Friday, April 9, 2010

Paul Krugman: We Need Inflation, and Lots of It

As I have said before, I appreciate Paul Krugman's openness in explaining his Keynesian views. True, he gives a few platitudes toward fiscal responsibility, but basically he recommends that government spend lots and lots of borrowed and printed money, and by doing so, will bring about economic recovery and prosperity.

The problem is not Krugman's saying such things; it's a semi-free country, after all. No, the problem is that when government follows these recommendations, disaster follows, even while Krugman and others are denying it or blaming the free market and sound money for economic evils. In today's column, he gives us more of the same.

As everyone knows, the government of Greece is in deep trouble. It overspent, went into deep debt, and now cannot pay back the debts. Even Krugman recognizes that fact, but then (as usual) draws the false conclusion that the way to deal with financial irresponsibility is, well, to be even more irresponsible:
Yes, Greece is paying the price for past fiscal irresponsibility. Yet that’s by no means the whole story. The Greek tragedy also illustrates the extreme danger posed by a deflationary monetary policy. And that’s a lesson one hopes American policy makers will take to heart.
Now, to say that any country now has a "deflationary monetary policy" is to be hallucinating. No one, I repeat, no one is engaging in deflation. Would be that were the case.

Here is Krugman in his own words about the crisis:
The key thing to understand about Greece’s predicament is that it’s not just a matter of excessive debt. Greece’s public debt, at 113 percent of G.D.P., is indeed high, but other countries have dealt with similar levels of debt without crisis. For example, in 1946, the United States, having just emerged from World War II, had federal debt equal to 122 percent of G.D.P. Yet investors were relaxed, and rightly so: Over the next decade the ratio of U.S. debt to G.D.P. was cut nearly in half, easing any concerns people might have had about our ability to pay what we owed. And debt as a percentage of G.D.P. continued to fall in the decades that followed, hitting a low of 33 percent in 1981.

So how did the U.S. government manage to pay off its wartime debt? Actually, it didn’t. At the end of 1946, the federal government owed $271 billion; by the end of 1956 that figure had risen slightly, to $274 billion. The ratio of debt to G.D.P. fell not because debt went down, but because G.D.P. went up, roughly doubling in dollar terms over the course of a decade. The rise in G.D.P. in dollar terms was almost equally the result of economic growth and inflation, with both real G.D.P. and the overall level of prices rising about 40 percent from 1946 to 1956.

Unfortunately, Greece can’t expect a similar performance. Why? Because of the euro.

Until recently, being a member of the euro zone seemed like a good thing for Greece, bringing with it cheap loans and large inflows of capital. But those capital inflows also led to inflation — and when the music stopped, Greece found itself with costs and prices way out of line with Europe’s big economies. Over time, Greek prices will have to come back down. And that means that unlike postwar America, which inflated away part of its debt, Greece will see its debt burden worsened by deflation.
Once again, Krugman gets it wrong. The USA followed pro-growth policies after World War II, unlike Greece (you know, where people actually are allowed to produce real goods without the government trying to put them out of business). However, Krugman, while admitting that Greece is not going to be so fortunate, then blames the semblance of sound money.

Like most Keynesians, Krugman believes a boom can last forever, just as long as government provides lots and lots of money, even if it leads to, well, double-digit (and worse) inflation. According to Krugman, the worst thing that can happen is deflation, and the real lesson here is that we need to debase the currency even more. Read on:
But what are the lessons for America? Of course, we should be fiscally responsible. What that means, however, is taking on the big long-term issues, above all health costs — not grandstanding and penny-pinching over short-term spending to help a distressed economy.

Equally important, however, we need to steer clear of deflation, or even excessively low inflation (Emphasis mine).
While Krugman does not define "excessively low inflation," nonetheless his point is clear. We need lots and lots of inflation, and anything else will be a disaster.

This is foolish advice, and it does not surprise me to read such nonsense from a Keynesian. After all, Keynesians believe that money is nothing more than a quantity variable that is to be manipulated to make aggregate models "work better." Is there unemployment? No problem; just add inflation, which will increase "aggregate demand" (because the demand for money falls as it loses value and velocity increases) and result in "full employment."

You see, to a Keynesian, this trick can be repeated time and again, as there are no real consequences from higher inflation except that prices go up. However, as Austrians point out, when inflation continues, malinvestments distort the structure of production, changing relative values of assets and ultimately leading to a crisis.

For example, contra Krugman, the housing boom could not continue because ultimately the factor prices in housing relative to everything else became too distorted to continue the charade. When the whole market depends upon being able to cram family incomes of $50K into paying a mortgage for a $500K house, the system cannot be sustained no matter how much new money government throws into the mix. Even Krugman recognizes that the housing market went bad, but then he reasons that it came about because of a lack of regulation, not because government was holding down interest rates and trying to direct that new money into housing. As I wrote in this post, such notions make no sense at all.

As I have stated many times before, the central problem is that Krugman and the Keynesians work from models in which all capital and all other assets are homogeneous. There can be no distortions in the structure of production, which always responds negatively to deflation and positively to inflation. This is a methodology that appeals to politicians and the modern, mainstream media, but it is not economics; it is Harry Potter Science.

Furthermore, we need deflation. That's right, far from avoiding it, we need to experience it. Yes, the initial results will be very painful (as though we are not experiencing pain now), but soon enough the factors of production will become balanced again, relative prices will make sense, and then the economy can find new lines of production that actually can be sustained.

However, because the initial stages of deflation are painful, Krugman says me must avoid it at all costs, even to the cost of destroying our money via inflation. Now, Krugman also believes that deflation will lead to a permanent downward spiral in which the economy ultimately becomes stuck at low production and high unemployment.

That is not true, not by a long shot. If Krugman were right, then the economy never would have recovered in 1982, when President Ronald Reagan and Fed Chairman Paul Volcker (who is the real hero here) permitted interest rates to rise, yet we had a real recovery in 1983 and beyond. While Krugman tries to claim that the recovery came about because of Keynesian-inspired deficit spending, the real results of that recovery contradict his story.

Had it been a "Keynesian recovery" (which in Austrian terms is an oxymoron), we would have seen growth in the usual sectors of manufacturing instead of seeing the growth centered on high-technology and telecommunications. Furthermore, Keynesians hold that one cannot have a recovery and have high interest rates, yet that is exactly what happened in the mid-1980s.

I agree with Krugman that the fact that Greece is on the Euro means that the government cannot inflate its way out of this mess -- and create a bigger mess. Yes, that means some real pain in the short run, but, contrary to what Krugman is claiming, in the long run it actually presents the Greeks with the opportunity to get things right.

Yes, there is a lesson from the fall of Greece. It is this: get your house in order and keep it in order. Don't keep printing money and claiming you are "saving the economy." Inflation is like heroin. It might feel good at the beginning stages, but in the end it destroys everything.


Unknown said...

The problem seems to boil down to the short-term vs. the long-term. Keynesians tend to focus on the short-term. Most people would admit that expansionary monetary and fiscal policy can have beneficial short-term effects: stopping bank runs and bankruptcies, reflating financial asset prices, lowering real debt burdens etc. But the problems from these actions come about down the road and by then the Keynesians can easily point to other causes as their interventions are no longer the proximate ones. Most people only care about the short-term so it's easy to criticize the "liquidationists" when you see firms failing, mass layoffs, and overwhelming private debt burdens but no one seems to care that it was previous short-sighted policy - and bad decisions by individuals - that caused the problems in the first place and will indubitably cause greater problems in the future.

Heroin is a good metaphor; in the keynesian world-view, apparently, it's impossible to over dose so long as wise technocrats are passing out the smack at just the right times, in just the right amounts. Unfortunately, our technocrats just cut the price of the dope and pass it out like candy expecting people to be responsible drug addicts.

Pandemic said...

I think there's also a distinction to be made between inflation and the first derivative, or rate of change of inflation, over time. My economics professor in college made this distinction, and I tend to agree with him. If inflation were truly constant, contracts would reflect that, and the overall distortions of inflation would cancel out over time. That's also why the mild deflationary effect of sound money (as the goods and services increase, but the money supply remains stable) doesn't matter. However, changing inflation distorts the ability of the market to adjust to the overall changing money supply and leads to malinvestment.

However, if inflation were held constant, it would lose its manipulative value to governments. Krugman seems to rationalize inflation as if it were constant when in fact the rate of inflation is changing, and that distorts the market.

Bryan said...

When you strip the varnish down to the bare wood, what P.K. advocates is legalized counterfeiting. You say you owe $100? No problem, just print up another $100. The problem is that the law of supply and demand are immutable. The more of something that there is, the less it's worth. That includes Federal Reserve Notes, and no amount of governmental prestidigitation can alter it.

Brutus, Esq. said...

Krugman's comparison of 2010 Greece to post-WWII America is absurd. US dollars were in high demand after WWII. There was talk of a "dollar shortage" that allowed the US government to inflate and temporarily avoid the consequences until the late 1950s (which is curiously where Krugman ends his analysis). Such is not the case with Greece.

Even without being an EMU member, Greece would be in trouble and would not be able to inflate their way out of it. If they still had the drachma and tried to do what the US did, the drachma would have more value in a lavatory than a cash register.

David Wozney said...

If the stated value, of “Federal” Reserve notes, falls enough compared to copper and nickel, the 1946-2009 nickels, composed of cupronickel alloy, could become relatively rare in mass circulation.

The April 9th metal value of these nickels is “$0.0609425” or 121.88% of face value, according to the “United States Circulating Coinage Intrinsic Value Table” available at

Paul the Cab Driver said...

Krugman is very ignorant of history. The USA recovered very rapidly post WWII despite its high debt for a number of reasons, including the Truman administration lifting hundreds of regulations on businesses, the partial demobilization of the US armed forces, and the situation in Europe. He doesn't remember that in those immediate post war years the USA faced virtually no competition as the industrial powerhouses of Europe and Asia lay in ruins. Japan had 90% of its urban areas wiped out by bombing. Germany had a similar situation. In addition, 1/3 of Germany had been taken over by the Soviets. France, Italy, the Netherlands, and Belgium had all been heavily damaged by the battles, and rampaging armies. then, to top it off the various European governments adopted milder versions of socialism that hampered their own recovery. These factors as well as others led to the USA becoming the mightiest industrial nation on earth in the fifties and sixties. it wasn't magic. It was a combination of giving businesses liberty, wide open markets, shrinking regulation, all things Krugman opposes.

keeman said...

@ Jim Brownfield

Your argument about constant inflation not distorting the economy relies on yet another flaw in aggregate models. When the "economy" is a single thing then putting money into "it" makes sense. You don't have to make distinctions about which part of "it" it goes into.

Put the fact is that in the real world, inflation happens because somebody is off the side printing money and using it. That this is, by itself, a very real first-order distortion in the economy and that it causes the second-order distortion that you are particularly incented to be doing business with the guy who's got the money-printing machine is lost in the macro models.

The false information problem is *in addition* to these distortions.

Pandemic said...


I don't completely disagree (although in a sound money system gold and silver mines still are creating money).

The bubbles, however, are products of false information, and I believe that's the primary problem. Money represents the synapses in the economic "neural network". Constant inflation (which I'm not advocating, just to be clear) can be adapted to by the neural net. Constantly varying inflation is more problematic. I still contend that Krugman's "dismissals" of inflation damage intentionally intermix the consequences of constant inflation (as in dI/dt = C, where C is a constant) with those of varying inflation. The varying inflation is far more problematic.

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keeman said...

@ Jim Brownfield

I think we're basically on the same page except that we disagree a bit as to the relative magnitudes of the direct wealth transfer effects vs the false-information effects. I understand your argument regarding the false-information effect and agree with you. Given the choice between constant (or, more generally, foreseeable) inflation and a randomly fluctuating one, surely the predicable one allows people to plan properly whereas the other does not.

But either way, the economy will reorg itself as people try to get better access to the money printing machines.

There is a crucial difference with commodity money: The cost of commodity money has strong negative feedback towards the cost of producing (e.g. mining) it. The profit in producing commodity money tends to be no more than other economic endeavors.

Not so with fiat money. You just turn a crank and money pops out. So the producer of this money distorts the economy by consuming without producing. His consumption leads producers to change their business models to better suit his needs. Resources are diverted from genuinely productive things. The more inflation there is, the more this occurs.

You can argue that the money typically gets lent, but that only passes the distortion one link down the chain and creates a false incentive to borrow. The guy with the money machine will lend out at absurdly low interest, because he has no risk: if the loan goes sour, he just prints more money. So borrowing money becomes the sensible thing to do. The guy with the money printing machine is essentially sharing his counterfeiting profit with you.

This is not a minor distortion when done at the scale of modern central banks.

Anonymous said...

I've been toying with the theory that holding down inflation during the boom's of the 90's and 2000's was exactly the wrong thing to do.

While housing made it's own false inflation, daily consumable purchases never saw any appreciable inflation. If that were to happen, where people actually asked themselves if they needed such a bigger newer home because other things cost a bit more than they were comfortable with, the housing boom/bust could never had the legs it did. Stocks could have never gotten that out of control (and they're back to being overpriced).

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