The Fed and its Role in the Economy: No Conspiracies, Just Bad Policy

In the comment section of my last post, one of my critics identified as JG made a point that I believe truly highlights the differences between Keynesians and the Austrians:

@ Anderson,"The Fed wants to drive money toward those assets by keeping their prices artificially high..."

Is that really what the Fed's goal is? To keep prices high? Do you really believe that QE is really a conspiracy to inflate MBS prices?

Someone less given to conspiracy theories would assume that the Fed was buying MBS to maintain liquidity in the financial system to faciliate lending during a time of weak demand.

True, the commenter was trying to lump me in with conspiracy theorists who seem to believe that the Fed principals conspire to wreck the economy and that they know exactly what they are doing and that is part of their dastardly plan. Now, I would agree that a bad economy in which an increasing number of people become dependent upon the government is good for President Obama in particular and the Democratic Party in general, especially if people come to believe that their state of dependence exists because the government is not taxing others enough or if businesses are conspiring to destroy the economy. We certainly see a lot of that from the Democrat/Keynesian camp, which is not without conspiracy theories of its own.

If I might use somewhat simplistic  models that I believe do reflect the differences in thinking between Keynesians and Austrians, the differences are portrayed as followed:

Keynesians: They believe that a market economy is internally flawed and will hurdle toward underconsumption at every turn. Their underconsumption lynchpin (wild swings in private investment, depending upon the "animal spirits" of investors) differs from that of the Marxists (capitalist profits suck the purchasing power from the proletariat, which leads to internal collapses of capitalist economies), but the results are similar.

For example, the housing boom and bust was a product of a pure, unregulated (by government) market in which none of the government agencies had anything to do with the crisis, except that the animalistic capitalist spirit so infected every regulatory agency that none of the regulatory agents -- even those who had perfect foresight (since most government agents are blessed with such foresight if they are performing under a regime run by the Democratic Party) -- did anything to stop it. The capitalists refused to read any price signals and led the economy into the abyss, as pure, unregulated capitalism always does. Had government agents been properly regulating the directing the housing market, it would have performed perfectly.

The Keynesians believe that capitalists do not respond to price signals (which are overblown, anyway, since an actual economy does not replicate the mathematical models of perfect competition), and that prices are useful mostly in their aggregation into various price indices, which themselves are statistics, not points of economic analysis.On the production side, market economies are prone to slide into the scourge of being overrun by monopolies, which create income inequality when then exacerbates the downward slide even more. Thus, without government oversight, and without the presence of a central bank like the Fed along with various government spending mechanisms, a market economy will implode into a miserable abyss of high unemployment and underconsumption. If there is deflation -- which always looms within a market economy -- then the system automatically will plunge into depression and stay there, since in the real world, entrepreneurs don't respond to price signals, anyway.

The important point here is that the Fed, along with the government agencies, exist in order to respond to private market failures, which the capitalists create on their own, with capitalist failures always being systematic. The Fed and the government, then, do not create conditions that lead to mass unemployment (unless someone at the Fed believes in Austrian theories that will make the central bank raise interest rates and choke off aggregate demand), but rather exists to offset those private market failures.

I believe this has been a fair interpretation of the Keynesian position. I now turn toward the Austrians.

Austrians: They believe that market economies are internally stable, and that government interventions, such as the ones made by the Fed, not only are counterproductive but actually help cause the downturns in the first place. No one is blessed at any time with "perfect information," but a price system actually sends the information that entrepreneurs and managers need to make production and exchange decisions regarding the future. Not all people respond properly to price signals, but the errors tend to be random, not systematic.

Intervention by government is harmful because it creates perverse incentives and directs production away from lines that are sustainable into those lines of production which are not. For example, far from being a free-market failure, the housing boom occurred because government in the form of the Federal Reserve System and the various government agencies that are tied to housing engaged in activities that directed investment and spending toward housing in amounts that could not be sustained. Not only did the Fed push down interest rates that encouraged more home buying and refinancing than what would happen in a normal market (without the intervention), but government agencies especially aimed their programs toward the "sub-prime" market in which were created vast amounts of mortgage securities that sold at prices well beyond what would have been the case had the government not been targeting housing in the first place.

Now, it was Wall Street, with its politically-connected banks and financial houses, that created many of these securities (Freddie and Fannie being the other two entities) but one must remember that these banks did not act within the structure of free markets. Instead, their principals acted knowing that the infamous Greenspan/Bernanke "Put" existed in the background, and that even though the mortgage securities certificates clearly stated that they were not guaranteed by the government, in essence that was a mere formality, for the government stood by to do just that: bail out Wall Street.

The point that Austrians emphasize is that without the government intervention and the promise of bailouts, the banks would have been much more likely to have followed the price signals that the markets were sending and not have marched over the cliff. Government here was not an entity that followed in the wake of private disasters in order to clean up the mess, but rather government was actively taking part in creating the mess in the first place.

As for the post-crisis mess, Austrians believe that since government interventions set the stage for the collapse, doing more of the same will not rescue the economy. In fact, it simply continues the same mistakes that occurred in the first place.

In response to the comment that I see Bernanke's purchases of mortgage securities as some sort of sinister plot to undermine the recovery, that is nonsense. My criticism is not of Bernanke's motives, but rather his actions. He is not "preserving liquidity" or anything like that; instead, he is propping up securities that markets already have rejected and continues to direct resources into lines of production that are unsustainable.

Keynesians counter with the "idle resources" argument that states that in a depressed economy such as ours, there are "idle resources" that are made idle by a lack of aggregate demand. When government resorts to what essentially are financial tricks such as the Fed purchasing securities, it is doing nothing more than engaging in unorthodox actions that are needed at this particular time because of very specific conditions that for the most part don't exist, i.e. the "liquidity trap." Without those actions, the economy will plunge into the abyss of a miserable, high-unemployment steady state in which we will be mired forever.

The Austrian response is that many of the "idle resources" are idle because they were malinvestments. The market does not support them because the patterns of purchasing and preferences shown by consumers do not and cannot keep those resources unemployed. Instead, entrepreneurs guided by price signals and interest rates (that follow a natural rate of interest, not something set by the Fed) will move resources from lower to higher-valued uses.

At the base of the thinking, I believe we can say the following: Keynesians believe that a market is not self-correcting in the event of a downturn, while Austrians believe that it is. There really is no middle ground between the two lines of thinking, which is why we see the kinds of responses we observe on this blog and elsewhere.

Is the Fed Hampering the Recovery?

In his blog post on "Calvinist Monetary Economics," Paul Krugman claims that a recent Wall Street Journal op-ed by John Taylor on why he believes the Fed is hampering the recovery by keeping interest rates low falls into the "Calvinball" category. Writes Krugman:

For those who don’t read the classics, Calvinball is a sport in which you change the rules whenever you feel like it, very much including in the middle of games.

Back then the tight-money types were inventing new and peculiar principles of monetary policy on the fly; it was obvious that they were looking for some reason, any reason, to justify a rise in rates, because, well, because.

Krugman goes on:

Now Taylor is doing the same thing. He claims that he can show that the Fed’s low-rate policy is actually contractionary, using “basic microeconomic analysis”. Actually, as Miles Kimball points out, he’s committing a basic microeconomic fallacy — a fallacy you usually identify with Econ 101 freshmen early in the semester (and as it happens the same fallacy committed by Rajan).

For Taylor argues that low rates engineered by the Fed are just like a price ceiling that reduces the supply of loans, and therefore reduces overall lending.

Wow. No, the Fed’s interest rate target isn’t a price control; there is no legal or other restraint on the rates lenders can charge. The Fed is driving down interest rates, or equivalently driving up the price of bonds, by buying bonds; I can’t think of any kind of economic analysis in which that would reduce the quantity of bonds sellers end up issuing, that is, the amount of borrowing (and lending) in the economy.

 I'll put all of this controversy in the simplest of terms: Keynesian orthodoxy claims that lower interest rates will always have a positive effect upon the economy because the low rates encourage more borrowing, ceteris paribus, even in a so-called liquidity trap. The issue of the "liquidity trap," according to Keynesians, is that other factors are holding back "aggregate demand" so that lowering rates by themselves cannot create enough aggregate demand to lift the economy out of a downturn.

That is where fiscal policy comes in, and that is what Krugman has been saying. Thus, anyone who might claim that attempts by the Fed to push down interest rates might have an opposite effect of what is intended is playing "Calvinball."

The Keynesian approach is pretty straightforward, maybe even crude. All economic activity of an economy, all of the relative prices, all of the relations of production, the products creates, everything, can be put into two functions, aggregate demand and aggregate supply. Push aggregate demand to the right, and as long as the AS curve in not in its steep region, economic growth will occur without too much inflation.

Should the economy be in a "liquidity trap," then the only way to get the AD curve to move to the right is for government to engage in lots and lots of spending. The positive results from the spending then will trickle down to everyone else, provided government spends "enough." However, as Bob Murphy has noted, it seems that Krugman is playing some "Calvinball" of his own:

Here is my observation: Paul Krugman will say that government spending has surged under Obama (and Bernanke has engaged in monetary stimulus) when he wants to blow up right-wingers for their failed predictions, yet referring to the same period of time he will say that government spending has actually been either normal or even contractionary, when explaining why his Keynesian solutions haven’t fixed the economy.

 Certainly, Krugman is not above using the "Heads I win, tails you lose," method of arguing. However, I'd like to address a larger question: Can the Fed's "expansionary policies" actually have a contractionary effect upon the economy?

I'd like to take a different approach than has Taylor and point out that the Fed's purchases of securities of all types -- government, mortgage securities, private assets -- is done in order to keep the asset prices high and send false signals to the markets that these securities are worth more than they really are. (The only word for it is fraud and I should point out that when someone in private business, as opposed to Ben Bernanke, tries to artificially jack up the price of securities, he is likely to be prosecuted.)

The Fed wants to drive money toward those assets by keeping their prices artificially high, and I would argue this has two problems that do hamper the economy:

• First, it prevents the needed liquidation of those assets which cannot be supported by market activity so that investors and entrepreneurs can follow real price signals to see where lines of sustainable investments are located. By throwing in what essentially are false prices, the Fed is making it harder for entrepreneurs to find the suitable production lines;

• Second, the Fed's policies discourage savings (which makes Keynesians very happy, given their vaunted "multiplier" is 1 over the savings rate, so the less we save, the greater the "multiplier"), as real savings provide the liquid capital for long-term investments.

Given Krugman's mechanistic views of the economy and his overt hostility toward economic activity that is not created by government fiat, I doubt what I have said would convince Keynesians of anything. To them, the economy is a simple thing controlled by levers of spending with the Really Smart People in Washington and at Princeton knowing at all times when to "step on the gas" and "when to apply the brakes."

Nonetheless, I also would argue that the Fed is holding back the recovery, even as it acts in the name of "aggregate demand." This isn't "Calvinball." It is economics.

The Prophecy Game

If Americans today did what Israelites were commanded to do back in Bible times -- stone false prophets to death -- there would be a lot of dead economists, and that would include Paul Krugman. Krugman has been wrong in the past (claiming that if Japan borrowed and spent enough money during the 1990s, that it would come out of its economic funk, with Japan doing the former but the latter not occuring), but he also knows that a good defense is a good offense.

Thus, he centers on an editorial that is more than three years old to claim that EVERYONE who might disagree with his wisdom is a false prophet. No, he doesn't want them stoned to death, just removed from any meaningful social contact with anyone. His theme is simple: anyone who predicted that the massive expansion of the Fed's balance sheets and attempts to monetize U.S. debt and deficits would lead to an increase in interest rates is an idiot:

...we cannot and will not persuade these people to reconsider their views in the light of the evidence. All we can do is stop paying attention. It’s going to be difficult, because many members of the deficit cult seem highly respectable. But they’ve been hugely, absurdly wrong for years on end, and it’s time to stop taking them seriously.

 Krugman points out that as long "as the economy is depressed," interest rates will remain low. Unfortunately, he wants to claim that this is a market phenomenon instead of something that is being done by Ben Bernanke, an effect of the bad economy. Yet, what should help revive the economy? You guessed it: low interest rates.

So, what is it? Are interest rates an effect of a bad economy, or do they ward off a bad economy? There is a problem of causality, as Krugman wants it both ways. We shall see in the coming year what actually happens. If Krugman is correct, the government's vast intervention into the economy is finally going to bear real fruit, as most sectors will rebound nicely and President Obama will have that real recovery that he deserves.

On the other hand, Krugman has been wrong before, not that he ever admits it. The Krugman paradigm is this: when the economy is depressed, government should suppress interest rates, create lots of new money, try to initiate inflation, and then borrow and spend lots of money. This will bring about a real recovery.

Since the financial crisis became painfully obvious in 2008 (and, really, more than a year before that), government has done all of these things, including bailing out banks, financial houses, and much of the domestic auto industry. The Fed's balance sheet has grown exponentially, and it seems that if nothing else, Bernanke is hellbent on making sure that no big bank goes out of business.

On the other hand, the real economy is not doing so well. If we see the kind of recovery Krugman predicts in the next four years, then Krugman will be able to claim victory, although he has a habit of claiming victory even when he is wrong. The problem is that, like most Progressives, he believes that leftist government is so magical that it can do away with the Law of Opportunity Cost by printing money.

I don't believe that economics is an "empirical" science. Instead, economic theory must submit to the laws of nature, not the laws made up by a British sexual pervert. That means a priori, and anything else is metaphysics, as far as I am concerned. So, we shall see in the end who is the false prophet.

Krugman: Nothing to See Here, Folks! The Economy is Doing Great!

Yes, yes, Paul Krugman's latest column is a stirring defense of the Welfare State, which in Wonderland is permanently sustainable because interest rates are low. And why are interest rates low? I think his former department chair, Ben Bernanke, might have something to do with that, but low rates certainly are not due to any increase in savings or positive long-term outlooks by investors.

Krugman writes:

...we are not facing any kind of fiscal crisis. Indeed, U.S. borrowing costs are at historic lows, with investors actually willing to pay the government for the privilege of owning inflation-protected bonds. So reducing the budget deficit just isn’t the top priority for America at the moment; creating jobs is. For now, the administration’s political capital should be devoted to passing something like last year’s American Jobs Act and providing effective mortgage debt relief. 

 Actually, an economy normally creates employment opportunities by creating new wealth, not printing money, but in Wonderland, the printing press is the real source of wealth and the more the Obama administration through Bernanke prints (and that essentially is what the guy is doing), the wealthier we are!

How do economies grow? Before the creation of Wonderland, they grew when entrepreneurs found ways to combine resources and factors of production in way that would enable them to move these factors and resources from lower-valued to higher-valued uses, as ultimately decided by people who purchased consumption goods. Over time, entrepreneurs found newer and better ways to apply these resources in a way in which we were able to produce more with less.

Even economists at one time believed that. Today, we have Nobel Prize-winning economists claim that economies grow via government spending, through vast subsidies given to industries run by people who are politically-connected to whomever is in power, and by keeping entrepreneurs from producing more wealth.

In Wonderland, "costs" simply are official price-denominated outlays that can be raised or lowered simply via government edict. As the Federal Reserve System quietly props up more banks and governments, we are told that Bernanke actually is creating a miracle world in which the Law of Opportunity Cost is repealed.

The real economy is doing very poorly, but Krugman and his friends in Washington, which has found itself in the position of becoming wealthier during this depression -- at the expense of the rest of the country -- are doing quite well, thank you. Federal workers are taking in more than ever, while the regulatory state grows and grows, while the police powers of the State of Wonderland increase.

Once upon a time, Washington would have been exposed for the parasitic economy it has become, but now that we are in the Age of Wonderland led by Really Smart People, Washington's new riches are seen as progress. Socialism comes to a grinding halt when, in Margaret Thatchers words, the socialists run out of other people's money to spend, but I guess we are not quite there yet.

You see, Krugman actually seems to believe that the "Social Safety Net" actually is a net creator, not a net consumer of wealth. It is economics turned upside down, but for the time being, the folks who believe we create new wealth by taxation, printing money, borrowing at record rates, restricting entrepreneurs, and promoting inflation have the microphone and they are not giving it up.

Krugman: Markets are good -- when they supposedly endorse Krugman's position

As a Keynesian, Krugman has embraced the price theory of his predecessors, that being the belief that "price" is the "P" on the y-axis of the Aggregate Demand -- Aggregate Supply graph. (It is hard to know that the "Y" -- Or is it "Q"? -- might be on the x-axis, given that GDP, or Y, is monetary-based and one cannot have the same thing on both axes. Likewise, an AS-AD graph cannot be logically configured to have just "physical output" on the x-axis, either. What's a Keynesian to do?)

Thus, "price" in the Krugmanian viewpoint is a statistic created by government, and it receives its meaning only as part of a state-configured weighted average. However, when it suits him, "price" suddenly can have all sorts of important meanings -- that is, something that supports his viewpoints.

Likewise, Krugman like many other "elite" academics has utter contempt for anything that smacks of the "market." In the academic world, as well as the world of mainstream/leftist journalism, markets are little more than evil creations made by those who wish to get rich on the backs of "the people." And "price theory"? Fuggediboutit, except when "markets" seem to affirm their position.

One of Krugman's constant themes is that there is very, very little inflation in our economy today. Rising fuel and food prices? Why that is just aggregate demand from abroad. QE1, QE2, and QE-in-perpetuity has nothing to do with that phenomenon, and anyone who claims differently does so because he or she is a racist or an Obama-hater (which means the person is a racist).

Why is this true, according to Krugman? Government bond prices. You see, if interest on U.S. Government bonds is low and prices high, then that is PROOF that there is no inflation. In other words, if he can spin a price into something that backs up his claim, then Krugman suddenly becomes Murray Rothbard in claiming that individual prices really do matter.

One thing that Krugman does not point out is that the ratings agencies have given U.S. Government debt their AAA ratings, but the rules applied to the government are different than rules applied elsewhere. I say this because the vast majority of U.S. Government debt (held in six-month T-bills) is repaid with more debt.

No other entity can get away with this. When New York City in 1975 secretly was selling bonds to pay back its previous bonds, the market ultimately revolted and the city had a financial crisis. In fact, what NYC did was illegal, and those behind it were committing criminal fraud, but because of their political connections, no charges were brought.

(Interestingly, the NY Times, which endlessly calls for criminal prosecutions against those alleged to have committed financial fraud, supported this fraud and the fraudsters. So much for the Grey Lady's consistency on criminal justice.)

As I see it, the AAA ratings from S&P and elsewhere are political in nature, and are not the result of any kind of careful -- and honest -- financial analysis. If any of the agencies were to downgrade U.S. Government debt, with its payment scheme of Rob-Peter-to-Pay-Paul, the government would be hauling executives from those firms into prison to join Bradley Manning. Don't kid yourselves on that; anyone who believes that an intimidation factor is not in play here does not understand the thuggery of the U.S. Government.

Yes, the government has declared that ONLY the U.S. Government can pay back bonds by selling other bonds, and as long as Congress raises the debt ceiling, some people believe this charade can go on forever. However, at some point, the real market will revolt against this fraudulent scheme. Yes, I am sure the Federal Reserve System will try to come to the rescue, but the Law of Scarcity will expose anything that Bernanke and company might try to do.

Peter Schiff makes a good point in this article, noting that the rating agencies are banking on the Fed's ties to the virtual printing press. He also notes that the ratings agencies were willing to hang onto the AAA ratings for a lot of mortgage paper that the market ultimately exposed to be worthless. Again, because of the political implications of the housing boom, I am sure that S&P, Moody's and others believed it to be in their best interests to pretend that mortgage bonds were sound investments.

And one can bet that at that point, Krugman will rise up and condemn the very market that he now claims provides "proof" that we have very low inflation and that government borrowing and spending is not out of control.

The Market, not the Central Bankers, Should Decide Interest Rates

Like Paul Krugman, I have little or no pity for the Banksters who are demanding that the rest of us stop saying nasty (and true) things about them. Unlike Paul Krugman, I believe that interest rates should be permitted to rise -- if that is where the market says they should be.

Krugman claims that Banksters believe that low interest rates are "feeding inflation," something he claims is not true. Yes, oil prices are rising, and so are gold and other commodities, but Krugman has an explanation for that: natural volatility and "emerging markets." (He also appeals to the same excuse that the Soviets used to explain decades of bad harvests: bad weather.)

Here is the problem: interest rates should not be decided politically. According to Krugman, any raising of rates will trigger a new bout of unemployment, and at one level he is correct. However, the artificially low interest rates that Krugman endorses are having the perverse effect of preventing the necessary relocations in the economy that will bring about a recovery. Explains Bob Murphy:

...at some point reality rears its ugly head. The central bank hasn't created more resources simply by buying assets and lowering interest rates. It is physically impossible for the economy to continue cranking out the higher volume of consumption goods as well as the increased output of capital goods. Eventually something has to give. The reckoning will come sooner rather than later if rising asset or even consumer prices makes the central bank reverse course and jack up interest rates. But even if the central bank keeps rates permanently down, eventually the physical realities will manifest themselves and the economy will suffer a crash.

During the bust phase, entrepreneurs will reevaluate the situation. If the government and central bank don't interfere, prices will give accurate signals about which enterprises should be salvaged and which should be scrapped. Those workers who are in unsustainable lines will be laid off. It will take time for them to search through the developing opportunities and find a niche that is suitable for their skills and is sustainable in the new economy.

During this period of reevaluation and search, the measured unemployment rate will be unusually high. It's not that workers are "idle," or that their productivity has suddenly dropped to zero; rather, it's that they need to be reallocated, and that takes time in a complex, modern economy. This delay can be due to simple search, where the workers have to look around to find the best spot that is already "out there," or it can be due to the fact that they have to wait on other workers to "get things ready" before the unemployed workers can resume.

Since Krugman holds that factors of production (for analytical purposes) are homogeneous, then raising interest rates makes no sense, as all that needs to happen is for government to stimulate more spending, which then will automatically translate to producers ramping up their productions lines, and all soon will be well. If this were the case -- and it did not matter where capital investments were made -- then Krugman would be correct.

However, if factors from labor to capital ARE heterogeneous, and that the value relationship between those factors matters, then Krugman actually is fighting against the very necessary economic readjustments that are needed to create a meaningful recovery. Furthermore, we forget that this country had an economic recovery -- a substantial recovery -- in the 1980s even though interest rates were substantially higher than they are now. The image below demonstrates my point:

Now, it is true that interest rates fell during the recovery, but they still remained in double-digits through much of the 1980s when the economy was going strong. Unfortunately, because Krugman continues to stick to his "aggregate demand" thesis, all of this to him is white noise.

As I see it, the issue is not whether the government or central bank or anyone else should decide if interest rates rise or fall. I want to know what the market says about rates of interest, and I cannot help but believe that with the Fed trying to flood the world with dollars, that they are going to go up sooner rather than later. But they will rise.

Commentary on Current Bond Rates

A number of people making comments on this blog have agreed with Paul Krugman that the relatively low bond rates right now "prove" that new monetary creation and an explosion of government spending bring no inflationary pressure. Thus, they claim, the concerns of people that the current "stimulus" efforts will lead to inflation are unwarranted.

I have asked a number of friends who are economists to comment. As I receive them, I will include them in this post.

Guido Hülsmann
Professeur des Universités
Faculté de Droit, d'Économie et de Gestion
Université d'Angers
France

If I understand this point correctly, higher deficits need not be monetized (or not much) because of the current drop of T-bill rates. Therefore, the danger of inflation is limited. Well, this argument presupposes that it is always possible for political institutions such as the Fed to stabilize TB rates at the current low levels, or even decrease them. But this is wishful thinking. In the past 20 months, the US Treasury, along with the German treasury and a few others, have benefited from the fact that investors have been losing confidence in all other market participants. Therefore, their TB rates have declined while the rates of all others have increased, or are starting to increase. However, this group of beneficiaries shrinks by the day.

Pressure is mounting for rates to go up, for three reasons: (1) there are more and more countries that have to pay higher rates, which will create pressure on T-bills and bonds precisely if and when the general situation seems to stabilize; (2) the supply of T-bills and bonds could dramatically increase if and when the general situation deteriorates, because the US and the German governments have started to act as financial problem-solvers of last resort; and (3) the return on investments in the "natural monies" gold and silver is outpacing the meager return offered by T-bills, and this at much lower risk. These facts are so glaringly obvious that even mainstream banks such as the Landesbank of Baden-Württemberg in Germany, Société Générale in France, or UBS in Switzerland are now hammering this point, to the benefit of their clients. See the latest installment of this wave of financial enlightenment.

As soon as the rates of US T-bills and of bonds start increasing to a moderate crisis level of, say, 10 percent, all government budgets will be belly-up. Then the only remaining alternative will be between (I) US and German government default, entailing a deflationary meltdown of world financial markets, and (II) monetizing T-bills and bonds, which will very quickly bring us on the road of world hyperinflation.

Krugman and the Keynesian "Stones into Bread" Fallacy

The more I read Paul Krugman's columns and papers, the more I realize just how great the gulf is between Austrian and Keynesian thought. It is impossible to sum up all of the differences between the two camps, but I do think that perhaps the disparities can be summed up in the Austrian rejection of Keynes' famous 1943 statement that expansion of credit by the central bank will create a “miracle . . . of turning a stone into bread.”

In his column today, Krugman in a roundabout fashion repeats this notion, as he excoriates the governments of the world for not borrowing, printing, and spending at a rate that he believes will keep the world economy from slipping into depression. At the heart of Krugman's exhortation is his belief that credit expansion is the same thing as creating wealth. I don't think so.

Krugman has almost a religious belief that borrowing and printing money and policies of spending for the sake of spending will pull the country out of a recession. He writes of the current mess:

...this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

Krugman ignores the recoveries after the 1921 recession and the 1982 recession, both of which occurred in the absence of inflation and and the presence of higher interest rates. Furthermore, while the U.S. Government in both instances ran deficits, they were deficits brought on by the fall in tax revenues due to the recession, not as matters of "deficit-based stimulus" policies.

But, there is a larger issue here, and it is this: Current spending by government does not create wealth, and it is the creation of wealth that will bring us out of the depression. Borrowing from future generations (or repudiating the debt through inflation) is nothing more than making a claim on future wealth. Furthermore, Krugman's recommendations do nothing to address the current set of malinvestments which plague the economy, not to mention the huge added burden of government-imposed costs which make production of wealth more difficult.

Lest we think that Krugman is saying something new, the great Ludwig von Mises more than 60 years ago exposed this faulty thinking. He wrote:

The stock-in-trade of all Socialist authors is the idea that there is potential plenty and that the substitution of socialism for capitalism would make it possible to give to everybody “according to his needs.” Other authors want to bring about this paradise by a reform of the monetary and credit system. As they see it, all that is lacking is more money and credit. They consider that the rate of interest is a phenomenon artificially created by the man-made scarcity of the “means of payment.”

In hundreds, even thousands, of books and pamphlets they passionately blame the “orthodox” economists for their reluctance to admit that inflationist and expansionist doctrines are sound. All evils, they repeat again and again, are caused by the erroneous teachings of the “dismal science” of economics and the “credit monopoly” of the bankers and usurers. To unchain money from the fetters of “restrictionism,” to create free money (Freigeld, in the terminology of Silvio Gesell) and to grant cheap or even gratuitous credit, is the main plank in their political platform.

Indeed, it was as though Professor Mises was anticipating Krugman's arguments. No doubt, Krugman would think Mises was a fool and a charlatan, but the joke is on Krugman. True, Mises did not have a Nobel Prize; but Mises had wisdom, and that makes all the difference.

Krugman: F.A. Hayek Wants You to Lose Your Job

One of the reasons I started this blog was to highlight the real differences between Keynesian "economics" and the economics of the Austrian School, and to defend Austrian concepts against the missives coming from Paul Krugman of Princeton University and the New York Times. Thank goodness, mine is not the best or most articulate voice from the Austrian camp, and I have highlighted others, including Robert Higgs, who I believe is infinitely a better economist than Krugman.

Krugman over the years has refused to explain the Austrian viewpoints in anything but outright caricatures and exaggerations. For example, here we get what he calls the "Hangover Theory," which outright misrepresents everything written by Ludwig von Mises, F.A. Hayek, and Murray Rothbard on the subject of business cycle theory.

In this June 14 post on his NYT blog, Krugman once again refuses to take a serious look at what the Austrians claim, deciding, instead, to place them in a false light in order to make them seem as though they are united by one thing: hatred of humanity. He takes the following quote from Hayek as his example of Austrian cruelty:

…still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production.If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed.The only way permanently to ‘mobilise’ all available resources is, thereforeto leave it to time to effect a permanent cure by the slow process of adapting the structure of production.

If one reads Hayek carefully, he is saying that when governments hold down interest rates to artificially low levels, they actually BLOCK the economic recovery, yet all Krugman can see is "persistent high unemployment." Krugman writes:

These days, relatively few economists are willing to say straight out that they regard persistent high unemployment as a good thing. But they find reasons to oppose any and all suggestions to use government policy — including monetary policy — to alleviate the slump. Same as it ever was.

Notice that Hayek has not said any such thing, but to Krugman, free markets and an economy not steered by government must by definition have "persistent high unemployment," although he does not explain why that would be so. (In fact, Krugman seems to believe that he really is above any such explanation, as his declaration alone should be regarded as ex cathera.)

In claiming that economists like Joseph Schumpeter and Hayek were champions of depression, Krugman (and his partner-in-crime Brad DeLong) violently misrepresent the Austrian viewpoint. The Austrians don't claim that the Great Depression was a "good thing," but rather the Great Depression occurred precisely because governments intervened in the economy to prop up malinvestments and to keep the necessary liquidations from occurring. Because of those policies, the economy got both liquidation AND high unemployment.

Unfortunately, Krugman and DeLong never see that simple point. In the Austrian view, we have EITHER liquidation of malivestments or long-term high unemployment, with any high amounts of unemployment coming from the liquidation process being temporary. Krugman and the Keynesians, on the other hand, believe that once the liquidation process begins, the economy never recovers. Ever.

As Robert Higgs writes about these "vulgar Keynesians":

With their great, simple faith in the efficacy of government spending as a macroeconomic balance wheel, vulgar Keynesians disregard malinvestment, past and future, and support government spending in excess of the government’s revenues, the difference being covered by borrowing. Of course, they favor central-bank actions to make such borrowing cheaper for the government. In fact, they chronically prefer “easy money” to more restrictive central-bank policies. As noted previously, they prefer easy money not only because it lowers the cost of financing the government’s deficit spending, but also because it induces individuals to borrow more money and spend it for consumption goods ― such increased consumption spending being viewed as always a good thing, notwithstanding the recent near-zero rate of saving by individuals in the United States. Reflecting on the vulgar Keynesian attitude toward Fed policy, I keep recalling a old country song whose refrain was: “older whiskey, faster horses, younger women, more money.”

Vulgar Keynesians do not spend much time worrying about potential inflation; on the contrary, they are obsessed with an irrational fear of even the slightest hint of deflation. If inflation should become an undeniable problem, we may count on them to support price controls, which, they are convinced on the basis of sketchy knowledge of such controls during World War II, can be made to work well.

I think that pretty much says it.