Monday, December 13, 2010

Krugman's Economic Advice: Shop Until You Drop

Even when Paul Krugman gets it right, he still manages to get it wrong. Thus it is today that in his column, he starts out on the right track, but then misinterprets what is in front of him and then goes off on yet another Keynesian spiel.

First, I present the good stuff. Krugman writes:
The root of our current troubles lies in the debt American families ran up during the Bush-era housing bubble. Twenty years ago, the average American household’s debt was 83 percent of its income; by a decade ago, that had crept up to 92 percent; but by late 2007, debts were 130 percent of income.

All this borrowing took place both because banks had abandoned any notion of sound lending and because everyone assumed that house prices would never fall. And then the bubble burst.
While he is right as far as he goes, unfortunately, Krugman the economist does not ask why the banks played the "band in 'Animal House'" role in thinking they could march through the wall. Why did banks abandon "sound lending" principles?

Krugman would answer that a Republican administration was full of free-market types that believed banks should not be regulated, and that suddenly, all bank regulators believed that market hype. That does not square with what we know about government and governance.

Krugman fails to point out that the housing market is heavily subsidized and regulated by government and was so even before the mortgage industry essentially was nationalized during the last year of the Bush administration. Indeed, as one real estate attorney told me last year, the government actively was urging banks to abandon lending standards in the name of promoting more and more home ownership.

At the same time, the Heritage Foundation and Cato Institute were promoting the "Ownership Society" mantra and the Bush administration was bragging that it had put more minorities into home ownership than ever before. I'll go further. The "subprime market" never would have taken off in a free market, not without real safeguards built into the system, which contrasts with the moral hazard that existed as the government told lenders directly and indirectly that the taxpayers had their backs.

That part never makes it into Krugman's narrative, and no wonder. If government played a role by pushing vast amounts of resources into unsustainable markets and promised to make good on bad loans, then no one should be surprised at what happened. Furthermore, there is no such thing as a free market in which those taking the risks don't have to bear losses, which clearly became the perception.

Unfortunately, that is the soundest argument Krugman makes in this column, and from there he goes off the Keynesian deep end. He writes:
What we’ve been dealing with ever since is a painful process of “deleveraging”: highly indebted Americans not only can’t spend the way they used to, they’re having to pay down the debts they ran up in the bubble years. This would be fine if someone else were taking up the slack. But what’s actually happening is that some people are spending much less while nobody is spending more — and this translates into a depressed economy and high unemployment.

What the government should be doing in this situation is spending more while the private sector is spending less, supporting employment while those debts are paid down. And this government spending needs to be sustained: we’re not talking about a brief burst of aid; we’re talking about spending that lasts long enough for households to get their debts back under control. The original Obama stimulus wasn’t just too small; it was also much too short-lived, with much of the positive effect already gone.
How, pray tell, does the government get the money to make up for all that lost consumer spending? As Krugman has said earlier, he believes that ALL of the Bush tax cuts should be permitted to expire, and that if he were in charge of the government, he would take that extra revenue and spend it.

Of course, taking money from people just makes them poorer, and the idea that government spending would make up for their loss is a howler. Contra Keynes and Krugman, governments make sure that friends are benefited and enemies punished. The second way for government to get money, according to Krugman, is to borrow (and borrow and borrow).

Here is where it gets interesting. Who is on the hook for all of this money? Obviously, the debt must be repaid or there has to be a default. Obviously, the government chooses default by inflation, with Americans being told they can have their cake and eat it, too. I hate to be the bearer of bad tidings this Christmas season, but paying back the debt by inflation is not the "free lunch" Krugman claims it to be.

(Remember, he declares in The Return of Depression Economics that there really is a "free lunch," and that all we have to do is to find it. The "free lunch" is the taking on of huge debt, and then quietly repudiating it by destroying the U.S. Dollar. Yeah, as if there are no consequences from so doing.)

In Krugman's economy, we move seamlessly from the housing bubble to continued full employment, just as long as government, people -- someone -- is spending money. This is a view that says resources don't matter, that factors of production are homogeneous, and that there really are no consequences at all for driving entire markets into a big hole via malinvestments.

In other words, it is economics as though the Law of Scarcity did not exist.

24 comments:

ReturnFreeRisk said...

Here is the scary thing. At least Krugman recognizes the problem. His prescription is wrong but he describes the ailment. Meanwhile, Bernanke and the Fed IGNORE all stock variables like level of debt and continue to treat this as a temporary flow problem and a crisis of confidence fixable with faux stock market gains. And that is if you dont believe the insidious incentive to inflate away government debt.

LK said...

While he is right as far as he goes, unfortunately, Krugman the economist does not ask why the banks played the "band in 'Animal House'" role in thinking they could march through the wall. Why did banks abandon "sound lending" principles?

Because of a deeply flawed neoliberal/New Classical inspired system of financial regulation:

http://socialdemocracy21stcentury.blogspot.com/2009/11/financial-deregulation-and-origin-of.html

Jonathan M.F. Catalán said...

When Krugman is talking about debt and spending he is talking both about consumption/investment. He is not being very specific, but his "crude" theory should not substitute real Keynesian theory (and, in this case I'm not sure it's unique to Keynesianism).

He's arguing that nominal spending should be maintained, otherwise aggregate supply is not being used to its "full potential" (i.e. there will be idle resources).

Where it gets kind of weird, at least in Krugman's case, is that instead of "socialization of investment" (per Keynes) he argues for greater consumption spending.

LK said...

I'll go further. The "subprime market" never would have taken off in a free market, not without real safeguards built into the system, which contrasts with the moral hazard that existed as the government told lenders directly and indirectly that the taxpayers had their backs

Wrong.
Australia had a free banking system and no central bank under a gold standard, yet a huge property bubble occurred in Australia in the 1880s which collapsed, causing a financial crisis and extremely severe depression in the 1890s (probably worse than that in the 1930s In fact).

See Charles R. Hickson and John D. Turner, 2002, “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review 9: 147–167.

No doubt you will complain that fractional reserve banking (FRB) was to blame and FRB needs to be abolished.

But as shown by in

G. A. Selgin and White L. H. 1996. “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians!,” Review of Austrian Economics 9.2: 83–107; and

Selgin, 2000. “Should We Let Banks Create Money?” Independent Review 5.1 (Summer): 93–100,

an FRB deposit is in fact a loan (or legally “mutuum”), a “contract under which a thing is lent which is to be consumed and therefore is to be returned in kind”. The depositor who lends the money gets a credit (or IOU) from the bank and a promise to pay interest. The money has been “sold” to the bank as a mutuum and is to be returned in genere. In demand deposits, you lose your absolute property rights to the money when you lent it to the bank voluntarily, and instead have entered into a contract with the bank to allow them to use it, even though they are obliged to return to you, on demand, money to the same amount in whole or in part from their other reserves and deposits. When people freely and voluntarily engage in this practice, it cannot be regarded as fraud.
In any consistent pro-free market system, the Austrian anti-FRB position is itself a evil, collectivist violation of private freedom.

So you’re just stuck with a system that can cause bubbles, like Australia’s in the 1880s.

Michael Duff said...

I had to look up the Australian Banking Crisis of 1893. Would welcome comments from someone who's done more than read a couple web links about it.

But it seems like the banking crisis was caused by two factors, a tremendous amount of foreign investment capital, plus a system of land speculation carried out by companies that called themselves "banks" but engaged in very reckless lending practices.

The price of Australian exports had been falling for some time, to the point where they were being subsidized by the government, but the foreign capital just kept pouring in.

So yes, the Australian banking system might have been free, but the credit was coming from outside that system.

The Australians didn't just wake up one morning and say, "I think we'll start printing money." Australia was a boom economy financed by the whole world.

I'd compare it to what Bernanke is doing to the emerging markets today. American businesses, awash in artificially cheap money, are causing all kinds of distortions in these economies.

So even if we grant that Australia had a free banking system in 1893, ignoring the role of government subsidies and conditions of moral hazard, was the entire world banking system free?

Or was Australia being used as a dumping ground for everybody else's cash?

William L. Anderson said...

Let me see if I have this right, LK. Had there been no huge amount of loan guarantees, no Fannie and Freddie, both of which are government-created entities, no Federal Reserve pushing down interest rates, and no government programs targeted specifically at pushing housing, that we would have seen exactly the same kind of housing bubble.

Why? Because there was a bubble in Australia in the 1880s. And because George Selgin and Larry White had a paper in QJAE to say that one could have fiduciary media in a free banking system.

Yep. That's Krugmanian logic. Oh, and I am sure that a socialist website is going to go to great lengths to give us an accurate view of deregulation. Just as the socialists have claimed that Castro worked an economic miracle in Cuba (his miracle was to make the blind man lame), and that Mao's China was paradise, or that Stalin was a great economic miracle worker before that.

Yeah, I have read the socialist sites. Their gig is socialism at all costs, not the truth.

Bob Roddis said...

From LK’s blog:

Financial deregulation is not correlated with better or faster growth. In fact, in the wake of financial deregulation in the 1980s, average GDP growth rates in the Western world fell sharply, as compared with the extraordinary period of post-WWII prosperity now known as the Golden Age of capitalism (1945–1973). This period was the Bretton Woods era of Keynesianism, social democracy, and financial regulation.

So, let me get this straight. The debt and military Keynesianism of the 1960s led to the Nixonian Keynesianism of 1971. Then we had the Reagan military Keynesianism of the 1980s. The “Golden Age” immediately preceded Nixon cutting the gold link to the dollar. Thereafter, things got worse. LK proves Austrian theory using historical anecdotes!

But the devastating proof of the failure of globalization is the fact that those countries that have followed the rules – in Africa, the Caribbean, Latin America, and the former Soviet Union – have seen growth rates collapse to a level lower than the Bretton Woods era, and in some areas poverty rates have got worse.

As we all know, Africa, the Caribbean, Latin America, and the former Soviet Union are examples of a pure Rothbardian paradise. Each has had sound money, no FRB and strict enforcement of property rights and contracts for even the most powerless of its citizens. Their recent hard times completely disprove the teachings of Murray Rothbard by the use of historical anecdotes!

This would all be pretty funny if it weren’t so pathetic.

Let’s all not forget that Ron Paul voted against repeal of Glass-Steagall:

http://clerk.house.gov/evs/1999/roll276.xml

Bob Roddis said...

As we get sidetracked by LK's little rants, note that the essential question is always ignored and never answered:

WHERE IN THE WORLD IS ALL THE STUFF SUPPOSED TO COME FROM TO SATISFY ALL OF THIS DEBT?

Wille "Jack Brown" Lee said...

Actually, banks do not have the right to lend my money to anyone else when I put in deposits with the good faith that they will be returned to me upon demand. See, we used to pay banks to keep our money safe until the FDIC came along and said it wasn't necessary anymore. That was the bargain: a fee for safety with the promise of return at any time.

Savings and Loan banks took money long term and then lent them out to others as loans. That's why we have certificates of deposit, which mean you have to leave your money in a bank's vaults for a certain amount of time (so it can be lent out to someone else without you coming and asking for it in the middle of a loan's term, you see, LK?)

To combine to two types of banking under one roof is simply immoral. You can't expect to take my deposit, which you are supposed to return to me at any time, and then give it someone else as a loan, pretending it's your own, as a banker.

Take your fancy terms (mutuum) and stuff it. Morality IS objective.

Mike M said...

WHERE IN THE WORLD IS ALL THE STUFF SUPPOSED TO COME FROM TO SATISFY ALL OF THIS DEBT?

Bob, In LK’s world, stuff, like capital, just happens.

LK said...

Let me see if I have this right, LK. Had there been no huge amount of loan guarantees, no Fannie and Freddie, both of which are government-created entities, etc etc

You get nothing "right". Your comments are a feeble straw man argument, plain and simple.

Care to tell us why a massive property bubble happened in Australia under a free banking system with no central bank and a gold standard? Care to refute Selgin et al. work on FRB?
I bet not.

Jonathan M.F. Catalán said...

People need to actually read the work they cite. I learned this myself the hard way.

LK said...

People need to actually read the work they cite. I learned this myself the hard way.

Right, such as:

Selgin, Those Dishonest Goldsmiths
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1589709

Debunking the ignorant nonsense that FRB in Britain began as fraud.

I bet most of you haven't read it, won't read it, or would ignore it even if you did bother to read it.

LK said...

All that matters is the effects of FRB on the economy and what effects that has on the stability and sustainability of FRB itself.

That's called utilitarianism - I thought you were a Randian objectivist.

The answer to that can only be no, if the record of suspension (by government) of bankers' obligation to redeem notes and deposits in specie is as Rothbard puts it

Then you cannot explain why the public continued to engage in FRB.
If there was widespread opposition to FRB and hatred of "evil" government support of it, then why didn't the vast majority of the public take their money and put it in gold warehouses or 100% reserve banks?

Bob Roddis said...

Then you cannot explain why the public continued to engage in FRB.

For the same reason people like candy and potato chips more than brocolli.

Why do people become Keynesians? Because bullying other people justified by ignorant myth is more fun than truth and respect for others.

Why bother trying to be free? Slavery was universal until about 145 years ago.

LK is getting desperate. And creepy.

Bala said...

"That's called utilitarianism - I thought you were a Randian objectivist."

Firstly, you got the label wrong. It is just Objectivist. Secondly, as usual, you just don't get the point. When I said

"All that matters is the effects of FRB on the economy and what effects that has on the stability and sustainability of FRB itself."

I meant that it matters for an economic analysis and for an argument that FRB is a product of a free-market. My main point was that a system of FRB is inherently unstable and prone to repeated collapse.

If a free-market has a check on the growth of FRB and the records show that that check was repeatedly made inoperable by the intervention of government, any claim that people chose FRB voluntarily and that FRB is a product of a free market is hollow at best and idiotic at worst.

LK said...

For the same reason people like candy and potato chips more than brocolli.

Idiotic.
The point is that businessmen and the PUBLIC have repeatedly preferred FRB in the past, as a system that has greater returns and benefits but with some risks that are taken for sake of the benefits.

You claim to support individual property and freedom to do business (so your position has to be self-consistent), but now that is exposed as nonsense as you pontificate to other people about not engaging in FRB.

And just who are you to tell 1 million people who freely and consensually became depositors in a FRB what to do?? You are now reduced to violating their freedom - your pro-liberty Austrian ideology is a sham.

LK said...

My main point was that a system of FRB is inherently unstable and prone to repeated collapse.

Wrong, as Selgin notes:

RF: Do you consider fractional reserve banking inherently problematic? Does free banking require a commodity standard so private banks don’t issue too much currency? ....

Selgin: .... As for fractional reserve banking, I think it’s a wonderful institution and that it’s crazy to argue that we need to get rid of it to have a stable monetary regime. Those self-styled Austrian economists, mostly followers of Murray Rothbard, who insist on its fraudulent nature or inherent instability are, frankly, making poor arguments. I don’t think the evidence supports their view, and that they overlook overwhelming proof of the benefits that fractional reserve banking has brought in the way of economic development by fostering investment.


http://www.richmondfed.org/publications/research/region_focus/2009/winter/full_interview.cfm

Bob Roddis said...

In conclusion, in the marvelous Rothbardian paradise of the future, LK can start a free-banking bank and the rest of us will make sure we don't accept any of his bank notes. And we might even ban him from our private defense area.

If he finds enough fools, I mean depositors, he might end up much richer than the rest of us.

Anonymous said...

LK,

You are priceless. The Selgin quote on the instability of FRB that you picked up is most hilarious. Please show evidence of FRB surviving bank runs and growing without government intervention to save banks from runs.

Bala

Anonymous said...

LK,

Your objections are the very reasons I consider to say that the solution may not lie in treating FRB as fraud or embezzlement but by abolishing legal tender, freeing the market in money, allowing people (individuals, not the collective) to decide what to use as money, defend property and contractual rights and leaving the rest to the free market.

Incidentally, defending property and contractual rights means no moratoria on redemption of notes and deposits in specie. That means that if a bank has over-issued notes and deposits ,d faces a ruinous run, government should not protect the bank but enforce the bank's obligatons to note and deposit holders.

Anonymous said...

Lord Keynes, because you are one of the smartest debaters on these comment boards and one of the most brilliant economics bloggers period (and I mean it), I'm interested in seeing your response to Bill Anderson's main points, which are -

1) The moral hazard from a heavily subsidized housing market causing bad lending practices.
2) The guarantees provided by government under home ownership legislations causing bad lending practices.
3) The fact that governments have ensured that taxpayers have the backs of lenders in the past, such as during the late 1980s and the 1960s, assured the banks further that there are no risks involved in making bad decisions.

Note: I don't dispute your points about Australia's experience with free banking. However, it so far still seems convincing that these are aggravating factors. In order to show that they played no part in the current crisis, we can't just say that a crisis could happen without those things existing (of course it can), but rather that those things have existed without crises happening.

Another Anonymous said...

Anonymous - legal tender laws are essentially meaningless, as economists from Adam Smith onwards have observed. The market in money is already free, and would not change if legal tender laws were abolished tomorrow. Not surprisingly, if one understands what money is, people already have freely decided as individuals, what to use as money. Government fiat money (and the bank money based on it).

Jonathan M.F. Catalán said...

The fractional reserve banking Selgin argues for is not the same as the one that exists today. That's why I suggested you actually read his work.

Yes, I have read it, and yes I am a pro-fractional reserve economist. Thanks for labeling me when you know absolutely nothing about me.

I just dislike when people use what others write in their favor without actually knowing the position of the author they're quoting. This is something you do quite a bit when quoting Austrian authors.