, and it is too small given the state of the economy.
Yes, readers are told simultaneously that (a) the deficit is dwindling because the economy is improving and, (b) the deficit needs to be bigger to help the economy. This is the classic non sequitur in which (a) does not imply (b). His logical chain, I believe, runs as such:
  • Deficits should be large if the economy is depressed because extra spending (as long as the revenues come from borrowing or outright money printing or taxes on the "idle hoards" of the rich) boosts the economy, as more deficit spending ultimately will lead to less deficit spending;
  • The current federal deficit is dwindling even as government spending increases because the U.S. economy is rapidly improving;
  • Therefore, the current U.S. federal deficit is too small.
The idea behind Krugman's thinking here is that the U.S. economy has been mired in a "liquidity trap," a set of circumstances in which individuals as a whole are mired in a perverse Nash Equilibrium in which no one will seek better gains from trade because no one else is willing to do the same. If government does not try to break the logjam with massive new spending (no worry of where to spend, just spend), then the economy will permanently be stuck at a miserable steady-state of high unemployment and low output. Only new government spending can change the circumstances.

Keep in mind that U.S. Government policies before 1929 pretty much adhered to what Krugman says not to do, yet the economy always recovered from downturns. Only from 1929 to 1940 did the government actively intervene, and we call that era the Great Depression, yet today we are told that the New Deal programs actually ended the Depression, which clearly is not true.

Murray Rothbard wrote about the penchant of governments to try to internally bring prosperity by more spending, and he predicted (accurately) that the programs would fail. This section from America's Great Depression is a very poignant commentary on what has been done in the past five years:
If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don't interfere with the market's adjustment process. The more the government intervenes to delay the market's adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favorite "anti-depression" arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:
  1. Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

  2. Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government "easy money" policy prevents the market's return to the necessary higher interest rates.

  3. Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.

  4. Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.

  5. Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by "food stamp plans" and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.

  6. Subsidize unemployment. Any subsidization of unemployment (via unemployment "insurance," relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.
Both the Bush and Obama administrations have done all of these things in spades, yet even now Krugman complains that we need larger budget deficits (although the current shrinking deficit reflects economic improvement). The above suggestions definitely set Keynesians to fits of apoplexy, but they pretty much have summed up what the government did before, and the economy always recovered.

The Keynesian response always is the same: we haven't spent enough money. How much is enough? The Keynesians will let us know when we have reached that point - but we haven't reached it yet.

Krugman is correct; the issue is not finding ways to cut the deficit per se, as much of the deficit is due to the condition of the economy. However, as Rothbard so clearly stated above, the massive government interventions have not helped the economy, but instead have slowed the recovery and have made it much harder for entrepreneurs to find those lines of production that are going to be profitable.

The fixation should not be on balancing the budget, both of us believe. However, we part company when we look at how to deal with the issue at hand.

I would ask this final question: If what Krugman has claimed earlier is true - that the U.S. Government's response to the crisis has essentially been one of "austerity" - then how is the economy growing fast enough to shrink the deficit? Furthermore, let me ask if this quote from Krugman even makes "Keynesian" sense:

“People are exhausting their savings,” he (Krugman) said. “People are running out of hope.”
Isn't the destruction of savings during a recession a key to bringing back prosperity? How can this be a sign of "losing hope" if the actions actually stimulate consumption, and every good Keynesian knows that consumption actually is the form of production that creates real prosperity? Furthermore, are we not supposed to be cheering on the Inflation Fairy as it destroys savings and raises real costs to individuals? Inquiring non-Keynesians really would like to know.


Jones said...

Explain Europe and their diverging fortunes with the U.S. then.

One cut gov't spending more and kept money tighter and the other (more or less) followed a new-Keynesian prescription of easy money and moderate stimulus. Guess who's doing better? Enough lose.

And don't try to explain this away with the old EU labor laws argument either...

Mike said...

"Enough lose."

A simpleton mono-dimensional worldview.

Mikaelus said...

"One cut gov't spending more and kept money tighter and the other (more or less) followed a new-Keynesian prescription of easy money and moderate stimulus. Guess who's doing better?"

Please, enlighten me, which is which?

Both of them bailed out banks, both of them propped up failing institutions with taxpayer funds, and both are barely hobbling along with high unemployment and low growth. Which is doing better, and how on Earth does that cause us to "lose" when both of them took the same pattern, neither of which we would have proscribed.

Oh, and before you talk about the EU pushing "austerity" (because that's where I assume this is going), keep in mind that most of the savings at home are being eaten up by budget expansions at the EU level.

Dikvoormekaar said...

The destruction of savings becomes even more apparent once you start calculating inflation like we used to (
It seems that every 10 years or so, the method of calculating CPI (which we know is not inflation anyway) gets "tweaked" and, lo-and-behold, inflation numbers drop by half. So inflation is supposedly at 2%, but if you use 1990's calculation it's 5%, and if you use 1980's calculation it's 10%. This is tantamount to fraud.

The immorality of cheating seniors out of their life savings, and pressing higher prices on the poor who rely on a fixed income (at the expense of bankers and other favored elites) is almost too much to bear.

Keep up the good work, professor!

William L. Anderson said...

EU labor laws are very bad when the economy is down because they encourage businesses to shed workers when times are uncertain. No, those laws don't account for all of the unemployment, but they account for a lot of it in places like Spain.

Furthermore, much of the "austerity" is aimed at propping up the banks, and it includes large tax increases, which are the wrong thing to do at this time.

So, no, I don't "lose."

ayassos said...

You asked the question which has been on my mind as I wade through Krugman's swamp of internal contradictions. He's been quite clear that the U.S. is engaged in "austerity" in the form of slowing down the rate of govt. expense increases. Yet despite this ill-informed, non-Keynesian approach, the U.S. economy continues to make "real headway." I guess this is where Krugman's doctrinaire beliefs are confounded by his Democratic cheerleading. He wants to give Obama credit for a robust recovery (while simultaneously claiming that we remain "deeply depressed"), yet claim that the actual federal govt. budgetary approaches are all wrong because the deficits remain too low. I guess this why he doesn't use too many numbers in his analysis: by keeping it all qualitative and adjective-driven, he can say anything he wants and retain deniability later.

KSB said...

"Explain Europe and their diverging fortunes with the U.S. then."

Europe isn't running a world wide military empire and didn't gleefully gut their industrial base, for starters.

But that's really not the nitty gritty of economic policy. Let's take a look at how Sweden jump started its economy when it began to sag.

- Across the board tax cuts with high income earners getting the most relief

- Reductions in government expenditures and selling off of unprofitable state run businesses to the private sector

- Refusal to adopt the Euro and instead standing by their local currency with the Swedish Central bank perusing a strict anti-inflation policy.

Yup, the Austrian school really has egg on their face now.

Pulverized Concepts said...

For the umpteenth time, and Nancy Pelosi pay particular attention, unemployment insurance benefits don't stimulate anything. Recipients instead make payments on existing obligations: rent and mortgage, car payments, cell phone and cable television contracts, electricity, gas and water service and cemetery plots. A smaller percentage might go for groceries and cigarettes, which are already part of the individual budget. Additionally, large numbers of the unemployed are seasonal workers and collect their UI every year, including federal employees like forest fire fighters. They consider UI benefits a normal part of their income.

Dinero said...

The CPI is not a measure of inflation in the monatarist sense. It is only tangentaly connected with money velocity or supply. For example if there is an ample supply of the products that make up the CPI, or they are produced at lower cost , then the CPI comes down - regardless of an increase in circulating cash. The CPI is a cost of living measurement rather than a monatarist gauge

Lord Keynes said...

"Keep in mind that U.S. Government policies before 1929 pretty much adhered to what Krugman says not to do, yet the economy always recovered from downturns."

And what Keynesian has ever said that an depressed economy will never recover? You do nothing but peddle straw man arguments.

The real issue is: how long, without intervention, will it take for the private sector to restore strong growth and low employment?

The evidence from the 19th century shows that it takes years - years of waste. This is easily verified by some modern unemployment estimates, e.g., 1870s and 1890s:

1873 | 3.99%
1874 | 5.53%
1875 | 5.83%
1876 | 7.00%
1877 | 7.77%
1878 | 8.25%

1879 | 6.59%

1891 | 4.34%
1892 | 4.33%
1893 | 5.51%
1894 | 7.73%
1895 | 6.46%
1896 | 8.19%
1897 | 7.54%
1898 | 8.01%

1899 | 6.20%

William L. Anderson said...

Thanks for proving my point, LK. Despite the fact that the periods you list were "panic" periods, the rate of unemployment was lower than it has been during the Obama years, when there has been massive intervention.

Indeed, if the economy can recover on its own, as you have just claimed, and the rate of unemployment is lower than it is during times of massive intervention, then why the Keynesian intervention?

Lord Keynes said...

(1) 2007-2009 was an unusually severe recession - you think the 1890s was exactly the same in every detail to 2007-2009?

Secondly, just look at other nations like Norway, South Korea or Australia from 2007-2009. All had well designed Keynesian stimulus packages. All have very low unemployment today.

The US stimulus stabilised unemployment but needed to be bigger to really drive the unemployment level down.

(2) If you know anything about 19th century economic history, you'd know that these figures happen to be some of the lower estimates. There are no definitive data.

Other estimates of, say, the 1890s are very interesting, e.g., Lebergott:

Year | Unemployment Rate
1890 | 4.0%
1891 | 5.4%
1892 | 3.0%
1893 | 11.7%
1894 | 18.4%
1895 | 13.7%
1896 | 14.5%
1897 | 14.5%
1898 | 12.4%

1899 | 6.5%
1900 | 5.0%

Romer (1986):

Year | Unemployment Rate
1892 | 3.72%
1893 | 8.09%
1894 | 12.33%
1895 | 11.11%
1896 | 11.96%
1897 | 12.43%
1898 | 11.62%
1899 | 8.66%

1900 | 5.00%

By these other estimates, even the 1890s could produce a period far worse than the 2008-2013 period and, by one estimate, not that far from the 1930s era unemployment.

(3) despite what you say, even these figures refute you.

A gold standard capitalist system produced recessions that resulted in years and years of unemployment.

There was no quick recovery in either the 1870s and 1890s.

Of course, that shatters your myth of quickly adjusting markets and the fantasy world of the gold standard.

Dennis said...

Massive government subsidies to the railway industry created a well-documented railway boom in the latter portion of the 19th century. As the subsidies petered out, the uneconomic nature of many of the rail lines was revealed, resulting in waves of bankruptcies and mounting unemployment. The railway boom was merely a pre-Keynesian stimulus policy, with predictable results.

Dennis said...

One should also not forget the vast costs of the military campaigns against the plains Indians during the last portion of the 19th century. At least the gold standard provided a necessary brake on the ambitions of empire builders in the Federal government, as they would face a run on gold if they did not eventually rein in their spending.

Anonymous said...

The Keynesian case rests on the assumption of sticky prices and sticky wages in causing a run-away aggregate demand gap after an initial demand shock unless the monetary authority can target inflation and nominal rates to match the real rate. This breaks down once the nominal rate reaches 0%. The only way out then is to fire up velocity. If no one in the private sector wants to spend, that leaves government as a spender of last resort.

While these conclusion may appear to logically follow from the assumptions, the assumptions can be questioned. What makes wages sticky to begin with? Previous rounds of government interventions? Are we really in a liquidity trap? Is private money really waiting for real returns to become negative enough before redeployment? Rothbard pointed out that thrift is simply a different time-preference related to unliquidiated malinvestments such as those on banks balance sheets and an all-too-obtrusive government fist on free market plaza. What is the Fed's role in creating the illusion of a liquidity trap? Why is the Fed allowing a few banks to amass a reserve mountain while side-lining all others? Does that matter?

Dinero said...

Rothbards point 5 - by shortage of saved capital does he mean a supply of investment loans . The supply of loans for investment is not quantitatively governed by savings.

LeRoy Matthews said...

Study my Letter on
I don't believe that your ideas are based on Austrian Economics, at all.
The politicians' Debts & Deficits are getting LARGER & LARGER. They AREN'T dwindling, nor is there any reason for them to do that. Just the Offical Debt of the so-called "US Treasury" alone- which ISN'T the National Debt,at all, of course- is about $16.7 Trillion, & GOING UP. Various Famous Economists, such as Professor Laurence Kotlikoff of Boston University, claim that what they call the National Debt is about $228 Trillion, & GOING UP about $1Trillion a month.
The so-called "federal government" is not only Bankrupt, & Head- Over-Heels in Debt, It's Operating Way In The Red, & Has A Huge, & Increasing, Budget Deficit. There's virtually zero $ for anything whatsoever.
(To find my Letter, try searching for Crazy Inbox, & look for D's picture.)