Wednesday, June 27, 2012

Krugman's Deleveraging Dilemma

In an earlier post, I embedded an MGM propaganda film from 1933 that extolled the virtues of inflation and how debasing money would lead America out of the Great Depression. That the depression lasted throughout the 1930s does not exactly square with the predictions, but the FDR sycophants never did believe that facts actually might matter, so we are supposed to believe that the New Deal and inflation (along with World War II) actually ended the Great Depression.

I mention this earlier post because Paul Krugman recently posted yet another Ode To The Wonder And Glory Of Inflation on his blog, although he comes at it from a different twist than what Keynesians argued during the 1930s. Nonetheless, the theme is constant: inflation is our savior. Hail, Inflation!

John Maynard Keynes argued that the "classical" economists were somewhat correct; a lowering of real wages would result in greater employment. However, Keynes argued, if wages were lowered, then workers would have less "aggregate demand" by which to purchase goods, meaning that shelves could not be cleared and unemployment would increase. Unless stopped, this downward deflationary spiral would go on indefinitely until the economy was mired in a perverse steady state in which unemployment would be high and poverty would abound.

There was an easy and painless way to accomplish the needed real wage cuts, Keynes argued, and that was via inflation. Since, in his view, working people cared only about "their money wages" (or what economists call "nominal" wages), they would not even notice when inflation reduced their purchasing power.

Economists like Krugman have embraced this Holy Doctrine even though it is based upon the assumption that inflation affects ALL people equally. In other words, over time, people will receive the new money is the exact proportions to their current earnings, and that the price relations between the various factors of production also will be unchanged.

If there are any "dislocations," they will be for the good as somehow the "rich" creditor class will find its real income being cut more than the "debtors," which means that there would supposedly be a wealth transfer from rich to poor. Given that Keynesians like Krugman also argue that high marginal tax rates that confiscate large sums of money from wealthy people also will help lead the economy into prosperity, government should be promoting wealth transfers in order to enhance the economic recovery.

Krugman applies this reasoning in his "deleveraging" post. He writes:
You might think that the process would be symmetric: debtors pay down their debt, while creditors are correspondingly induced to spend more by low real interest rates. And it would be symmetric if the shock were small enough. In fact, however, the deleveraging shock has been so large that we’re hard up against the zero lower bound; interest rates can’t go low enough. And so we have a persistent excess of desired saving over desired investment, which is to say persistently inadequate demand, which is to say a depression.

By the way, this is in a fundamental sense a market failure: there is a price mechanism, the real interest rate, that because of the zero lower bound can’t do its job under certain circumstances, namely the circumstances we face now.
This is the Keynesian perverse steady state in a nutshell from the finance point of view. Everyone is frozen and because of circumstances beyond their control, people are not able to find the necessary gains from trade that would allow commerce to flourish. What to do? Princeton's Finest comes to the rescue:
One answer is fiscal policy: let governments temporarily run big enough deficits to maintain more or less full employment, while the private sector repairs its balance sheets. The other answer is unconventional monetary policy to get around the problem of the zero lower bound: maybe unconventional asset purchases, but the obvious answer is to try to create expected inflation, so as to reduce real rates.
Krugman, of course, wants both options to be exercised simultaneously. Government spending will place new money in the hands of those who are unemployed and inflation will induce everyone else to spend more and, Voila!, Instant Prosperity! And anyone who disagrees does so because of an evil desire lurking within for people to be poor and unemployed; there can be no other reason, since everyone knows that Keynesian "economics" is correct.

Here is the problem: the Keynesian scheme assumes that all of the players in the system act as did the band members in "Animal House" that tried to march through the wall, apparently not noticing that bricks and mortar stood in their way. In this system, no one makes adjustments, no one changes his or her behavior, nothing. The "magic" of inflation works perfectly so that either people are in a state of contented bliss, or the folks being fleeced are legally boxed in to where they cannot do anything but be plundered through high taxes, capital controls, or coercive legislation in which government seizes their assets on a whim.

Furthermore, there is no reason for anyone else to adjust his or her behavior because they are just happy to be working and earning an income again. Although Krugman likes to claim that the factual history of Keynesianism "proves" that he and Keynes have been correct, he conveniently ignores how people react -- ordinary workers -- when inflation starts revving its engines.

To make matters worse, Krugman operates on the assumption that inflation has the same effect on all factors of production, in essence, lowering their real prices so as to make them more employable. It never seems to occur to Keynesians like him that just as inflation favors some people over others, it also changes the value ratio between the factors. For example, in the late 1970s and in 1980, American farmers expanded their operations (many going into huge debt) because commodity prices were rising quickly (and federal agriculture officials, in their infinite wisdom, told farmers that inflationary conditions would last for many years).

And we all know what happened. Federal Reserve Chairman Paul Volcker slammed on the monetary brakes and commodity prices fell rapidly. Yes, Hollywood jumped into the fray with movies such as "Country" and "The River," and a lot of politicians demanded the return of inflation so that farmers could "deleverage" their debts. Dan Rather even began one of his news broadcasts at a farm foreclosure.

Yet, in the Keynesian view -- and certainly from what Krugman has been writing in the past couple of years -- commodity prices are no more sensitive to monetary changes than are prices for most consumer goods. (All Krugman can say is that commodity prices are "volatile," which really does not explain anything, but, then, Keynesians really don't have to explain anything since disagreeing with them is like disagreeing with the Inquisition.)

Likewise, Krugman seems to believe that if the Fed really jolts the economy with a huge burst of inflation, the only thing that will happen is that real interest rates will fall -- and nothing else will change, except unemployment will fall. Lenders won't change anything, inflation will have absolutely no effect upon long-term investment and all of the pieces magically will fit together.

This is what I have decided to call the Keynesian Perfect Market Hypothesis (as opposed to the Perfect Market Hypothesis that comes from the University of Chicago). This hypothesis can be stated as such: New government spending and new monetary creation from the Fed will inject new money into the economy, and the economy will perfectly distribute that new money without any economic dislocations.

Yes, we need much, much more inflation. We have nothing to lose but our rate of unemployment, or so we are supposed to believe.


Dennis said...

Excellent post, Professor Anderson. I remember living through the inflation of the 1970's. Despite inflation rising in a very obvious and deliberate manner, unemployment steadily increased along with it, confounding Keynesians of the day. To combat the drastic decline in real wages, governments instituted wage and price controls, which resulted in shortages of everyday goods like gasoline.

As the inflationary spiral threatened to literally explode by the late 70's, central banks were finally forced to act and raised interest rates to previously unheard of levels. It was then that unemployment really soared, and our economy took years to recover from its prior inflationary binge. That, I am afraid, is what we are in for in the future.

Anonymous said...

I think the essence of Keynesian theory is fluidity, that we can adjust for any situation, and get out of any problem. Some minds can't grasp the nuances of the theory because their minds are too dogmatic. The notion that what works in one situation would be a complete failure in another and vica versa is just too radical for some to understand. They can't use every tool in our arsenal because the dogmatic mind has a tendency to demonize certain tools as always bad and others as always good. The reality is that certain tools that you might never use in one circumstance is the perfect solution in another. And the real evil is to have a knee jerk reaction to certain tools, or a mind that can't grasp how situations may differ.

William L. Anderson said...

This is hilarious. Sorry, but what you essentially are saying is that the Law of Scarcity holds when Keynesians want it to hold, and then it can be ignored when Keynesians decide that it is irrelevant.

And speaking of demonization, just read some of Krugman's posts and columns and you will find that he not only demonizes people who disagree with him, but claims that their disagreement is founded upon their hatred for humanity and their desire to watch other people suffer. Small and dogmatic minds, indeed.

Dennis said...

Here's my analogy to explain Keynesians' penchant for inflation:

Let's say you're at a 10 person poker tournament and all the participants get a starting stack of $2000 in chips. Total chips in play: $20,000. Minutes before the game begins, the host suddenly gives each player another $2000 in chips. Total chips in play: $40,000. You could say that table GDP has doubled, but is anyone better off (richer) for it? Since everyone has the same advantage vis a vis each other, nothing has actually changed.

In a truly Keynesian poker game, however, only the good friends of the host would get extra chips. Half the players would each be limited to a $2000 stack, while the other half would get $6000 each. Now, the politically favored players have a huge advantage over half the table. Nonetheless, the Keynesian host would claim that he has doubled aggregate demand and therefore all players are richer.

Dinero said...

IN the post you say that Keynes argues that

if wages were lowered, workers would have less aggregate demand and unemployment would then increase. But this would not happen if their purchasing power was reduced by inflation.

Did Keynes really argue that, aggregate demand is reduced in both cases is it not.

William L. Anderson said...

No, Keynesians say that because people save less during periods of inflation, they will spend more and, more important, the "marginal propensity to save" becomes smaller. The Keynesian Multiplier is made larger, the smaller the rate of savings or MPS.

So, in the Keynesian view, more inflation does increase real GDP.

Anonymous said...

You don't understand the argument- the general idea is that real falling wages COULD help solve the problem, but a number of factors prevent nominal wages from adjusting quickly (people with debt can't take lower wages, psychologically people resist working for less money, etc).

Inflation works to help lower real wages without lowering nominal wages. If you believe lowering real wages can help- you must believe inflation can help because they work through the same channel. If lowering real wages can cause economic growth by increasing employment, then so can a spurt of inflation. Of course, this only works when unemployment is high.

Sam said...

Funny. During the depths of the financial crises, I witnessed people taking, and offering to take, lower wages just so they could keep their jobs.