Austrians and Predicted Inflation: My Reply to John Carney

Your points in the November 29 column on Paul Krugman and the Austrians makes good points, and I would like to make a few comments of my own.

I do believe that when one makes apocalyptic comments, one gets what he deserves if the predictions don't pan out. As you said, that does not mean the Austrians are wrong regarding money and inflation, but expansions of money, especially in the way that the Fed has gone about doing so, are going to have a number of effects, rising consumer prices being only one of them.

I also believe that some of the Austrians, when they predicted near-instant hyperinflation, should have known better. An expansion in the monetary base can lead to what Milton Friedman called the "pushing on a string" effect, as an expansion of bank reserves will not increase the amount of money in circulation (at least not significantly) if businesses and individuals are not borrowing.

This is not to say that the Law of Marginal Utility, as applied to money, is somehow invalidated. An expansion of money in circulation will mean that the value of the marginal unit – in this case, the dollar – will fall, which means more money will be necessary to complete monetary transactions. That is the straight Law of Marginal Utility, and it applies to money as much as it would to anything else that is scarce.

As Murray Rothbard points out in his book, America's Great Depression, the amount of money in circulation during the 1920s grew, and he terms that as "inflation." However, according to the Consumer Price Index of that time, consumer prices fell by roughly one percent a year, which the late Jude Wanniski used as "proof" that Rothbard was wrong when he claimed that the 20s was an inflationary period. What we witnessed was an apples-and-oranges kind of comparison, as most people (including most economists) generally are used to defining inflation as an increase in the government's CPI, but the Austrians would say that changes in the CPI would be the result of inflation and in our case, the result of the monetary policies of the Fed.

While both Austrians and the Monetarists would see inflation as a monetary phenomenon where changes in relative prices of goods and services occur because the value of money, which is used to denote those relative price relationships, changes as the supply expands and contracts. The Austrians take one step further, however, as they go beyond the quantity effects of increases in the amount of money and look at how these monetary increases change the relative prices of real goods. In other words, the significant effect of changing the amount of money in circulation is not necessarily the changes in consumer prices (although they will change over time relative to the money in circulation), but rather the effect that monetary changes will have upon the relationships of the value of real goods to each other.

This point is vital, for the Austrians hold in their business cycle theory that when the central bank manipulates the banking system to increase the amount of money in circulation, the larger effect is not in consumer price changes but rather the fact that relative values of real goods are changed in a way that directs longer-term investment into lines of production that would seem to be profitable but over time turn out not to be. We certainly saw that in the housing boom and in the tech boom a decade earlier. Investments were directed into production lines that could not be sustained, given the preferences of consumers and their own financial constraints.

In the meantime, the actions of the central bank, when added to various policy initiatives by government, can create these booms that are unsustainable within a market setting and sooner or later are exposed by the markets themselves. When the meltdown became absolutely apparent in September 2008, we were seeing a situation where the market was declaring the mortgage securities held by Wall Street firms to be near-worthless.

(I would like to add a separate point here. Why is it that when a firm tries to manipulate the market to make an asset look more valuable than the market would say it is, authorities view that as being illegal, but when the Fed does it, as it is doing with its QE policies, that is considered "good for the economy"? After all, by purchasing billions of dollars of mortgage securities, the Fed is manipulating their values, given that the sheer purpose of Ben Bernanke's actions is to artificially raise security prices, which is deemed criminal behavior if a private firm does it.)

Krugman has explained that these bubbles were due to nothing more than the failures of private markets, and that unless government regulators intervene, markets always will go over the cliff because, well, because markets are just like that. Yet, if one holds that price signals really do matter, then one would ask why all markets do not behave in the manner we saw. Why not an automobile bubble or a bubble gum bubble or a firewood bubble? Instead, Krugman wants to absolve the Fed, Freddie and Fannie, and the various government agencies that were pushing home ownership and refinancing through policies of having played any part whatsoever in the housing bubble, as he wants us to believe that the problems were due solely to what he and other Keynesians believe to be the inherent failures that automatically accompany market transactions.

Austrians, on the other hand, look for the cause-and-effect. Carl Menger, the original Austrian Economist, begins his classic 1871 Principles of Economics with: "ALL THINGS ARE SUBJECT to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary." Why the "irrational exuberance?" Krugman holds to the Keynesian line of "animal spirits" of investors, but that is no cause at all. Why shouldn't "animal spirits" bid down the values? Do they believe that investors are irrational when bidding up asset prices, but are rational when bidding them down? The Austrians would say that Fed policies of driving down interest rates where they would greatly affect mortgage markets, along with the drive-people-into-home-ownership policies of the Federal government created huge incentives for the creation of the housing boom, which ultimately turned into a bubble, and then a huge bust.

Regarding the consumer price effects of the Fed's policy of spreading dollars around the world, we can see some price increases in various commodities, i.e. food and fuel. Those of us who purchase gasoline or go to the grocery story can attest to some very large price increases over the past five years, and farmers where I live tell me they are having to absorb large increases in the price of animal feed, fertilizer, and diesel fuel. While Krugman wants to explain away these changes as being driven purely by inherent "volatility" and economic growth in places like China, it would seem to me that large increases in the money prices of those things denominated worldwide in dollars just might be due to large increases in the amount of money being poured into these assets and lines of production.

There is one more point. The Fed has vastly increased its balance sheet and has been spreading dollars around the world, mostly to purchase "assets" that essentially have little or no value so that the holders of those assets do not have to take the necessary financial bath. Such actions would not necessarily result in a huge increases of consumer prices overall, but they would have the effect of directing real investment away from those lines of production that would be both profitable and sustainable. Whether it is protecting the banks or the "green investors" or governments that have spent themselves into financial oblivion, the Fed has stymied the recovery by forcing assets into production areas that are doomed to failure. The result is what we see around is in the anemic economic growth.

Where some of the Austrians went wrong was in assuming that all of the Fed's new money pumping would be channeled into the purchase of consumer goods, thus driving up their prices. We have to look at where the new money is going, not where we might think it is going.

Paul Krugman and His Zombie History

Murray Rothbard liked to say that economist often tended to specialize in the area where their knowledge was the worst, and given Paul Krugman's butchery of the historical record, I'd say Rothbard had a good point. Regular readers of Krugman's columns and blog posts and other public statements would believe, for example, that World War II ended the Great Depression, that Jimmy Carter and Ted Kennedy were conservative Republicans, and that the only thing better than war to bring prosperity would be the nationwide preparation to fight an invasion of imaginary space aliens.

As always, whenever Krugman goes on a partisan political screed, truth is left behind, and his recent column is no exception. While I have no problem with his criticizing Republicans, nonetheless I actually would want for him to get his criticisms correct, especially his points that the Republican Party is dedicated to laissez-faire economics and actually cutting the size and scope of government.

Unfortunately, he decides to make essentially this set of claims:

• The financial meltdown was purely the fault of private enterprise except for one governmental error: it did not regulate enough;
• The GSEs, Freddie and Fannie, had absolutely nothing to do with the meltdown.

Krugman writes:

Start with the big question: How did we get into the mess we’re in?

The financial crisis of 2008 and its painful aftermath, which we’re still dealing with, were a huge slap in the face for free-market fundamentalists. Circa 2005, the usual suspects — conservative publications, analysts at right-wing think tanks like the American Enterprise Institute and the Cato Institute, and so on — insisted that deregulated financial markets were doing just fine, and dismissed warnings about a housing bubble as liberal whining. Then the nonexistent bubble burst, and the financial system proved dangerously fragile; only huge government bailouts prevented a total collapse.

Instead of learning from this experience, however, many on the right have chosen to rewrite history. Back then, they thought things were great, and their only complaint was that the government was getting in the way of even more mortgage lending; now they claim that government policies, somehow dictated by liberals even though the G.O.P. controlled both Congress and the White House, were promoting excessive borrowing and causing all the problems.

Every piece of this revisionist history has been refuted in detail. No, the government didn’t force banks to lend to Those People; no, Fannie Mae and Freddie Mac didn’t cause the housing bubble (they were doing relatively little lending during the peak bubble years); no, government-sponsored lenders weren’t responsible for the surge in risky mortgages (private mortgage issuers accounted for the vast majority of the riskiest loans).

But the zombie keeps shambling on — and here’s Mr. Rubio Tuesday night: “This idea — that our problems were caused by a government that was too small — it’s just not true. In fact, a major cause of our recent downturn was a housing crisis created by reckless government policies.” Yep, it’s the full zombie.

The only accusation he left out was that Republicans were responsible for keeping the space aliens away from us, thus nullifying our chances for economic recovery. But, let us take a look at the record, given that Krugman has made some very important claims.

Understand that he is quietly making the larger claim: price signals mean nothing to entrepreneurs; only government regulators and agents can understand the economy and what actually is happening, and that only government, through spending, regulation, and outright ownership and control of the factors of production, can bring about prosperity.

So, let us talk about the government's role in this whole thing. First, he leaves out an important player, the Federal Reserve System, and the fact that neither Alan Greenspan nor Ben Bernanke would admit to the creation of the housing bubble and both continued with their policies of pushing down interest rates and directing funds into the housing market through their statements and actions.

Second, Krugman ignores the simple fact that government is the single largest player in the mortgage business through its policies of encouraging and funding home ownership. To claim that the only influence government had through the housing bubble was not regulating enough is yet another Krugman howler, and his claims that Freddie and Fannie were not lending during the "peak bubble years" and that government agencies did not encourage loans to "sub-prime" borrowers is the typical Krugman rewriting of history.

I'll get to Freddie and Fannie in a moment, but the notion that the banks simply came up with the idea of lending to sub-prime borrowers on their own really does defy history. Yes, it is true that the vast majority of sub-prime loans DID come from the banks, and that their attempts to securitize these loans in order to mitigate the risks were a disaster. I have no problem with this accusation against the Wall Street firms, but there is one thing that Krugman leaves out: the infamous Greenspan-Bernanke "Put."

When the financial deregulation occurred both during the Carter-Reagan years and at the end of the Clinton administration, the government did not get rid of the moral hazard that essentially guaranteed reckless behavior. Both Greenspan and Bernanke time and again promised to "create liquidity" if the banks got into trouble, and when the markets had the trillions of the Fed standing behind them, it is no wonder that they ran off the rails. Moral hazard has a way of encouraging the very actions that lenders and the entities supporting them should not be taking.

Free markets entail both profits and losses, and when the government essentially lets the banks keep their profits but then promises to socialize the losses, why are we shocked, SHOCKED when the banks do the things they did? What Krugman refuses to do is to acknowledge that the players in private enterprise really will respond to the prospect of losses when they engage in risky behavior. Instead, he simply ignores the fact that the banks knew the Fed and the taxpayers were covering their behinds and so they could be free to engage in behavior that anyone with half a brain knew could produce very bad outcomes.

I'll make another point about the crisis: the Austrians were on it long before the Keynesians and the rest of American economists jumped on the bubble bandwagon. Mark Thornton in 2004 wrote:

Signs of a "new era" in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, "extract equity" to increase their spending, and lower their monthly payment! As one loan officer explained to me: "It's almost too good to be true."

In fact, it is too good to be true. What the prophets of the new housing paradigm don't discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures.

Furthermore, while the Austrians may be laissez-faire in their economic viewpoints, they hardly are fans of the banks and they certainly did not believe that the Fed and the housing bubble constituted a new era of prosperity. (For that matter, I warned the property tax appeals board in Allegany County, Maryland, in the spring of 2006 that the current housing situation was a bubble and that it would crash, and that government officials should not make future budget predictions off what we were presently seeing. They told me flat out that I was wrong.)

By leaving out the Fed's "Put" and the other quiet assurances from Congress and the Bush administration that the government had the backsides of the banks, Krugman ignores an important reason as to why the banks ignored price signals and engaged in reckless behavior. While I am sure that Krugman was taught early in in graduate school about moral hazard, his leaving out that important point more to his intellectual dishonesty than it does his lack of economic knowledge.

Freddie and Fannie

Were the GSEs actually non-players in this whole affair, as claimed by Krugman? First, if that were so, then neither entity would have gone bankrupt in 2007, since they did not have risky loans on their books. While it is true that neither GSE was responsible for the vast creation of the subprime loans and their subsequent securitization, but that did not mean they were minor players in the system at the time.

Veronique de Rugy writes:

Fannie and Freddie contributed to the housing crisis by making it easier for more people to take out loans for houses they could not afford. Beginning in 2000, Fannie and Freddie took on loans with low FICO scores, loans with low down payments, and loans with little or no documentation.

The federal government’s role in the housing market goes back at least to 1938, but that role changed fundamentally in the 1990s when the government made a push to increase homeownership in the United States. At that time, the federal government pursued several policies that were meant to encourage banks to lend money to lower income earners and to give incentives to low income earners to buy houses. The result, as we now know, was a gigantic amount of subprime mortgages at a time when house prices were starting to go down.

In other words, the encouragement to create sub-prime housing loans came from federal policies, something that Krugman ignores. (Krugman apparently wants us to believe that the banks would suddenly create a bunch of bad loans on their own, and with the full knowledge that if they lost money, the government would not be there to force taxpayers to underwrite these bad loans.) Freddie and Fannie did play a role in creating these sub-prime securities, even if Krugman and the NYT want to ignore that fact.

It gets better. Far from being an almost non-existent player in the crisis, we find that the GSEs actually did have large housing portfolios during this time:

...Fannie Mae and Freddie Mac are considered government-sponsored enterprises (GSEs). Although both were, before the crisis, privately financed, the general sentiment was that in the event of a crisis in the mortgage market, the federal government would step in and back the GSEs. In other words, the government implicitly guaranteed Fannie and Freddie's securitized loans. This allowed them to borrow at interest rates below those of the financial markets and to hold much lower capital requirements than commercial and investment banks. The aggregate value of this subsidy has been estimated to range "somewhere between $119 billion and $164 billion, of which shareholders receive respectively between $50 and $97 billion. Astonishingly, the subsidy was almost equal to the market value of these two GSEs."

As a result, by the time the housing crisis began to unfold, Fannie and Freddie had become the dominating force in the secondary mortgage market, providing 75 percent of financing for new mortgages through securitization at the end of 2007. At the end of 2010, they still held about 50 percent of securitized, first-lien home loans.

Economist Russ Roberts also investigated and found that Freddie and Fannie were more like silent partners in the crisis, contra Krugman:

Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS [mortgage-backed securities] sold in the first half of 2006, according to Inside Mortgage Finance Publications, a Bethesda, MD-based publisher that covers the home loan industry.

In 2005, Fannie and Freddie purchased 35.3% of all subprime MBS, the publication estimated. The year before, the two purchased almost 44% of all subprime MBS sold.

We are not speaking of insignificant numbers. Furthermore, as de Rugy points out, Congress and the administration were not exactly non-players in setting the table for a housing crisis:

In addition, lawmakers in both parties enacted policies directed at increasing home ownership rates, resulting in lower mortgage underwriting standards for Fannie and Freddie. Roberts notes that from 2000 on, Fannie and Freddie bought loans with low FICO scores, loans with very low down payments, and loans with little or no documentation. Contrary to Paul Krugman’s assertions, Fannie and Freddie did not “fade away” or “pull back sharply” between 2004 and 2006.

As the following chart from Roberts’ study shows, during that same time Government Sponsored Enterprises (GSEs) bought near-record numbers of mortgages, including an ever-growing number of mortgages with low down payments.

Moreover, as the chart below shows, while private players bought many more subprime loans than Freddie and Fannie, GSEs purchased hundreds of billions of dollars worth of subprime mortgage-backed securities (MBS) from private issuers, holding these securities as investments. (The charts are shown in the Roberts article.)

What Krugman would have us believe is that the government, along with its Frankenstein financial creatures, only wanted banks to make sound mortgages with the usual minimum of 20 percent down, good credit scores, and the like. That clearly is nonsense. As Thomas DiLorenzo notes, the only way that banks on their own would have made such risky loans was the fact that federal policies demanded they do so.

One does not need to hold the banks to be innocent bystanders to recognize the role of government policy in the financial crisis. Furthermore, while I have no problem with financial deregulation, I DO have a problem with financial deregulation that is backed by moral hazard. Deregulation was supposed to free financial entities to diversify their loan portfolios and to be able to provide liquid capital to entrepreneurs and businesses that had promising and new ventures.

Furthermore, financial deregulation did make possible the revolution in computers and telecommunications, and had we kept the regulatory system Krugman endorses in place, there would be no Apple Computers, cellphone networks, improved transportation, and IBM would still be the industry leader in the dominant mainframe computer business. Since Keynesians know nothing about entrepreneurship and even less about finance, Krugman probably is incapable of understanding how economies grow, still being stuck in the "aggregate demand" intellectual ghetto.

But financial deregulation only could have worked in the long run had the government made banks and financial houses responsible for their losses. By increasing the various government-led financial backstops as deregulation occurred, Congress almost guaranteed more reckless behavior, and no one should be surprised at what happened.

Unfortunately, these tidbits of truth are left out in Paul Krugman's own zombie version of economic history. That this rewriting of history comes on the editorial pages of the New York Times should shock no one. After all, the "Newspaper of Record" has been fabricating the "record" for a long time.

Uh, Isn't this a Case of Malinvestment? I Forgot; Krugman Doesn't Believe in Malinvestment

A while back, Paul Krugman mocked the Austrian Business Cycle Theory (ABCT -- or ATBC), claiming it was akin to the "phlogiston theory of fire." Why would he use such terms? Because the ABCT is based on the view that government economic intervention -- and especially aggressive monetary intervention -- creates malinvestments that cannot be sustained, and every good Keynesian knows that the real problem is "aggregate demand."

Thus, to get an economy quickly back on track after a bout of poor aggregate demand, all that is needed is for a government to engage in aggressive spending, borrowing, creating inflation (when the economy is in a "liquidity trap"), and creating vast subsidies in order to ramp up more spending. Krugman has emphasized these points time and again the past four years, and they are part-and-parcel to Keynesian doctrines.

Yet, in his most recent column, Krugman tries to claim that a financial crisis is "different" from other business cycle downturns because it takes longer for the economy to recover. Yet, to me, this brings up a number of questions that seem to contradict his Holy Keynesian Faith. He writes:

... President Obama’s people failed to appreciate something that is now common wisdom among economic analysts: severe financial crises inflict sustained economic damage, and it takes a long time to recover. (emphasis mine)

The simply question I ask is: Why? For that matter, given the Keynesian view that for analytical purposes factors of production are homogeneous, why should a housing bubble be a bad thing? (Oh, I forgot, the Federal Reserve System is trying to reflate the housing market and Krugman approves. That's called creating another bubble.)

If a housing bubble, or any other financial bubble, puts prices out kilter with fundamentals, why is that a problem given that Keynesian doctrine treats an economy simply as two curves, an aggregate demand curve and an aggregate supply curve? No matter what the government does as long as it encourages more demand is just fine.

Does Krugman believe this? No, or at least if he recognizes financial bubbles, then he also recognizes malinvestments, even if he claims otherwise. However, in looking at his infamous "Hangover Theory" article, there is a contradiction that Krugman never has tried to erase. He writes:

...let's ask a seemingly silly question: Why should the ups and downs of investment demand lead to ups and downs in the economy as a whole?

However, during both the Tech Bubble and the Housing Bubble, unemployment rates did go down and we had a general economic boom. (The Clintonistas claimed that they had created a "New Economy" by raising the top tax rate to 39.6 percent.) The booms were the trigger mechanism for much of the creation of new money and were central points of spending. Furthermore, the U.S. dollar was considered to be the world's "reserve currency," so when people were able to hold more dollars, the rest of the world was glad to accept them.

Even Krugman would acknowledge that point, but he has no intellectual theory to explain why it is that a housing bust and financial crisis should then result in long-term economic damage complete with high unemployment. His criticism of the ABCT could just as well be criticism of his own Keynesians beliefs:

The hangover theory, then, turns out to be intellectually incoherent; nobody has managed to explain why bad investments in the past require the unemployment of good workers in the present.

We could say the same thing about Keynesian Theory and Krugman's earlier point about financial collapses. If government simply takes over all lending and spends and spends and spends, then why should there be any residual problems at all? In fact, the government has done all of these things, yet the underlying economy is very weak. Krugman can try to play the political operative and spin the current mess as a huge success for the Obama administration, but he has not explained how a financial bubble (1) could help create a boom and (2) how a bursting of the bubble would cause damage given that government can fix things with spending.

Furthermore, if prices really don't matter (except aggregates put into an index), how would we know in the first place that a bubble had occurred? So what if housing prices are high; if the relationship of the prices don't really matter, then who is to say that housing is out-of-kilter? No doubt, these statements will enrage a Keynesian True Believer, but Keynesians -- including Krugman -- are not free to claim that prices matter when they want them to matter and that prices don't matter when Keynesians claim they don't.

Krugman, College, and the Higher Education Bubble

Paul Krugman claims (implausibly) that he was the first (or one of the first) economists to point out that the hot housing market really was a financial bubble. Of course, Krugman two years earlier had claimed that Alan Greenspan would have to create a housing bubble in order to revive the economy. (Krugman claims that he was just being tongue-in-cheek, and I will let readers decide for themselves.)

In 2004, Mark Thornton wrote:

Signs of a "new era" in housing are everywhere. Housing construction is taking place at record rates. New records for real estate prices are being set across the country, especially on the east and west coasts. Booming home prices and record low interest rates are allowing homeowners to refinance their mortgages, "extract equity" to increase their spending, and lower their monthly payment! As one loan officer explained to me: "It's almost too good to be true."

In fact, it is too good to be true. What the prophets of the new housing paradigm don't discuss is that real estate markets have experienced similar cycles in the past and that periods described as new paradigms are often followed by periods of distress in real estate markets, including foreclosure sales, bankruptcy and bank failures.

Granted, Thornton is from the Austrian School, so he can't possibly know anything about economics or what happens when the Fed forces down interest rates. And given that Austrians are so ignorant about everything, I will use another Austrian, Doug French, to give a counterpoint to Krugman's latest missive about higher education.

Krugman's latest column attacks Republicans for questioning ANYTHING about higher education, claiming that anyone who might have such thoughts is championing ignorance. I hate to say it, but it is not just the Republicans who are asking some serious questions about what is happening and whether or not our system of higher education is sustainable.

Krugman writes:

Here’s what the candidate told the student: “Don’t just go to one that has the highest price. Go to one that has a little lower price where you can get a good education. And, hopefully, you’ll find that. And don’t expect the government to forgive the debt that you take on.”

Wow. So much for America’s tradition of providing student aid. And Mr. Romney’s remarks were even more callous and destructive than you may be aware, given what’s been happening lately to American higher education.

I hate to say it, but most "student aid" is in the form of loans, and when one takes a student loan, their is no divorce from it until every farthing is repaid. (Student loans cannot, by law, be figured into bankruptcy proceedings, so if one owes huge amounts of money and cannot pay it back, tough luck. The government will make your life miserable, and in a recent case in California, government agents literally sent a SWAT team to a house where a man's estranged wife was behind on her student loan payments.)

Krugman goes on to blame Republicans and anyone else who refuses to submit to the fantasy that state governments can continue to spend at Krugman-approved levels, including continuing payments to public colleges and universities at pre-depression levels. However, because he claims that the only thing that is needed solve the problems of higher education is for taxpayers to throw more money at it, he ignores the real underlying financial crisis that involves higher education.

Doug French knows otherwise. In a recent article, he takes on what he calls the "Higher Education Bubble" and throws cold water on the fantasies that Krugman is trying to weave. He writes:

Like all booms, higher education has been fueled by credit. In June of last year, total student-loan debt exceeded total credit-card debt outstanding for the first time, totaling more than $900 billion.

All of this credit has pushed the average cost of tuition up 440 percent in the last 25 years, more than four times the rate of inflation. But while the factors of production on campus have been bid up, just as they are in any other asset boom, the return on investment is a bust. In 1992, there were 5.1 million mal-employed college graduates. By 2008, the number was 17 million.

With Krugman, the answer is simplistic: throw more money into the higher education fire and out of it will appear a wonderful, golden calf.

French, on the other hand, sees the trends and the hard numbers to boot. And while Krugman might claim to have been a prophet on the housing bubble, he clearly is blind to what is happening in higher education. And when someone tries to point out the realities, Krugman does what Krugman always does: he makes insults and partisan statements.

I will go further: higher education really has become a consumer good instead of a producer's good for many people. As a college professor, I can attest to that last statement, as much as I wish that Krugman were correct. But he is not.

Krugman changes his tune (in time to shill for Obama)

I have said many times that Paul Krugman is much more a political operative than an economist, and while that makes people mad, it also is true. And the day before President Obama's State of the Union Speech, suddenly the gloomy, "We-Are-Practicing-Austerity" Krugman was singing the praises of Obama the Great.

Yes, this is the same Obama that recently Krugman was claiming was not spending enough and was going to throw us into another downturn because of his policies of "austerity." But now that we are in a political campaign, Krugman is singing, "Happy Days are Here Again."

He claims that he was abused when he pointed out the housing bubble, and I find it interesting that in his blog posts and elsewhere, he has attacked Peter Schiff, yet it was Schiff who was the most vocal about the bubble and its meaning. Furthermore, Mark Thornton in 2004 had made the point about the bubble, and Ron Paul was playing Paul Revere on the subject in 2003. However, since Krugman thinks Austrians are idiots and don't know any economics, he throws the Austrian warnings down the Orwellian Memory Hole.

(Now, don't forget that Krugman's good friend Ben Bernanke also missed the bubble, but Krugman isn't about to jump on his ally for being wrong. No, Krugman is much too smart a political operative to do that.)

Yet, there are a couple things in this column that are puzzling. First, he claims that somehow we can revive the economy with...more housing:

But the economy is depressed, in large part, because of the housing bust, which immediately suggests the possibility of a virtuous circle: an improving economy leads to a surge in home purchases, which leads to more construction, which strengthens the economy further, and so on. And if you squint hard at recent data, it looks as if something like that may be starting: home sales are up, unemployment claims are down, and builders’ confidence is rising.

And why might housing be a bright spot in the future? He writes:

Furthermore, the chances for a virtuous circle have been rising, because we’ve made significant progress on the debt front.

That’s not what you hear in public debate, of course, where all the focus is on rising government debt. But anyone who has looked seriously at how we got into this slump knows that private debt, especially household debt, was the real culprit: it was the explosion of household debt during the Bush years that set the stage for the crisis. And the good news is that this private debt has declined in dollar terms, and declined substantially as a percentage of G.D.P., since the end of 2008.

Krugman is talking apples and oranges. No one has claimed that government debt brought about the recession; instead, they are saying that adding trillions of dollars of government debt only exacerbates the problem. Moreover, he is saying that housing has bottomed and maybe things will get better.

Why didn't housing bottom sooner? It did not bottom because Krugman and others argued that the government should continue to pump huge amounts of money into those failing sectors in order to prop them up, as though higher prices bring prosperity. So, the government did just that and housing fell, albeit more slowly, but it fell, so the pain was stretched out.

So, in order to avoid a worse recession, the government created a depression. But now that Obama is up for re-election, suddenly he is Mr. Job Creator. Yes, the man who has pumped hundreds of billions of dollars into "green energy" and other such boondoggles suddenly is responsible for bringing back prosperity. Somehow, I doubt that is happening, but political operatives are not exactly known for their truth telling.

As for Krugman's claim that more inflation and more government debt will give us recovery, Frank Shostak, who is a much better economic analyst than Krugman, says that recovery will come only when the government ends its jihad against savings. No, Shostak doesn't have a Nobel, but he does actually understand economics.

The lure of inflation

In a couple of blog posts this week, Paul Krugman has heaped praise upon that phenomenon known as inflation, claiming, among other things, that the euro could be successful only if it is inflated enough. Since Austrians say that inflation is bad, period, there obviously is a huge disconnect between the two camps.

Before going further, however, I need to clarify the difference in how Austrians and Keynesians define inflation (and even there, I am sure that I will leave out lots of nuances that could invoke lots of discussion among Austrian-oriented grad students). Keynesians see inflation as an increase in the government-created "price level," period. Inflation is defined as a visible and general rise in prices and nothing else.

Thus, according to Krugman and the Keynesians, a large increase in the monetary base itself (excess reserves held by U.S. banks) is not in itself inflationary, especially if the reserves just sit there and are not loaned out. (Obviously, if they are loaned into the system and the new loans reflect the amount of money in that base, then even the Keynesians agree that price levels will increase -- which is exactly what they want to happen.)

Austrians, on the other hand, hold that the actual increase in the amount of money in circulation is inflation in and of itself, even if the monetary increase is not reflected in an increasing price level. The reason for this position is that increasing the amount of money in circulation is going to affect the relationships among assets, changing relative prices.

Furthermore, increasing the amount of money in circulation also keeps prices higher than they would have been otherwise. Furthermore, Austrians argue that even if the official government price level index is relatively flat, nonetheless, the increase in the amount of money in circulation is going to have a negative effect upon the relative value of both higher-order and lower-order goods.

As I see it, Krugman's praise of inflation is based upon an assumption that inflation will provide the cut in real wages, making labor relatively cheaper (and boosting employment), and the fact that money is losing its value brings people to spend rather than save. (Don't forget that the vaunted Keynesian "multiplier" is the number 1 over the rate of savings. So a higher rate, say 20 percent, produces a "multiplier" of 5, while a 0.01 percent rate of savings gives us a multiplier of 100. So, the less we save, the wealthier we will be.)

Krugman also has praised inflation as a tool for "deleveraging," which is a nice way of saying that we can inflate away debt by debasing the dollar and paying the debt service in cheaper money. (One is reminded of people paying their "debts" in Weimar in 1923 by dumping bags of worthless money onto the desks of creditors.)

This is part of what Krugman claims is a "free lunch." But it clearly is not, as the borrower might be gaining a temporary advantage, but as inflation increases, lenders protect themselves by changing the terms of the loan payments to reflect the increase in inflation.

What Krugman and other inflationists never seem to understand is that inflation is not a static thing. Over time, it draws resources from productive to unproductive uses, destroys savings (which is necessary for capital development), and it encourages malinvestments. Inflation is NOT a mechanical thing, but an insidious development in which the "good" effects are felt first (the brisk spending and the fall in unemployment). The bad effects -- malinvestments and, yes, increasing unemployment AND wildly-increasing prices -- are on the back end.

Notice that Alan Greenspan's Fed aggressively increased monetary reserves in the late 1990s, and we had a boom in which some people claimed we were in a "New Economy" in which the business cycle was a thing of the past. After the 2001 bust (when the stock bubble collapsed), the next recovery, featuring the housing boom, was not quite as robust as what had been the case in the late 1990s, and now we are in a non-recovery stage, a depression.

In 2001, the Bush administration resorted to a "hair of the dog" program for economic recovery. Following the last recession, it seems that Krugman and the Obama administration want the dog to get drunk, too. The government can throw spending and the Fed new money at the economy, but the economy is not going to respond as though it were 1998.

Krugman's call for the Fed to purchase U.S. paper directly also needs to be seen as a destructive scheme. First, the "benefits" are not spread directly. Instead, the new money will fall into the hands of those who either are government employees or are politically-connected. Second, these groups will be able to purchase goods at the OLD prices with NEW money, but as the money is spread through the economy, one can see how the insidious wealth transfers develop. Those who are NOT in the direct money pipeline will see their incomes rising very slowly and consumer price increases will outpace their ability to pay.

In other words, Krugman, for all of his talk about "income inequality," simply wants to change the terms of income inequality. He now wants huge transfers of wealth to groups that are politically-connected to the White House and, more specifically, to the Democratic Party. This has nothing to do with improving the economy as a whole; it is a scheme to benefit some groups at the expense of others -- and I should add that it won't be the "rich," but rather others who are middle class earners who don't have the same Democratic political connections.

Inflation is not a "solution." It is something that only will make things worse. Yes, I guess Paul Krugman would consider me to be an "enemy of the people" for not believing that all of the answers lie in debasing the dollar, but as I see it, the enemy consists of those who tell us the Big Lie that we can inflate our way out of this mess.

There's a hole in the logic, dear Krugman, dear Krugman...

When numerous financial houses and banks in the USA and Europe were finally exposed for their massive holdings of worthless securitized mortgages and the infamous Housing Bubble was exploding, the political and financial "leaders" around the world quickly decided upon the "solution": Create a bigger bubble, and use the government's ultimate "Rabbit-Out-of-the-Hat" scheme, which is getting the central banks to do what governments in Latin America and Zimbabwe have done to pull off the scam.

In a recent column, Paul Krugman excoriates these creators of the New Bubble for their actions. No, he is not declaring that all they did was to make the problem worse; instead, he tells them in no uncertain terms that, in his opinion, they didn't make the Bigger Bubble big enough.

Yes, had the U.S. and European central banks been even more aggressive in creating and sustaining a huge bubble in government securities (that are as worthless as the mortgage securities that turned toxic), then we would be in a real economic recovery right now. If you think I am joking, read what Krugman says:

Think about countries like Britain, Japan and the United States, which have large debts and deficits yet remain able to borrow at low interest rates. What’s their secret? The answer, in large part, is that they retain their own currencies, and investors know that in a pinch they could finance their deficits by printing more of those currencies. If the European Central Bank were to similarly stand behind European debts, the crisis would ease dramatically.

Yes, what Krugman is saying is that the central banks of the USA and Great Britain can print money to buy their own government securities and the process can go on indefinitely. Lest anyone think that printing more dollars and pounds might have a negative effect upon those currencies, Krugman also has The Answer:

Wouldn’t that cause inflation? Probably not: whatever the likes of Ron Paul may believe, money creation isn’t inflationary in a depressed economy. Furthermore, Europe actually needs modestly higher overall inflation: too low an overall inflation rate would condemn southern Europe to years of grinding deflation, virtually guaranteeing both continued high unemployment and a string of defaults.

Yeah, it all is Ron Paul's fault. But in the next paragraph, Krugman demonstrates that he wants the Federal Reserve System to do what has been prohibited from the very creation of the 1913 law that created the Fed: have the central bank purchase short-term U.S. Government paper in the primary market. He writes:

But such action, we keep being told, is off the table. The statutes under which the central bank was established supposedly prohibit this kind of thing, although one suspects that clever lawyers could find a way to make it happen.

The cynicism drips off the column with that one, and his comments are a dream come true for those who claim (falsely) that governments are "not revenue constrained," as though the printing press can erase the Law of Opportunity Cost. Krugman's Ultimate Solution, one that I have said for months underlies most of his economic commentary, is dependent upon printing money and nothing else.

Understand the logical construct of what Krugman has declared in this latest column. If the various central banks announce that they are going to start buying short-term government bonds from whatever country seems on the verge of default (or simply cannot pay its bills with regular tax revenues), this immediately will stop the various runs on banks that are holding this government paper, increase the value of government bonds, lower interest rates, bring more spending in the economies of the world, and give us a widespread economic recovery. That is the Krugman economic logic in one sentence.

So, recovery is just a "clever lawyer" away. Intent of laws that were written to prevent the U.S. and European governments from doing what Juan Peron did in Argentina and Robert Mugabe did in Zimbabwe mean nothing, and Krugman makes it clear that he really believes that the secret to prosperity is the printing press:

The story of postwar Europe is deeply inspiring. Out of the ruins of war, Europeans built a system of peace and democracy, constructing along the way societies that, while imperfect — what society isn’t? — are arguably the most decent in human history.

Yet that achievement is under threat because the European elite, in its arrogance, locked the Continent into a monetary system that recreated the rigidities of the gold standard, and — like the gold standard in the 1930s — has turned into a deadly trap.

So, it turns out that the secret to Europe's prosperity was not producing goods and services that other people wanted and needed. Instead, the "secret" was political democracy and the welfare state, as though both of these entities actually produce something. No doubt, Krugman claims that these economies are in a "liquidity trap," and such a situation turns the laws of economics upon their heads. That is nonsense, pure nonsense, for no government and no economist can repeal the Law of Scarcity and the Law of Opportunity Cost.

The world is in financial trouble because central banks, the financial districts, and governments created massive malinvestments in housing and the stock markets in order to achieve a veneer of "prosperity." Those malinvestments have been exposed, and exposed greatly.

Instead of dealing with that reality, Krugman and others insist on creating a New Reality, one in which people are forced to "invest" in government spending, as though flooding economies with various currencies magically will bring back the prosperity that was lost. In other words, Krugman believes that creating The Mother Of All Financial Bubbles in government securities is going to bring our economies into the bliss of recovery. While Krugman uses the song, "There's a Hole in the Bucket," to push his point (the solution, according to Krugman, is to fill the "bucket" with newly-created money), he forgets that his logical constructs themselves are full of holes.

What happens when THAT bubble blows up like a volcano? Just print more money.

Rabbit holes and rabbits from the hat

I find it ironic that given this blog deals with Paul Krugman's residence in Economic Wonderland, The Great One himself has referred to the "rabbit hole" of Wonderland in his latest bout of Wisdom From On High (or at least from Princeton). As I read Krugman's current attempt to rewrite history, I find that he pretty much is sticking to the same fanciful script and calling it economics. In other words, while claiming others are living in Wonderland, Krugman actually is writing about himself.

Before going on, however, let me say how grateful I am to Krugman for his willingness to sit through yet another Republican presidential debate and to be our eyes and ears. Some of us unfortunates who either cannot find an available TV or who are too busy looking after our families to watch thank him for his important contribution to the civil and political fabric of our nation. Thanks, Paul!

Of course, because I have not watched the debates, I have been unable to catch the latest on 9-9-9 (which makes me think of the song from the Beatles' white album in which we hear over and over again, "Number nine, number nine, number nine"....) or Ponzi schemes or the name of Rick Perry's hunting club. You know, the important things.

However, I have my doubts that even the Republicans are blaming Barney Frank for this entire mess, although he did play an important role by shilling for Fannie and Freddie and helping to keep them alive in the days when they were leveraged about 75 to one. In other words, if they wanted to put some of the blame on Steven Gobi's good friend, I would not object.

However, it seems that Krugman really wants us to believe that the ENTIRE crisis was simply generated by the failure of unregulated private enterprise and that government did only good. You think I exaggerate? Read on:

In the real world, recent events were a devastating refutation of the free-market orthodoxy that has ruled American politics these past three decades. Above all, the long crusade against financial regulation, the successful effort to unravel the prudential rules established after the Great Depression on the grounds that they were unnecessary, ended up demonstrating — at immense cost to the nation — that those rules were necessary, after all.

But down the rabbit hole, none of that happened. We didn’t find ourselves in a crisis because of runaway private lenders like Countrywide Financial. We didn’t find ourselves in a crisis because Wall Street pretended that slicing, dicing and rearranging bad loans could somehow create AAA assets — and private rating agencies played along. We didn’t find ourselves in a crisis because “shadow banks” like Lehman Brothers exploited gaps in financial regulation to create bank-type threats to the financial system without being subject to bank-type limits on risk-taking.

Yes, you see that the financial deregulation that began in the late 1970s and was strongly bolstered by DIDMCA in 1980 was the product of Republican rule and ideology. (And Krugman has written that many times, folks, like it or not.)

Whoops! Democrats had the presidency AND overwhelming majorities in the House and Senate during those years. Being that Ted Kennedy was a major architect of deregulation, I had no idea the guy was a closet Republican, but there it is. Krugman has a Nobel, so he ought to know. (Notice that Krugman never even tries to look at what was happening during that time, events that sparked the deregulation movement. Instead, he rewrites history and attacks anyone who might challenge his false claims.)

Furthermore, let us look at why this housing bubble came about. In Krugman's Wonderland, banks just all of a sudden started going wild with mortgage lending about 20 years after some of the handcuffs had been taken off. There is no causality, nothing other than some of the regulations had been removed two decades before.

In Krugman's Wonderland, there are no government programs to promote home ownership, and the Federal Reserve System played absolutely no role at all in helping to provide the massive amount of funds that went into this bubble. There was no Community Reinvestment Act and no directives from the federal government that lenders target people with bad credit scores or no savings and tailor loans to fit their situations. Furthermore, there was no encouragement from Alan Greenspan's and Ben Bernanke's Fed to lenders that if they got into a pinch, that Uncle Sugar would provide the "liquidity" to get them through the crisis. No, none of that.

Wonderland Economics, you see, has no cause-and-effect. The government changes some of the rules for banking and -- Voila! -- years later, all of the lending institutions suddenly run off the cliff like a pack of lemmings. There is no reason, nothing. It just happens.

But, Krugman has yet another howler up his sleeve:

The demonization of Mr. Frank aside, it’s now obviously orthodoxy on the Republican side that government caused the whole problem. So what you need to know is that this orthodoxy has hardened even as the supposed evidence for government as a major villain in the crisis has been discredited. The fact is that government rules didn’t force banks to make bad loans, and that government-sponsored lenders, while they behaved badly in many ways, accounted for few of the truly high-risk loans that fueled the housing bubble.

I spoke to some real estate lawyers during the aftermath of the collapsing bubble, and they told me that both federal AND state government officials were pressuring lenders to reduce their underwriting standards, something that Krugman knows, but cleverly denies. To add to the government's role, Veronique de Rugy points out:

The federal government’s role in the housing market goes back at least to 1938, but that role changed fundamentally in the 1990s when the government made a push to increase homeownership in the United States. At that time, the federal government pursued several policies that were meant to encourage banks to lend money to lower income earners and to give incentives to low income earners to buy houses. The result, as we now know, was a gigantic amount of subprime mortgages at a time when house prices were starting to go down.

Furthermore, we see from Daniel Indiviglio at the Atlantic:

Does Wall Street deserve some of the blame? Absolutely. It was concentrating on the profit that could be made and ignoring risk. Mortgage underwriters, investment banks, rating agencies, and investors all made this mistake. Of course, the GSEs did the same thing. And remember, they also got the party started to begin with. It was their incredible performance from 2001-2003 that made banks take notice.

So were the GSEs the only cause of the housing bubble? Of course not. But it doesn't make any sense to say that they weren't a central cause or didn't play a major role. If you look at their enormous quantity of originations over the past decade, their presence is undeniable. And if you look at the losses they've sustained since then -- which have led to a $148 billion bailout so far -- it's hard to keep a straight face and say they paid enough attention to risk.

I would agree wholeheartedly with both de Rugy and Indiviglio. The banks and financial houses were irresponsible (that is a most mild term, as I cannot think of one that actually fits their conduct this early in the morning), but the fuel for their fires came in large part from government-sponsored entities.

Krugman wants us to believe that Wall Street entities all of a sudden came up with the idea of throwing huge amounts of resources into an unsustainable housing bubble. It just happened; there was no causality, nothing.

But Krugman is not done. No, while he writes of "rabbit holes," he also is promoting the economics of "pulling rabbits from hats." Yes, President Obama can turn things around with his latest "jobs bill" or the Fed can push "aggregate demand" through Operation Twist, and the beat goes on.

Krugman wants us to believe that government can subsidize us into recovery through "green jobs" while cutting out nearly 10 percent of the current electricity grid through environmental regulations. He wants us to believe that government can discourage capital formation through taxes and regulation and then claim it doesn't matter since there is "unused capacity" out there, so capital formation isn't necessary.

Perhaps I am a romantic, but I have this quaint idea that decorated academic economists should not act as shills for a particular candidate or political party. Furthermore, I have this quaint notion that economists really should be looking at cause-and-effect, as opposed to making political claims of good and evil, and then saying government is good (when the Democrats are running it) and private enterprise is evil (because profits are evil).

That is not economics. That is Politics in Wonderland.

Krugman: Government programs had nothing to do with the housing bubble

I must say that when Paul Krugman gets on a subject, he sticks with it, and the latest chapter in his "it's all the fault of free markets" mantra comes in today's column in which he deals with the report of Financial Crisis Inquiry Commission. Not surprisingly, he sticks to his other mantra -- Republicans always are the cause of all problems and ills and Democrats have all the answers -- in this screed.

Unfortunately, the one thing he does not do is to deal with the actual problem, but to Krugman, solutions to the current crisis are problems, while in his view, we "solve" this problem by, well, creating more problems.

He begins (predictably):

When the financial crisis struck, many people — myself included — considered it a teachable moment. Above all, we expected the crisis to remind everyone why banks need to be effectively regulated.

How naïve we were. We should have realized that the modern Republican Party is utterly dedicated to the Reaganite slogan that government is always the problem, never the solution. And, therefore, we should have realized that party loyalists, confronted with facts that don’t fit the slogan, would adjust the facts.

As one who has read Krugman for a long time, I definitely believe that the last statement describes him quite well. So, here we go with Krugman's "facts" about the bubble:

It’s not as if the story of the crisis is particularly obscure. First, there was a widely spread housing bubble, not just in the United States, but in Ireland, Spain, and other countries as well. This bubble was inflated by irresponsible lending, made possible both by bank deregulation and the failure to extend regulation to “shadow banks,” which weren’t covered by traditional regulation but nonetheless engaged in banking activities and created bank-type risks.

Then the bubble burst, with hugely disruptive consequences. It turned out that Wall Street had created a web of interconnection nobody understood, so that the failure of Lehman Brothers, a medium-size investment bank, could threaten to take down the whole world financial system.

Now, it is true that, in George W. Bush's words, "Wall Street got drunk," but as Peter Schiff noted in a speech at the Mises Institute in 2009, there is this little issue of who was supplying the liquor -- the Federal Reserve System. As I have noted before, the government has a number of programs to extend home ownership well beyond its logical bounds and there was pressure from authorities for banks to throw away the underwriting standards for mortgages. That this would build up into a bubble is no surprise.

There also is the matter of Lehman Brothers. I'm sorry, but the notion that the reason we had this crisis is because the government let Lehman fail is a bit much. Wall Street as a whole was overleveraged, but unlike Krugman, who wrongly says that it was because banks and the "shadow banks" were operating in a market totally unregulated by government, it seems to me that the famed "Greenspan Put" that also was part of Fed policy under Ben Bernanke created huge moral hazards that encouraged this drunken spree.

In Krugman's Keynesian world, markets don't respond to price signals, as prices have meaning only in the aggregate as part of an index. Things like relative prices and profits are meaningless, which is why Krugman can claim that the heavily-subsidized industry of "alternative energy" can lead us out of this depression. (Krugman does not seem to believe that free market profits have anything to do with the valuation of the factors of production, and why should they, given that in the Keynesian view, factors are homogeneous, economically speaking.)

Krugman's defense of Fannie and Freddie is pretty hilarious:

In the world according to the G.O.P. commissioners, it’s all the fault of government do-gooders, who used various levers — especially Fannie Mae and Freddie Mac, the government-sponsored loan-guarantee agencies — to promote loans to low-income borrowers. Wall Street — I mean, the private sector — erred only to the extent that it got suckered into going along with this government-created bubble.

It’s hard to overstate how wrongheaded all of this is. For one thing, as I’ve already noted, the housing bubble was international — and Fannie and Freddie weren’t guaranteeing mortgages in Latvia. Nor were they guaranteeing loans in commercial real estate, which also experienced a huge bubble.

Beyond that, the timing shows that private players weren’t suckered into a government-created bubble. It was the other way around. During the peak years of housing inflation, Fannie and Freddie were pushed to the sidelines; they only got into dubious lending late in the game, as they tried to regain market share.

In this view, Freddie and Fannie were the victims of those rapacious capitalists. There was no subprime market; the Fed had nothing to do with this, and government came in on the tail end of things.

This is NOT a defense of Wall Street or the Republicans. I will say outright that one cannot have both a deregulated financial system AND something like the "Greenspan Put." It is not possible because the kinds of moral hazards that such policies create are such that we should not be surprised when we see a meltdown of this magnitude.

I don't think the banks were "suckered" by the government; they were in bed with the people who were supposed to be regulating them. Unlike Krugman, however, I don't think that this lack of oversight was due to free market ideology, as I know no free-market economist who believes that markets and moral hazard can exist simultaneously without creating real problems.

No, people were getting rich and not having to work very hard at it. As in a bubble atmosphere, even if everyone knows there is a bubble, the trick is to jump off before the whole thing peaks and then pops.

Because Krugman is stuck in his ideological and political ghetto, he really offers nothing but inflation as a "solution." He claims to understand the effects of financial bubbles, but his ideology, partisanship, and Keynesian thinking blinds him to the cause of bubbles. And if he cannot understand the cause of the problem, he hardly is qualified to recommend solutions.

Krugman's Hocus-Pocus Economics

Well, following the elections, which were pretty disastrous for the Democrats, at least regarding the U.S. House of Representatives, I figured Paul Krugman's first column would be yet another attack on the Republicans. Instead, he attacked President Obama for not having enough "audacity" in his economic programs.

We have been down this road before. Krugman's favorite theme -- other than Republicans come from the Pit of Hell -- has been that Obama did not spend enough, inflate enough, or regulate enough. What Krugman wants us to believe is that the most leftist president of my life somehow did not have the courage to tax, borrow, and spend, and that Obama's lack of "courage" is what blew up the House.

Writes Krugman:

Mr. Obama’s problem wasn’t lack of focus; it was lack of audacity. At the start of his administration he settled for an economic plan that was far too weak. He compounded this original sin both by pretending that everything was on track and by adopting the rhetoric of his enemies.

The aftermath of major financial crises is almost always terrible: severe crises are typically followed by multiple years of very high unemployment. And when Mr. Obama took office, America had just suffered its worst financial crisis since the 1930s. What the nation needed, given this grim prospect, was a really ambitious recovery plan.

Could Mr. Obama actually have offered such a plan? He might not have been able to get a big plan through Congress, or at least not without using extraordinary political tactics. Still, he could have chosen to be bold — to make Plan A the passage of a truly adequate economic plan, with Plan B being to place blame for the economy’s troubles on Republicans if they succeeded in blocking such a plan.

But he chose a seemingly safer course: a medium-size stimulus package that was clearly not up to the task. And that’s not 20/20 hindsight. In early 2009, many economists, yours truly included, were more or less frantically warning that the administration’s proposals were nowhere near bold enough.

And there's more:

I felt a sense of despair during Mr. Obama’s first State of the Union address, in which he declared that “families across the country are tightening their belts and making tough decisions. The federal government should do the same.” Not only was this bad economics — right now the government must spend, because the private sector can’t or won’t — it was almost a verbatim repeat of what John Boehner, the soon-to-be House speaker, said when attacking the original stimulus. If the president won’t speak up for his own economic philosophy, who will?

There is much economic "hocus-pocus" in these statements, a veritable treasure trove of Frederic Bastiat's "Fallacy of the Broken Window." For all his "the stimulus should have been bigger" line, never does he in this or any other column explain how that move would result in a long-term recovery. Oh, yes, he says it would give the economy "traction," as though an economy is a perpetual motion machine that just needs a little push.

So, what should Obama do? Krugman (of course) has the right answers:

There is an alternative: Mr. Obama can take a stand.

For one thing, he still has the ability to engineer significant relief to homeowners, one area where his administration completely dropped the ball during its first two years. Beyond that, Plan B is still available. He can propose real measures to create jobs and aid the unemployed and put Republicans on the spot for standing in the way of the help Americans need.

Would taking such a stand be politically risky? Yes, of course. But Mr. Obama’s economic policy ended up being a political disaster precisely because he tried to play it safe. It’s time for him to try something different.

The only way to "engineer relief" to homeowners is to give them checks or pay their mortgages if they default. It does not take a Nobel Prize to know that a government program that taxes homeowners who are paying their mortgages in order to give to people who are unable to do so is not going to save the housing industry, but it will send a message to people who work and pay their bills that the government thinks them to be an unlimited ATM for the president to buy votes.

Obama playing it safe? The guy who has pushed through a 2,500-page bill that no one has read in its entirety (and no one person knows exactly what is in it) to engineer a complete government takeover of medical care is "playing it safe"? Maybe in Krugman's world, but definitely not in the world where the rest of us live.

Is the Recession Simply a Zero-Sum Game?

Paul Krugman seems to be a True Believer that any disagreement with the principles he espouses MUST come from bad faith. I mean, who could be against more government spending that would give the economy "traction" and put us back into prosperity?

Thus, he reasons, there must be a much darker reason that some people out there seem to believe that piling on more government debt and spending might not have the effects that Krugman claims will be at the end of the tunnel. Isn't he a Nobel winner? Is he not on the Princeton faculty? Did he not receive his doctorate at prestigious MIT? So, to disagree with him is to engage in No-Nothingness!

As the election has approached, Krugman has become even more shrill than usual, laying out personal attacks and portraying anyone who might disagree with him as being motivated by pure evil. Why are they evil? Read the second paragraph again.

In his column today, Krugman now lays our present troubles at the feet of what he calls "debt moralizers." He writes:

“How many of you people want to pay for your neighbor’s mortgage that has an extra bathroom and can’t pay their bills?” That’s the question CNBC’s Rick Santelli famously asked in 2009, in a rant widely credited with giving birth to the Tea Party movement.

It’s a sentiment that resonates not just in America but in much of the world. The tone differs from place to place — listening to a German official denounce deficits, my wife whispered, “We’ll all be handed whips as we leave, so we can flagellate ourselves.” But the message is the same: debt is evil, debtors must pay for their sins, and from now on we all must live within our means.

And that kind of moralizing is the reason we’re mired in a seemingly endless slump.

First, I see Krugman continue his practice of taking stray quotes and fashioning huge movements from them. Being that the vast majority of so-called Tea Partiers could not tell you who Rick Santelli is, I doubt that hundreds of thousands of people have demonstrated across the country in the Name of Rick. (I guess we are supposed to believe that had he not said anything, the Democrats would not be facing huge midterm election losses.)

Second, I have not heard any U.S. politician claim that America must be good for its debts to China and other entities that have purchased U.S. Treasury debt, and the notion that suddenly we have become a nation of "debt moralizers" is really silly. Does anyone really think that if the Republicans take over Congress (or at least the House) -- or even the White House in two years -- that the USA suddenly will stop being the world's largest debtor nation in history?

But, even with these Krugman pronouncements, what I find amazing is his belief that the real problem is that businesses and individuals refuse to take on even more debt, and, specifically, that the infamous Housing Bubble was nothing more than a zero-sum game. He writes:

The years leading up to the 2008 crisis were indeed marked by unsustainable borrowing, going far beyond the subprime loans many people still believe, wrongly, were at the heart of the problem. Real estate speculation ran wild in Florida and Nevada, but also in Spain, Ireland and Latvia. And all of it was paid for with borrowed money.

This borrowing made the world as a whole neither richer nor poorer: one person’s debt is another person’s asset. But it made the world vulnerable. When lenders suddenly decided that they had lent too much, that debt levels were excessive, debtors were forced to slash spending. This pushed the world into the deepest recession since the 1930s. And recovery, such as it is, has been weak and uncertain — which is exactly what we should have expected, given the overhang of debt.

The key thing to bear in mind is that for the world as a whole, spending equals income. If one group of people — those with excessive debts — is forced to cut spending to pay down its debts, one of two things must happen: either someone else must spend more, or world income will fall.

Thus, in Krugman's view, the Keynesian Cross really is a Model for the Whole World. The bubble really was nothing more than a huge wealth transfer, and now the people who got the wealth are selfishly squirreling it away. He goes on:

Yet those parts of the private sector not burdened by high levels of debt see little reason to increase spending. Corporations are flush with cash — but why expand when so much of the capacity they already have is sitting idle? Consumers who didn’t overborrow can get loans at low rates — but that incentive to spend is more than outweighed by worries about a weak job market. Nobody in the private sector is willing to fill the hole created by the debt overhang.

So what should we be doing? First, governments should be spending while the private sector won’t, so that debtors can pay down their debts without perpetuating a global slump. Second, governments should be promoting widespread debt relief: reducing obligations to levels the debtors can handle is the fastest way to eliminate that debt overhang.

So there you have it. There WERE no malinvestments. All of the assets created in the boom have exactly the same value that they had before the crash occurred. However, those Bad, Bad Moralizers want to see people suffer for their sins:

But the moralizers will have none of it. They denounce deficit spending, declaring that you can’t solve debt problems with more debt. They denounce debt relief, calling it a reward for the undeserving.

And if you point out that their arguments don’t add up, they fly into a rage. Try to explain that when debtors spend less, the economy will be depressed unless somebody else spends more, and they call you a socialist. Try to explain why mortgage relief is better for America than foreclosing on homes that must be sold at a huge loss, and they start ranting like Mr. Santelli. No question about it: the moralizers are filled with a passionate intensity.

I can't say that I have watched too many "moralizers" flying into a rage, as the Rage Guy is Krugman himself. People who disagree with him, he writes, can only be motivated by Really Bad Intentions, and if you wonder why that is so, read the second paragraph of this post (again).

However, in this Keynesian-Cross/Zero-Sum analysis, something does not make sense. If all of this really is a zero-sum game, as Krugman is claiming, then why would the houses have to be sold at a loss? Is the lowering of housing values also a plot by Mitch McConnell and The Forces of Evil? After all, Krugman has written elsewhere that the Austrian Theory of the Business Cycle is nothing more than an economic version of the Phlogiston Theory of Fire. Part of that theory says that credit-fired economic booms also create large amounts of malinvested assets that cannot be sustained over time, and certainly the housing boom/bubble fits that description. (David Gordon wrote an excellent rebuttal to Krugman's portrayal of the ATBC in 1998.)

My point is this: Krugman cannot have it both ways. He is not free to claim both that all that has occurred is a transfer of wealth, and, at the same time, the value of housing truly has fallen. Furthermore, we are not just dealing with a "capacity" issue, as Robert Higgs' "Regime Uncertainty" theory has merit here.

For the past four years, the political Left has controlled the U.S. Senate and the U.S. House of Representatives, and for the last two years, the White House as well. All three entities have been a wellspring of anti-enterprise rhetoric, and we are reading on the NY Times editorial page that government must be more aggressive in criminalizing entrepreneurial error. This hardly is an atmosphere in which any firm would want to invest, given that if a someone were to misread the future, that mistake would mean he or she goes to prison.

Furthermore, Krugman's notion that more spending will cure everything by giving the economy more "traction" is nothing more than the application of circular logic to economic theory. Unfortunately, circular logical today is passed off by our "elites" are Real Wisdom.

When it became evident three years ago that the Housing Boom could not be sustained, the Bush administration and Congress had a couple of choices. They could have realized that it was futile to continue down the same path and to permit the economy to adjust to those assets that were sustainable, or it could pretend that all the economy needed to keep the charade going was to inject more "spending." Not surprisingly, they chose the latter, although now Krugman says that they were not playing Charades aggressively enough. Moreover, he further claims that the Really Bad People know the truth, but just enjoy making others suffer.

No, an economy is not a zero-sum game, nor is it just one big circle in which (to take Israel Kirzner's example) someone eats breakfast so he can go to work, and then goes to work so he can eat breakfast.

What About Mortgages?

At the end of class yesterday, a student and I were discussing the housing bubble and the current situation with foreclosures and things that could be done. I remarked that I was puzzled as to why banks were not willing to do more renegotiating to keep foreclosures from happening, since traditional foreclosures are poison for banks as they deal in money, not real estate.

In his October 14 column, Paul Krugman makes some sense, but I can see that he is as puzzled as the rest of us regarding what should be done. Furthermore, I agree with much of what he says here:

Horror stories have been proliferating, like the case of the Florida man whose home was taken even though he had no mortgage. More significantly, certain players have been ignoring the law. Courts have been approving foreclosures without requiring that mortgage servicers produce appropriate documentation; instead, they have relied on affidavits asserting that the papers are in order. And these affidavits were often produced by “robo-signers,” or low-level employees who had no idea whether their assertions were true.

Now an awful truth is becoming apparent: In many cases, the documentation doesn’t exist. In the frenzy of the bubble, much home lending was undertaken by fly-by-night companies trying to generate as much volume as possible. These loans were sold off to mortgage “trusts,” which, in turn, sliced and diced them into mortgage-backed securities. The trusts were legally required to obtain and hold the mortgage notes that specified the borrowers’ obligations. But it’s now apparent that such niceties were frequently neglected. And this means that many of the foreclosures now taking place are, in fact, illegal.

This is very, very bad. For one thing, it’s a near certainty that significant numbers of borrowers are being defrauded — charged fees they don’t actually owe, declared in default when, by the terms of their loan agreements, they aren’t.

Beyond that, if trusts can’t produce proof that they actually own the mortgages against which they have been selling claims, the sponsors of these trusts will face lawsuits from investors who bought these claims — claims that are now, in many cases, worth only a small fraction of their face value.

And who are these sponsors? Major financial institutions — the same institutions supposedly rescued by government programs last year. So the mortgage mess threatens to produce another financial crisis.

Furthermore, I think he is partially correct in this next statement, taking his hyper-partisanship into account:

True to form, the Obama administration’s response has been to oppose any action that might upset the banks, like a temporary moratorium on foreclosures while some of the issues are resolved. Instead, it is asking the banks, very nicely, to behave better and clean up their act. I mean, that’s worked so well in the past, right?

The response from the right is, however, even worse. Republicans in Congress are lying low, but conservative commentators like those at The Wall Street Journal’s editorial page have come out dismissing the lack of proper documents as a triviality. In effect, they’re saying that if a bank says it owns your house, we should just take its word. To me, this evokes the days when noblemen felt free to take whatever they wanted, knowing that peasants had no standing in the courts. But then, I suspect that some people regard those as the good old days.

Lest anyone think that the TARP (which Krugman endorsed) actually solved anything, think again. As much as anything, the TARP and the willingness of so many in Congress to bestow favors to financial institutions that were busy running off the cliff certainly feeds the belief by many that the "banksters" are above the law, and even above the laws of economics.

Krugman makes another point next, and I believe it bears some discussion:

What should be happening? The excesses of the bubble years have created a legal morass, in which property rights are ill defined because nobody has proper documentation. And where no clear property rights exist, it’s the government’s job to create them.

That won’t be easy, but there are good ideas out there. For example, the Center for American Progress has proposed giving mortgage counselors and other public entities the power to modify troubled loans directly, with their judgment standing unless appealed by the mortgage servicer. This would do a lot to clarify matters and help extract us from the morass.

Indeed, Krugman is right when he points out that ill-defined property rights can cause much economic dislocation. (When he endorses socialistic schemes that, in effect, eviscerate property rights, I cannot figure out why he is shocked, SHOCKED when they don't work.)

The securitization of mortgages -- done first by the government entities Fannie and Freddie and then picked up by private Wall Street firms -- has put a huge new wrinkle into this mess. Furthermore, I absolutely agree that if a financial entity cannot establish legal title to a property (and Krugman forgets that the private title companies were the first organizations to sound the alarm on this latest scandal), then it should not be permitted to perform foreclosure.

As for Krugman's statement that it is up to the government to "create" property rights, that makes no sense. What Krugman is saying is that governments de facto own everything, but if we follow some rules given by the state, the government will let us pretend that we own property. At best, government can be a referee in this process, although I believe our government these days is so abusive and so dysfunctional that it is incapable of turning into a trusted referee.

There is one thing he writes, however, that I think absolutely is wrong:

The accounting scandals at Enron and WorldCom dispelled the myth of effective corporate governance.

Enron's demise was not due to an accounting "scandal," nor was it a failure of corporate governance. (As we can presently see, government governance is not exactly going great guns, as the Congressional Budget Office makes the Enron crowd look like A-plus prognosticators.)

The Enron collapse was the collapse of a company that depended heavily upon the stock bubble AND easy credit. When the credit dried up, the heavily-leveraged firm crashed down hard, as one might expect. The accounting measures that Enron did pushed the envelope, but were not illegal.

(I have participated in a project that takes a second look at the Enron case, and I discuss on camera both the legal and economic aspects of what happened at Enron. Now, I absolutely disagreed with the person who put this project together on the role of the short sellers. The late Ken Lay insisted that short sellers caused the demise of Enron; I say that the short sellers exposed Enron. That's a huge difference.)

Krugman, Keynesians, the Austrians, and the Housing Bubble

In a blog post, Paul Krugman points out that a number of "austerians" (people who believe we need to have fiscal and monetary responsibility) did not see the "housing bubble" approaching -- and he did. Therefore, according to Krugman logic, "austerity" must be bad.

As I see it, the logical construct goes this way:

1. The "austerians" were wrong on the housing bubble;
2. Krugman was right on the housing bubble;
3. Therefore, we need lots more government spending because Krugman believes that is what we need.

This is a classic non sequitur, and I hate to say it, but Krugman's correct view of the bubble does not mean he is correct today. The rightness or wrongness of his argument depends upon both the application of laws of economics and the current situation, period.

Now, in looking at the whole housing bubble business, let me say that I am not going to jump on Krugman's 2002 comment about Alan Greenspan needing to create "a housing bubble to replace the NASDAQ bubble." Krugman has denied that he was advocating such a bubble, and I am willing to take him at his word.

Nonetheless, there are two things that need to be discussed here. The first is the fact that the Austrians, and specifically Mark Thornton, were out in front to call the housing bubble what it was. Thornton wrote in 2004 that the housing market was "too good to be true," and also had this article in February 2004 that buttresses his claims.

Yet, Professor Thornton also is an "austerian," at least in Krugman's definition. He also predicted and recognized the housing bubble long before even Krugman made mention of it. So, there seems to be a crack in Krugman's rejection of "austerity" measures for the economy.

Before going further, however, I need to point out that Austrians are not "austerians" in the mainstream (or statist) view of economics. Austrians believe that the market should be free to sort out the malinvestments that came with the boom, and for the necessary liquidation and repositioning of assets to occur. This is quite different than the view that GOVERNMENT should be IMPOSING austerity. In the Austrian view, the government role is passive while in the mainstream view, government is active in its imposition of policies.

(I need to point out that Krugman rejects both viewpoints. Government needs to be active, showering new money, encouraging spending, and doing lots of borrowing and spending itself, according to Krugman.)

My second point is more theoretical. Keynesians deal solely in aggregates, because they believe that if government both engages in generalized spending (and encourages consumers and businesses to do the same), the economy will recover and grow to full employment -- provided the spending is great enough. However, Keynesianism does not have any kind of coherent capital theory, and I don't see how one can have a bubble, which constitutes a malinvestment in the Austrian view, AND, at the same time, claim that all that is needed is spending.

As I have written many times before (and I am hardly the only Austrian to be saying this), the Keynesian view implies that factors of production are homogeneous, and that it does not matter what kind of spending takes place, just as long as there is adequate spending. This cannot logically square with the creation of bubbles, since asset bubbles are specific and they clearly are malinvestments, yet Krugman continues to deny any theory that includes malinvestments.

Furthermore, Krugman knows that one cannot sustain a bubble, since bubbles by their very definition are not sustainable. Yet, he seems to be arguing that we need to both try to sustain this bubble, or at least not let housing prices fall, and, at the same time, recognize what a bubble really is. These two views are mutually exclusive.

So, in both sets of arguments, I believe that Krugman is using a non sequitur, nor does it surprise me he is doing so.