Icelandic Airhead Economics

Update: Krugman's latest column continues the same narrative: (1) financial deregulation causes all of our problems, (2) inflation is the answer, and (3) despite massive inflation, which has slashed real wages, Iceland has not seen its standard of living fall.

I also find it interesting that he praises Iceland for letting the banks fail when, at the same time, he also has claimed that Washington needed to bail out Wall Street. Indeed, as is pointed out below, maybe it would have been prudent to let ours fail, too.

Although Krugman writes of the "path not taken," the path he calls for is government control of the economy, easy money (inflation), central bank financing of government spending via the printing press, and capital controls. I would suggest that this is EXACTLY what is occurring today. If anything, the central banks and governments have blown up even bigger financial bubbles.

However, I would like to suggest another path: a real profit and loss system, not crony capitalism, and certainly not central bank financial tricks. End Update

As I write this, Paul Krugman is in Iceland and anyone who wants to watch him in a webcast can do so. Last month, when flying home from Latvia, we passed by Iceland and I can say that from the air, it is a barren place.

Its economy also has been barren, suffering a huge fall in about everything after its own speculative bubbles had fallen apart. Not surprisingly, Krugman claims that this was due to free markets, deregulation, and probably Milton Friedman, and the cure has been inflation and capital controls. Thus, Iceland is his poster child for doing things "correctly."

There is another perspective, and Tim Cavanaugh at Reason Magazine offers a very good and believable scenario, one that chronicles the same events as Krugman acknowledges, but adds something that Krugman has conveniently left out: how Iceland's central bank engaged in the worst kind of moral hazard.

Cavanaugh notes:

For every government-driven bad improvement you can find in the west, you’ll find boom-era Iceland taking it to the next level. Where the U.S. Federal Reserve’s promise to backstop financial institutions was merely implicit, the Central Bank of Iceland in 2001 gave an explicit guarantee to big banks, making it inevitable that they would become bloated with risky and ultimately toxic assets. Our own government-sponsored—and as of 2008, government-owned—entities Fannie Mae and Freddie Mac made a hash of responsible lending by buying mortgages in the secondary market (and as we now know, lying about the poor quality of debt on their books). But Iceland’s government-run Housing Financing Fund managed to do even worse, lending directly to borrowers and competing with private lenders on both interest rates and loan quality. By mid-decade 90 percent of Icelandic households had government loans, and no-money-down home purchases were as common in Iceland as they were in Florida. (Emphasis mine)

You see, Krugman always assumes that free markets, be they in finance or anything else, have nothing to keep them from running over the cliff, and only the stern hand of government regulation can save the markets from themselves. Yet, we know that a profit-and-LOSS system provides its own brakes, provided that governments don't try to override market verdicts, as they have done in the USA, Iceland, and Europe. As he always does, Krugman only tells part of the story.

As Cavanaugh notes, there is much more to the story than Krugman wants to admit. Iceland was not able to get much of anything resembling a bailout, and had to face the crisis alone:

This international neglect turned out to be Iceland’s saving grace. The crisis ended almost as quickly as it had begun. The Organization for Economic Co-operation and Development expects Iceland’s economy to grow by 2 percent this year and next. That’s not enough to replace the post-2007 loss, but it’s more than enough to return to the pre-boom trend line, and it’s much stronger than the performance of Portugal, Italy, Ireland, Greece, and Spain, affectionately know as the PIIGS economies. Iceland’s long-term interest rate, a not-inconsiderable 8 percent, compares well with a rate of over 13 percent for Greece, which is astounding when you consider that Iceland endured a default that Greece, in name at least, has so far avoided. The difference in unemployment—5.8 percent for Iceland against 16 percent for Greece—is even more striking. Iceland expects to have a balanced budget in 2013.

And then this, contradicting Krugman:

Paul Krugman naturally draws the wrong conclusion, contending that Iceland saved itself through rapid inflation and capital controls. This is like saying the March tsunami gave the people of Tohoku a nice chance to go swimming: Iceland’s central bank tried desperately to control the króna’s collapse before giving up. Nevertheless, Erlingsdottir is right: The “grownups”—a center-left coalition led by Social Democrat Johanna Sigurdardottir—are back in charge and have done their best to double down on the bad policies of the past, including reducing fish quotas when local fishermen most need to be producing and selling. The government is also, in the face of strong popular opposition, moving toward E.U. membership, which has worked out so beautifully for other troubled European economies.

So what’s causing the recovery? The plain-sight answer is the one nobody will consider. Iceland is coming back specifically because its banks went out of business. That happened in spite of strenuous public efforts, but the removal of the tiny nation’s colossally bloated financial sector turns out not to have eliminated all that much value.

There are some things to keep in mind. First, Iceland is substantially poorer than it was before. More people have work, but their real wages have fallen substantially from where they were before the crisis began. Currency crises have a way of exposing the problems, something Krugman does not want to admit, and the combination of default, inflation, and letting its banks implode means that Icelanders have received a huge dose of reality, and reality can suck at times.

Second, for all of the talk about rates of unemployment and having its exports being cheaper because of the decline in the country's currency relative to other currencies, inflation hardly is the miracle "cure" that Krugman claims it to be. Yes, inflation has cut the real wages Icelanders earn by substantial amounts, which means they have received a real cut in pay, which in turn makes their labor substantially cheaper. However, they still have to produce something, and that means directing resources to the sustainable lines of production in Iceland's economy.

Yes, I know that Krugman is a "macro" guy, and they look only at GDP figures. Thus, according to the Keynesians, World War II was a time of unprecedented prosperity because (1) everyone had work, and (2) GDP was high. What else do we need to know about the economy?

While Krugman has been touting bailouts and even having the Fed directly purchase government bonds to finance the government's operations (as though this were a magic elixir instead of the fraud it really would be), he forgets that Iceland's crisis was SO big that its central bank could not bail out anyone, despite an explicit promise from the central bank that it would backstop all losses. Furthermore, it never occurs to him that if we get rid of the moral hazard, we also get rid of the systematic wild speculation.

Instead, he continues to call for easy money, but he also wants that money to be tightly regulated, which in the end means that banks lend only to those firms that have a track record. One of the reasons there was so much pressure for deregulation in the 1970s and early 80s was that a large number of firms based upon the new high technologies and the new reality of telecommunications could not get capital from the usual lending sources.

For example, Ted Turner in setting up CNN, went to Michael Milken because the banks would not touch his cable news idea. Likewise, we never would have seen funding of a number of other familiar companies had the old regulatory structure remained. Unfortunately, what Krugman demands is both the old structure AND policies of easy money, which simply is not possible. Furthermore, his call for the Fed to be buying bonds wily-nily does not exactly speak to getting rid of the moral hazard that put us in this position in the first place.

If there is a lesson in Iceland, it is not what Krugman might be telling us. First, Iceland experienced the unthinkable: the utter collapse of its banks, but it lived to come back another day. On our front, for all of the dire talk of what might have occurred has the government not bailed out Wall Street, I believe that while the economy would have taken a hit, we already would be climbing well out of that hole and would in a full-fledged recovery.

Instead, we are in a depression, and Krugman is claiming that inflation and bailouts are the key to changing our economic direction. In other words, we can have prosperity and a free lunch, too. Just inflate.

California's Krugman Solution: A Modest Proposal

In his best seller The Return of Depression Economics (which I had my MBA students read this past year), Paul Krugman writes: “Recessions, in other words, can be fought simply by printing money—and can sometimes (usually) be cured with surprising ease.”

Indeed, as I read his latest string of columns that increasingly are laced with partisan invective and personal attacks, there is one constant theme: government needs to fight this downturn by churning out new money and quickly spending it. There are problems, however, when political bodies like Greece and Ireland fall into crisis because their currency, the Euro, is created by the European Central Bank.

In Krugman's view, the solution always lies in creating more money, and since he thinks that Europe is being stingy, he has been writing that the real shame is that Ireland, Greece, and Spain cannot "devaluate" in the way that Iceland has done. As I see it, if printing money would work for Iceland, then it would work for the biggest banana republic in the USA (which increasingly is becoming a banana republic, itself), California.

Yes, debt-and-deficit-riddled California, the once-Golden State now has become a prisoner not only of its mismanagement of prosperity, but also of the leftist ideology that is its governing philosophy. The state that gave us Apple Computer and Google now gives us bloated government worker unions, high tax rates, ridiculous regulations, a swarm of bureaucrats, and Nancy Pelosi.

California now is at the end of the line. It is driving out businesses, criminalizing and demonizing entrepreneurship, and things only will become worse. What to do? Why, there is only one thing to do: print money.

Of course, California is part of the big political union called the USA, but it seems to me that a "Krugman solution" already has been reached: government scrip. Yes, the outgoing Guhvuhnatuh, Ahnuhld Himself, used IOUs to pay California workers, and if Krugman is to be believed (and he IS a Nobel Prize winner, after all), then California really has no budget problems at all.

Yes, the Ultimate Chartalist Solution is at hand, and I hope that Krugman will recognize it, since he already has supported the concept of the idea. California can stop paying its workers in USD and use its own scrip. Given the state legislature's penchant for passing law after law, it can declare the scrip to be California legal tender and ORDER state businesses to accept it, on pain of workers and business owners going to prison.

(This would be quite appropriate, since one of the fastest-growing areas of criminal prosecution in this country has been the category of "economic crimes," as the USA borrows from the legal past of the USSR.)

Granted, there might be a showdown from Washington, although I figure that since Democrats control the executive branch of the U.S. Government and the U.S. Senate, and children in California DID sing praises to Obama ("Obama's gonna save us"), perhaps the god in the White House will relent and let California carry on its Krugman scheme.

Everyone would be happy, I guess. California would not be "budget constrained," the state could multiply its bureaucracies, authorities could arrest and try more business owners, Google could be used to spy on capitalists and other evil-doers, and there would be enough money for all!

Furthermore, California could enjoy an "export boom." (I'm sure Krugman would like that.) True, the only thing the state could export would be bureaucracy and videos of children singing praises to Obama, but that should be enough to entertain the masses. (California would NOT be able to use "Yes, We Can!" as its state slogan, since Obama already took that one. Maybe the incoming Gov. Moonbeam might employ "Accept our money -- or else" as the state slogan.)

So, all it takes is guts, I suppose. Make Paul Krugman California's secretary of the treasury and the country will take off. Moonbeam, you have a mission!! (It cannot be a "mission from God," however, as California intellectuals are godless.)

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.