The Inflation Prisoner

About 30 years ago, I read a book by Irwin Schiff (yes, THAT Irwin Schiff) called The Biggest Con in which he exposed Keynesian economics and declaring that the only "arrow in the quiver" of Keynesianism was inflation. As I read Paul Krugman's column today on Spain and its problems, I can see that if Krugman is the most public spokesman today for Keynesian thinking, then Schiff was correct. Let me begin.

In The General Theory, John Maynard Keynes argues that the standard supply-demand wage theory holds only if there is full employment of labor. However, if there is widespread unemployment, the way to get labor back to full-employment levels is to sneak in a general wage cut via inflation. Keynes writes:

...it is fortunate that the workers, though unconsciously, are instinctively more reasonable economists than the classical school, inasmuch as they resist reductions of money-wages, which are seldom or never of an all-round character, even though the existing real equivalent of these wages exceeds the marginal disutility of the existing employment; whereas they do not resist reductions of real wages, which are associated with increases in aggregate employment and leave relative money-wages unchanged, unless the reduction proceeds so far as to threaten a reduction of the real wage below the marginal disutility of the existing volume of employment. Every trade union will put up some resistance to a cut in money-wages, however small. But since no trade union would dream of striking on every occasion of a rise in the cost of living, they do not raise the obstacle to any increase in aggregate employment which is attributed to them by the classical school. (Emphasis mine)

I believe that the concepts shown in this paragraph really are at the heart of Krugman's column today in which he says that Spain easily could get out of its present situation if it had its own currency and could engage in a devaluation which, in his view, would establish something close to full employment and boost Spanish exports. He writes:

Now what? If Spain still had its own currency, like the United States — or like Britain, which shares some of the same characteristics — it could have let that currency fall, making its industry competitive again. But with Spain on the euro, that option isn’t available. Instead, Spain must achieve “internal devaluation”: it must cut wages and prices until its costs are back in line with its neighbors.

And internal devaluation is an ugly affair. For one thing, it’s slow: it normally take years of high unemployment to push wages down. Beyond that, falling wages mean falling incomes, while debt stays the same. So internal devaluation worsens the private sector’s debt problems.

What all this means for Spain is very poor economic prospects over the next few years. America’s recovery has been disappointing, especially in terms of jobs — but at least we’ve seen some growth, with real G.D.P. more or less back to its pre-crisis peak, and we can reasonably expect future growth to help bring our deficit under control. Spain, on the other hand, hasn’t recovered at all. And the lack of recovery translates into fears about Spain’s fiscal future.

Should Spain try to break out of this trap by leaving the euro, and re-establishing its own currency? Will it? The answer to both questions is, probably not. Spain would be better off now if it had never adopted the euro — but trying to leave would create a huge banking crisis, as depositors raced to move their money elsewhere. Unless there’s a catastrophic bank crisis anyway — which seems plausible for Greece and increasingly possible in Ireland, but unlikely though not impossible for Spain — it’s hard to see any Spanish government taking the risk of “de-euroizing.”

The concept is strikingly similar to what Keynes wrote, although Krugman also exposes his own biases of aggregation in this column. After all, what happens when a government devaluates the currency? There is a cut in real wages, and while the goods denominated in that currency become cheaper relative to goods made elsewhere, nonetheless people at home do suffer a fall in their standard of living.

Like Keynes, Krugman argues that what he calls an "internal devaluation" is bad because real wages are cut and people can see firsthand that they are making less, and in countries like Spain that are dominated by labor unions, that spells trouble. However, an inflation-led "wage cut" tends to be less visible or less clear, even if the same thing, relatively speaking, is accomplished.

However, all of this assumes that the effects of inflation are exactly the same as a cut in wages and government spending. (Actually, Krugman believes that inflation is superior because, in his view, people spend more in the short term, which he claims gives an economy "traction," enabling it to move forward on its own.) According to Krugman, or at least what I ascertain through his columns, inflation does not distort the structures of production nor cause any internal dislocations.

This last point is important, because one can have such a view ONLY if factors of production are homogeneous. However, if there are malinvestments that come about through inflation, and these malinvestments over time become unsustainable, then there is a problem.

In a nutshell, that is a huge difference between Austrians and Keynesians. While the devaluation of which Krugman speaks might have some "good effects" at first, nonetheless, this "solution" only exacerbates the long-term problem. For example, within an economy, the wages that tend to be out-of-kilter with the rest of the economy often are centered in unionized industries, and when inflation hits, those sectors tend to be able to force employers (and the government, since these countries have powerful public sector unions) to give raises that better keep up with inflation than workers who either are not unionized or have weak or non-existent political connections.

Thus, the internal distortions are likely to grow. In countries like Spain, Greece, and Portugal, the very sectors that are bloated and are gobbling up resources are the government sectors. A bout of inflation in the long run then would further empower those very employment groups that are most responsible for the current trouble.

To a Keynesian like Krugman, none of this matters, as all sectors are homogeneous and there is no such thing as economic distortion. The only thing that matters are aggregate numbers, as economics to him is nothing more than charts, numbers, and aggregations. To "cure" an economy, give it a bout of inflation, and when the inevitable problem arise, deal with them via another bout of inflation.

When things deteriorate -- as they surely will -- then one blames the "greedy" corporations which, in the view of someone like Krugman, need to be reined in by activist government. All that is needed is to find the "Goldstein," demonize, rage on, and then inflate some more. In the end, THAT is the "Krugman solution."

Krugman, Causality, and the Irish Financial Crisis

Whenever I read one of Paul Krugman's columns, I don't expect to be in agreement, so I am pleased when he makes points that I believe are spot on. However, somewhere through the column, he suddenly makes a turn in which the entire thing is turned into a giant non sequitur that leaves me scratching my head to his logical progressions.

For example, in 2003, he wrote a column in which the theme was the "Lump of Labor Fallacy," which tends to be the underlying theme that labor unions present in their worldview. Throughout the column, he lays out the intellectual case debunking this fallacy, but then writes this:

Since 2001, sensible economists have been pleading for federal aid to state and local governments so schoolteachers and police officers needn't be laid off because of a temporary fall in revenues. They've also urged the administration to stop dragging its heels on much-needed homeland security spending, not just because such spending is needed to make the country safer, but also because it would create jobs and put more income into the hands of Americans likely to spend it. (And if you're worried about spending's leading to increased deficits, why not cancel some of those long-run tax breaks for upper brackets?) Until we've done the obvious things, there's no reason to despair about job creation.

I remember my reaction the first time I read it: Say what? The intellectual basis behind calling the "Lump of Jobs Fallacy" a fallacy is that we apply theories of division of labor and marginal utility and, yes, the Law of Scarcity. Krugman, on the other hand, tied it to a Keynesian notion that more spending creates jobs and prosperity.

(In fact, Krugman's view of "jobs" is that a "job" is something we do and its main purpose is for an avenue of income to boost spending. He does not tie the production aspect of work to production of goods themselves as the basis for our purchasing power. Instead, we get an amorphous view of "spending" that has only a loose connection to production.)

Thus, it is today in Krugman's "Eating the Irish" column. He begins on a strong note, but then veers off the Keynesian cliff in a way that leaves me scratching my head.

First, I begin with the sound part:

The Irish story began with a genuine economic miracle. But eventually this gave way to a speculative frenzy driven by runaway banks and real estate developers, all in a cozy relationship with leading politicians. The frenzy was financed with huge borrowing on the part of Irish banks, largely from banks in other European nations.

Then the bubble burst, and those banks faced huge losses. You might have expected those who lent money to the banks to share in the losses. After all, they were consenting adults, and if they failed to understand the risks they were taking that was nobody’s fault but their own. But, no, the Irish government stepped in to guarantee the banks’ debt, turning private losses into public obligations.

I fully agree and hold that there should have been NO bailouts, but that also includes the bailouts that occurred in this country. Not only do I believe that Wall Street should have been on the hook for its role in creating and sustaining the Housing Bubble, but I also believe that had the Bush and Obama administrations permitted that to happen, we would not have had the Great Implosion that everyone (including Krugman) predicted.

Yes, it would have been difficult as the markets sorted out which firms had solid assets and which had worthless paper, and some CEOs would have lost their mansions in Connecticut. However, it would not have taken long to liquidate the malinvested assets, and we would be well on our way to a real recovery instead of the stagnation that we have now.

Unfortunately, after this paragraph, Krugman veers off into, well, Krugmanism. He writes:

Before the bank bust, Ireland had little public debt. But with taxpayers suddenly on the hook for gigantic bank losses, even as revenues plunged, the nation’s creditworthiness was put in doubt. So Ireland tried to reassure the markets with a harsh program of spending cuts.

Step back for a minute and think about that. These debts were incurred, not to pay for public programs, but by private wheeler-dealers seeking nothing but their own profit. Yet ordinary Irish citizens are now bearing the burden of those debts.

Or to be more accurate, they’re bearing a burden much larger than the debt — because those spending cuts have caused a severe recession so that in addition to taking on the banks’ debts, the Irish are suffering from plunging incomes and high unemployment. (Emphasis mine)

So, while taking on the obligations that the government should not have taken on in the first place, the Irish government then should have increased spending? With what? Tax revenues fell and the Irish government could not print Euros, so all it could have done was to borrow, and somehow I doubt that the world was anxiously awaiting the acquisition of more Irish government debt.

Furthermore, his contention that spending cuts "caused" the recession is utterly laughable. Is Krugman claiming that had Ireland continue to spend at current levels or even boost spending (With what?), that Ireland would not have experienced a recession? Krugman's statement is a classic non sequitur, something that a competent economist should not be pursuing. He goes on (unfortunately):

In early 2009, a joke was making the rounds: “What’s the difference between Iceland and Ireland? Answer: One letter and about six months.” This was supposed to be gallows humor. No matter how bad the Irish situation, it couldn’t be compared with the utter disaster that was Iceland.

But at this point Iceland seems, if anything, to be doing better than its near-namesake. Its economic slump was no deeper than Ireland’s, its job losses were less severe and it seems better positioned for recovery. In fact, investors now appear to consider Iceland’s debt safer than Ireland’s. How is that possible?

Part of the answer is that Iceland let foreign lenders to its runaway banks pay the price of their poor judgment, rather than putting its own taxpayers on the line to guarantee bad private debts. As the International Monetary Fund notes — approvingly! — “private sector bankruptcies have led to a marked decline in external debt.” Meanwhile, Iceland helped avoid a financial panic in part by imposing temporary capital controls — that is, by limiting the ability of residents to pull funds out of the country.

And Iceland has also benefited from the fact that, unlike Ireland, it still has its own currency; devaluation of the krona, which has made Iceland’s exports more competitive, has been an important factor in limiting the depth of Iceland’s slump. (Emphasis mine)

First, I doubt that Iceland is exactly wallowing in prosperity at the moment. The imposition of capital controls hardly is a solution, no matter what Krugman thinks. It is a statement that the government owns one's property, period. The only reason that governments impose capital controls is that those in power want to steal property of others and the only way to do it is to keep it in the country where government agents can find it.

This is the financial version of the Berlin Wall, and it is theft, pure and simple. Why am I not surprised that Krugman endorses this action?

As for the currency issue, there is some truth in that matter, but Krugman leaves out something important: Iceland may be able to repudiate some of its obligations via currency devaluations (which really is a sophisticated way of saying it is printing more money and impoverishing anyone whose wealth is held in Kronas), but it is less likely to attract future investment from outside the country. In other words, it trades a temporary fix for future problems.

However, since Keynes himself declared that "In the long run, we all are dead," I guess that even if short-term actions hold long-term consequences, we should not worry. That will be someone else's problem.