The Federal Deficit is a Symptom, Not a Disease

Member of Congress are infamous for attacking symptoms of a problem instead of going straight to the heart of the disease, and the current "discussion" on the massive federal deficits are yet another case in point. While I do find myself in some agreement with Paul Krugman on the issue of deficits in his most recent column, nonetheless I also find that once again Krugman sets up the straw man argument and falsely portrays himself as a lonely voice of sanity.

I will say it again; the federal budget deficits are symptoms of the larger problem of federal spending and lawmakers and economists should not be fixated upon them while ignoring more important issues. While I agree with Krugman that as the economy improves, deficits will grow smaller, I contend that the Keynesian prescription -- spend like crazy during the recession -- actually has made the economy worse and has prevented a more robust recovery.

Then there are following statements like this that make me scratch my head in disbelief:

What’s really remarkable at this point, however, is the persistence of the deficit fixation in the face of rapidly changing facts. People still talk as if the deficit were exploding, as if the United States budget were on an unsustainable path; in fact, the deficit is falling more rapidly than it has for generations, it is already down to sustainable levels, and it is too small given the state of the economy.

Yes, readers are told simultaneously that (a) the deficit is dwindling because the economy is improving and, (b) the deficit needs to be bigger to help the economy. This is the classic non sequitur in which (a) does not imply (b). His logical chain, I believe, runs as such:

• Deficits should be large if the economy is depressed because extra spending (as long as the revenues come from borrowing or outright money printing or taxes on the "idle hoards" of the rich) boosts the economy, as more deficit spending ultimately will lead to less deficit spending;
• The current federal deficit is dwindling even as government spending increases because the U.S. economy is rapidly improving;
• Therefore, the current U.S. federal deficit is too small.

The idea behind Krugman's thinking here is that the U.S. economy has been mired in a "liquidity trap," a set of circumstances in which individuals as a whole are mired in a perverse Nash Equilibrium in which no one will seek better gains from trade because no one else is willing to do the same. If government does not try to break the logjam with massive new spending (no worry of where to spend, just spend), then the economy will permanently be stuck at a miserable steady-state of high unemployment and low output. Only new government spending can change the circumstances.

Keep in mind that U.S. Government policies before 1929 pretty much adhered to what Krugman says not to do, yet the economy always recovered from downturns. Only from 1929 to 1940 did the government actively intervene, and we call that era the Great Depression, yet today we are told that the New Deal programs actually ended the Depression, which clearly is not true.

Murray Rothbard wrote about the penchant of governments to try to internally bring prosperity by more spending, and he predicted (accurately) that the programs would fail. This section from America's Great Depression is a very poignant commentary on what has been done in the past five years:

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don't interfere with the market's adjustment process. The more the government intervenes to delay the market's adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favorite "anti-depression" arsenal of government policy. Thus, here are the ways the adjustment process can be hobbled:

1. Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.


2. Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government "easy money" policy prevents the market's return to the necessary higher interest rates.


3. Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.


4. Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.


5. Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by "food stamp plans" and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.


6. Subsidize unemployment. Any subsidization of unemployment (via unemployment "insurance," relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.

Both the Bush and Obama administrations have done all of these things in spades, yet even now Krugman complains that we need larger budget deficits (although the current shrinking deficit reflects economic improvement). The above suggestions definitely set Keynesians to fits of apoplexy, but they pretty much have summed up what the government did before, and the economy always recovered.

The Keynesian response always is the same: we haven't spent enough money. How much is enough? The Keynesians will let us know when we have reached that point - but we haven't reached it yet.

Krugman is correct; the issue is not finding ways to cut the deficit per se, as much of the deficit is due to the condition of the economy. However, as Rothbard so clearly stated above, the massive government interventions have not helped the economy, but instead have slowed the recovery and have made it much harder for entrepreneurs to find those lines of production that are going to be profitable.

The fixation should not be on balancing the budget, both of us believe. However, we part company when we look at how to deal with the issue at hand.

I would ask this final question: If what Krugman has claimed earlier is true - that the U.S. Government's response to the crisis has essentially been one of "austerity" - then how is the economy growing fast enough to shrink the deficit? Furthermore, let me ask if this quote from Krugman even makes "Keynesian" sense:

“People are exhausting their savings,” he (Krugman) said. “People are running out of hope.”

Isn't the destruction of savings during a recession a key to bringing back prosperity? How can this be a sign of "losing hope" if the actions actually stimulate consumption, and every good Keynesian knows that consumption actually is the form of production that creates real prosperity? Furthermore, are we not supposed to be cheering on the Inflation Fairy as it destroys savings and raises real costs to individuals? Inquiring non-Keynesians really would like to know.

Britain and Post-War France

In his never-ending quest to sanitize inflation, Paul Krugman now compares Great Britain and France in the 1920s, claiming that Britain chose the route of "virtue" while France inflated away its postwar debt, with France coming out the better. As is his M.O., Krugman does not tell the entire truth, but when one is bashing so-called virtue, I guess not telling the truth is to be expected.

He writes:

The two countries dealt with their debts very differently. Britain was a model of orthodoxy, returning to the gold standard and running huge primary surpluses to pay its debts; France, with a weaker political system, ended up inflating away much of its debt and accepting a big devaluation of the franc.

He then shows graphs that show a bigger gain in postwar GDP growth, which I guess is proof that inflation confers wonderful general economic benefits. (I am not putting the graphs on this page, so if you want to see them, go to his blog.)

First, Krugman overdoes it with the whole "virtue" thing. There was no "virtue" in Great Britain overvaluing its Pound Sterling following the war; virtue, after all, requires honesty and the Brits were not being honest about what World War I had done to its economy. (Like Krugman, they were in the "let's pretend we still are rich" mode of thinking.) Murray Rothbard in America's Great Depression noted that British financial policy was a disaster:

Great Britain, in particular, faced a grave economic problem. It was preparing to return to the gold standard at the pre-war par (the pound sterling equaling approximately $4.87), but this meant going back to gold at an exchange rate higher than the current free-market rate. In short, Britain insisted on returning to gold at a valuation that was 10-20 percent higher than the going exchange rate, which reflected the results of war and postwar inflation. This meant that British prices would have had to decline by about 10 to 20 percent in order to remain competitive with foreign countries, and to maintain her all-important export business.

However, notes Rothbard, because of the political power of Britain's labor unions, the needed wage contractions did not take place:

But no such decline occurred, primarily because unions did not permit wage rates to be lowered. Real-wage rates rose, and chronic large-scale unemployment struck Great Britain. Credit was not allowed to contract, as was needed to bring about deflation, as unemployment would have grown even more menacing—an unemployment caused partly by the postwar establishment of government unemployment insurance (which permitted trade unions to hold out against any wage cuts).

.As a result, Great Britain suffered from high unemployment during the 1920s. Indeed, had the Brits been "virtuous" instead of, well, British, they would have been willing to be honest about the real value of the pound and let it fall to market levels. To make matters worse, the USA through the actions mostly of the New York Federal Reserve Bank, actively increased the U.S. money supply, an action which did stabilize the pound at the higher price -- but at a high cost both to the British economy and ultimately to the USA itself.

Postwar France suffered from both inflation and political instability, as outlined by Benjamin Anderson in Economics and the Public Welfare. Anderson notes that by late July 1926, the French franc had fallen in value to about two cents. He writes:

Every day the housewife of Paris found that her bread and her herring and her wine were rising in price. A German housewife in the late autumn of 1925, speaking of the French housewife, said "Poor thing." The German housewife had been there herself.

That is the side of inflation Krugman claims does not exist, or is reluctant to admit. But when one writes that printing money will bring back prosperity, one is not going to admit the downside of inflation.

Krugman: Government debt is no burden because "we owe it to ourselves"

In his latest missive, "Nobody Understands Debt," Paul Krugman proves that he does not know debt, or at least government debt, either. While there is much to dislike in the column, I am going to deal with his claim that government debt is different because it is "money we owe to ourselves."

Now,I will agree with Krugman that government debt is different than typical "family debt," but not for the reasons he gives. Krugman writes:

First, families have to pay back their debt. Governments don’t — all they need to do is ensure that debt grows more slowly than their tax base. The debt from World War II was never repaid; it just became increasingly irrelevant as the U.S. economy grew, and with it the income subject to taxation.

Second — and this is the point almost nobody seems to get — an over-borrowed family owes money to someone else; U.S. debt is, to a large extent, money we owe to ourselves. (Emphasis mine)

Krugman's reasoning, however, can apply to private debt as well, since he decides to use collective terms. In the case of private debt, individuals borrow from banks or other individuals, and bank loans are created by individual deposits. Therefore, when individuals don't pay back their debt, someone has to take a haircut.

Government loan guarantees tend to cloud this picture, but even when a guaranteed loan falls into default, individuals -- taxpayers and consumers -- are forced to give up some of their real income either through taxation or inflation. There really is not a free lunch, even if Krugman wants to claim there is.

(Because of government loan guarantees -- and deposit "insurance" falls into this category -- a lot of moral hazard is built into the private lending system. Defenders of this system say that it promotes worthy "investments" -- such as "green energy" -- that would not be funded otherwise by private lending, while critics such as the Austrians say that it promotes malinvestments and reckless behavior by lenders that ultimately leads to a crisis.)

Most Americans borrow from other Americans, so using the standards for public debt that Krugman has given, it would seem that most private lending also involves money "we owe to ourselves." One is not free to apply a collective term to government and then claim that it is not applicable to private activity, given there is nothing magical about government that can create a "collective" by fiat.

After all, individuals and institutions hold government debt, and if Krugman is claiming that an individual is not harmed when he or she lends money to the government and is not paid back, then he is dead wrong. (In other words, it is business as usual.)

Adding to that point, Murray Rothbard writes:

The ingenious slogan that the public debt does not matter because “we owe it to ourselves” is clearly absurd. The crucial question is: Who is the “we” and who are the “ourselves”? Analysis of the world must be individualistic and not holistic. Certain people owe money to certain other people, and it is precisely this fact that makes the borrowing as well as the taxing process important. For we might just as well say that taxes are unimportant for the same reason.

Even Krugman does admit that there can be problems with debt:

Now, the fact that federal debt isn’t at all like a mortgage on America’s future doesn’t mean that the debt is harmless. Taxes must be levied to pay the interest, and you don’t have to be a right-wing ideologue to concede that taxes impose some cost on the economy, if nothing else by causing a diversion of resources away from productive activities into tax avoidance and evasion. But these costs are a lot less dramatic than the analogy with an overindebted family might suggest.

And that’s why nations with stable, responsible governments — that is, governments that are willing to impose modestly higher taxes when the situation warrants it — have historically been able to live with much higher levels of debt than today’s conventional wisdom would lead you to believe. Britain, in particular, has had debt exceeding 100 percent of G.D.P. for 81 of the last 170 years. When Keynes was writing about the need to spend your way out of a depression, Britain was deeper in debt than any advanced nation today, with the exception of Japan.

In other words, more government debt is good when government is trying to "spend (our) way out of a depression," but the act of more borrowing does have its opportunity costs, but the costs are not all that great, or at least Krugman assures us of that. Of course, if the problem becomes too great, then the Federal Reserve, through the workings of "clever lawyers," can find a way to directly purchase U.S. Government debt on the primary "market," which Krugman touts as a "solution." (One wonders why Krugman does not recommend what would be the Ultimate Fix to our problems to have the Fed purchase ALL government bonds, and that the bonds encompass ALL federal spending. Then the Fed could forgive the debt, monetize everything, and the government would have limitless funds to spend and to bring us into prosperity.)

In the Keynesian world, there is no opportunity cost. As Keynes wrote in 1943, credit expansion by the central bank performs the "miracle" of "turning stones into bread." Because Keynesians believe that a market economy is destined to implode because individuals save some of their income, not spending all of it instantly, it is up to government, to paraphrase Krugman, to "fill the hole" left by the loss of private spending.

There is one more issue to cover, and that is my earlier statement in which I agreed with Krugman that government debt was "different" than private debt, but for different reasons. In this area, I turn to Rothbard:

The public debt transaction, then, is very different from private debt. Instead of a low-time preference creditor exchanging money for an IOU from a high-time preference debtor, the government now receives money from creditors, both parties realizing that the money will be paid back not out of the pockets or the hides of the politicians and bureaucrats, but out of the looted wallets and purses of the hapless taxpayers, the subjects of the state. The government gets the money by tax-coercion; and the public creditors, far from being innocents, know full well that their proceeds will come out of that selfsame coercion. In short, public creditors are willing to hand over money to the government now in order to receive a share of tax loot in the future. This is the opposite of a free market, or a genuinely voluntary transaction. Both parties are immorally contracting to participate in the violation of the property rights of citizens in the future. Both parties, therefore, are making agreements about other people's property, and both deserve the back of our hand. The public credit transaction is not a genuine contract that need be considered sacrosanct, any more than robbers parceling out their shares of loot in advance should be treated as some sort of sanctified contract.

Any melding of public debt into a private transaction must rest on the common but absurd notion that taxation is really "voluntary," and that whenever the government does anything, "we" are willingly doing it. This convenient myth was wittily and trenchantly disposed of by the great economist Joseph Schumpeter: "The theory which construes taxes on the analogy of club dues or of the purchases of, say, a doctor only proves how far removed this part of the social sciences is from scientific habits of mind."

Rothbard was writing in favor of repudiation of government debt (which then would discourage individuals from lending to the government in the future), but the larger point still stands. All taxpayers are on the hook for repaying government debt, but the terms are decided by others. It is the ultimate "loan guarantee" in which people who don't participate in the process still are forced to pay for it.

Krugman calls it a "social contract." I think it should be called something else.

Rule by inflation

When John Maynard Keynes called for the "euthanasia of the rentier," he meant that the government's monetary authorities should hold the rate of interest low enough to where people who earn money from lending no longer would be willing to lend. Thus, the "rentier" would disappear from the scene.

Paul Krugman is repeating that call, and now claims that it is that evil "rentier" that is dragging down the economy. If only the authorities were willing to listen to him and have more inflation; if and only then would people be able to find jobs and the economy would hum along nicely:

While the ostensible reasons for inflicting pain keep changing, however, the policy prescriptions of the Pain Caucus all have one thing in common: They protect the interests of creditors, no matter the cost. Deficit spending could put the unemployed to work — but it might hurt the interests of existing bondholders. More aggressive action by the Fed could help boost us out of this slump — in fact, even Republican economists have argued that a bit of inflation might be exactly what the doctor ordered — but deflation, not inflation, serves the interests of creditors. And, of course, there’s fierce opposition to anything smacking of debt relief.

Looking at the Fed's balance sheet post TARP, one hardly can say that the Fed has not been "aggressive" in trying to spread more dollars throughout the world. However, I suspect that when Krugman calls for the Fed to be "more aggressive," he means the Fed finding a way to purchase short-term Treasuries directly, as opposed to buying them on the secondary market. (The original Federal Reserve Act prohibits the Fed from such direct purchases, although given that Washington no longer has to abide by the same laws that govern the rest of us, I am sure Ben Bernanke can find a way around such pesky requirements.)

Krugman's call for more inflation is based upon his belief that inflation benefits low-income people and hurts the wealthy. Thus, the reason that inflation is not higher is due to unwarranted lobbying by the rich, who are benefiting at the expense of the rest of us.

Now, when the main financial crisis hit in 2008, I argued (contra Krugman) that not only would bailouts retard any recovery, as they would prevent or postpone liquidation of bad assets, but also would increase the political strength of the very people who had driven the economy over the cliff. Krugman now thinks that the people on Wall Street have too much political influence, but he fails to see the connection between the bailouts and their political strength.

I will go even further. Krugman is absolutely wrong on inflation, in that the people most hurt by it are NOT the rich, but rather the small savers and people on fixed incomes. (Krugman claims that people on SS and other fixed incomes would not be hurt because SS is indexed to inflation.)

Here is the problem, and it demonstrates that Keynesians (once again) really have no concept of money and see it only as a "quantity variable." Yet, what actually happens with a burst of inflation?

As Henry Hazlitt points out in his excellent Economics in One Lesson, inflation creates a "mirage" of prosperity at the beginning, but in the end is like the "Dead Sea fruit that turns to dust and ashes in its mouth." A new bout of inflation does not raise all prices and incomes at the same time. Instead, those who receive the new money first receive the benefits, while those at the back of the line (small savers and, yes, people on fixed incomes, even those incomes indexed to inflation) bear the costs. Murray Rothbard writes:

Inflation, then, confers no general social benefit; instead, it redistributes the wealth in favor of the first-comers and at the expense of the laggards in the race. And inflation is, in effect, a race--to see who can get the new money earliest. The latecomers--the ones stuck with the loss--are often called the "fixed income groups." Ministers, teachers, people on salaries, lag notoriously behind other groups in acquiring the new money. Particular sufferers will be those depending on fixed money contracts--contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."

He continues:

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations. For example, accounting practice enters the "cost" of an asset at the amount the business has paid for it. But if inflation intervenes, the cost of replacing the asset when it wears out will be far greater than that recorded on the books. As a result, business accounting will seriously overstate their profits during inflation--and may even consume capital while presumably increasing their investments.

In Krugman's Keynesian world, however, none of that matters. If anything, businesses are parasites and government, by creating "new money," also creates wealth. That really is the "New Economics" in a single sentence.

Krugman's Willful Distortion of the Austrian Theory of the Business Cycle

Once again, Paul Krugman creates a caricature of the Austrian Theory of the Business Cycle, calling it the "Hangover Theory," and then continues to misrepresent what it says and what its adherents say in their analysis of the boom and bust cycles. His recent blog post continues this dishonesty.

Before dealing directly with his accusations about the ATBC, I will note that both David Gordon and Robert Murphy do credible jobs in debunking Krugman's misrepresentations. I will add briefly to what they already have written.

Krugman declares:

...one more thing struck me: at least some members of the FOMC have bought into the hangover theory — the modern version of liquidationism in which mass unemployment is somehow necessary in the aftermath of a burst bubble....

This is an important point, because while Austrians are adamant that malinvested resources and capital that were created or advanced during the boom are NOT sustainable during the crisis and the subsequent bust. (Krugman, it should be noted, insists on saying that Austrians, such as Nobel-Prize Laureate F.A. Hayek, push an "overinvestment" theory when, in fact, the Austrians have dealt with that very term and have said it is not an appropriate one in the ATBC. In other words, even though Austrians address that very word, Krugman still pretends as though they have not done so.)

Furthermore, Austrians, unlike Keynesians, who believe that factors of production generally are homogeneous and are equally affected by new injections of spending, look carefully at the issues of the factors, for what is where the result of the downturn are concentrated. Furthermore, NO Austrian calls for some sort of "general liquidation" of the economy. Instead, Austrians hold that those investments in capital and other factors that no longer are sustainable should be liquidated or transferred to other uses for which there clearly is consumer demand. This is a far cry from Krugman's point.

I know of NO Austrian who claims that "mass unemployment is somehow necessary in the aftermath of a burst bubble," none. Austrians say that if there is mass unemployment (and especially if that unemployment is chronic) we can look to government intervention as the reason. Rothbard, in America's Great Depression, writes:

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don't interfere with the market's adjustment process. The more the government intervenes to delay the market's adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure. If, in fact, we list logically the various ways that government could hamper market adjustment, we will find that we have precisely listed the favorite "anti-depression" arsenal of government policy. (Emphasis mine)

Rothbard then explains the policies that are most harmful:

1. Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

2. Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government "easy money" policy prevents the market's return to the necessary higher interest rates.

3. Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.

4. Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.

5. Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by "food stamp plans" and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed.[15] Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.

6. Subsidize unemployment. Any subsidization of unemployment (via unemployment "insurance," relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.

Interestingly, ALL of these things listed above are precisely what Krugman claims will END the downturn. Yet, we have seen government do these things in spades, yet the economy continues to tank. Rothbard clearly notes that mass unemployment, and especially mass unemployment over a long period of time, is NOT necessary, but generally occurs because of government intervention, not in spite of it.

So what does Krugman do? He claims that the REAL problem is that government did not spend enough, regulate enough, tax enough, jack up wages past marginal productivity levels, and subsidize enough unproductive industries (i.e. "green" jobs). And when the economy continues to tank, he creates a caricature of the only business cycle theory that accurately explains what is happening, and then builds a series of falsehoods from there. Just another day at the office for Paul Krugman.

Is There Really a "Keynesian Case"?

Despair overtakes Paul Krugman. It is so bad that he wants "to stick a pencil" in his eye, which not only would hurt a lot, but also just might blind him and make him even more despairing.

Why this deep, dark depression? It seems that pundits do not "understand" the so-called Keynesian Case, that special set of circumstances which, according to all True Believing Keynesians, justifies government spending sprees, printing of money, and borrowing into oblivion. As Krugman writes:

I’ll be frank: the discussion of fiscal stimulus this past year and a half has filled me with despair over the state of the economics profession. If you believe stimulus is a bad idea, fine; but surely the least one could have expected is that opponents would listen, even a bit, to what proponents were saying. In particular, the case for stimulus has always been highly conditional. Fiscal stimulus is what you do only if two conditions are satisfied: high unemployment, so that the proximate risk is deflation, not inflation; and monetary policy constrained by the zero lower bound.

That doesn’t sound like a hard point to grasp. Yet again and again, critics point to examples of increased government spending under conditions nothing like that, and claim that these examples somehow prove something.

In other words, Krugman is demanding that we meet him on what he considers to be HIS ground. He then takes issue with Tyler Cowen's criticism of "fiscal stimulus" when Cowen uses the experience of Germany in the early 1990s:

1. This was not an effort at fiscal stimulus; it was a supply policy, not a demand policy. The German government wasn’t trying to pump up demand — it was trying to rebuild East German infrastructure to raise the region’s productivity.

2. The West German economy was not suffering from high unemployment — on the contrary, it was running hot, and the Bundesbank feared inflation.

3. The zero lower bound was not a concern. In fact, the Bundesbank was in the process of raising rates to head off inflation risks — the discount rate went from 4 percent in early 1989 to 8.75 percent in the summer of 1992. In part, this rate rise was a deliberate effort to choke off the additional demand created by spending on East Germany, to such an extent that the German mix of deficit spending and tight money is widely blamed for the European exchange rate crises of 1992-1993.

In short, it’s hard to think of a case less suited to tell us anything at all about fiscal stimulus under the conditions we now face.

While Krugman never is going to admit that one can legitimately criticize his positions, nonetheless I do believe it is instructive to look into this "special Keynesian Case," better known as the "Liquidity Trap." Because I include Krugman's explanation above about this particular set of circumstances, and even though he does not identify it as a "Liquidity Trap," that is what he is describing.

My counter arguments will feature Murray N. Rothbard, who was the best-known Austrian economist of the late 20th Century after F.A. Hayek. In fact, Rothbard deals directly with the "Liquidity Trap" theories both in America's Great Depression and his tome, Man, Economy and State. In America's Great Depression, he has this to say about the "Keynesian Case":

What, then, does an expectation of rising interest rates really mean? It means that people expect increases in the rate of net return on the market, via wages and other producers' goods prices falling faster than do consumer goods' prices. But this needs no labyrinthine explanation; investors expect falling wages and other factor prices, and they are therefore holding off investing in factors until the fall occurs. But this is old-fashioned "classical" speculation on price changes. This expectation, far from being an upsetting element, actually speeds up the adjustment. Just as all speculation speeds up adjustment to the proper levels, so this expectation hastens the fall in wages and other factor prices, hastening the recovery, and permitting normal prosperity to return that much faster. Far from "speculative" hoarding being a bogy of depression, therefore, it is actually a welcome stimulant to more rapid recovery.

Understand that Rothbard and Krugman are arguing from two very different vantage points. Krugman sees deflation as tragic because he believes that it will lead to a downward spiral in which falling factor prices mean lower absolute incomes, and lower incomes mean less aggregate demand, and the beat goes on.

Rothbard, on the other hand, believes that deflation can be positive because it means that the true relative values of the factors are getting into balance, and are shaking off the distortions that occurred during the inflationary booms. Deflation, in Rothbard's view, means that the previous malinvestments are being cleansed from the system, and that a recovery based upon real values of factors can begin.

Obviously, the two cannot be farther apart. Krugman sees everything in aggregates (Y = C + I + G + [X-M]), while Rothbard views the economy as being a complex web of capital, labor, and other factors in which entrepreneurs are moving resources in ways that they anticipate consumers will desire. For good measure, Rothbard also attacks the entire Keynesian concept of "Liquidity Preference," which is a nice way of saying that during deflation, money increases in value relative to other factors, so that people want to hold more money. Rothbard writes:

The final Keynesian bogey is that people may acquire an un­limited demand for money, so that hoards will indefinitely in­crease. This is termed an “infinite” liquidity preference. And this is the only case in which neo-Keynesians such as Modigliani be­lieve that involuntary unemployment can be compatible with price and wage freedom. The Keynesian worry is that people will hoard instead of buying bonds for fear of a fall in the price of securities. Translating this into more important “natural” terms, this would mean, as we have stated, not investing because of expectation of imminent increases in the natural interest rate. Rather than act as a blockade, however, this expectation speeds the ensuing adjustment. Furthermore, the demand for money could not be infinite since people must always continue consum­ing, whatever their expectations. Of necessity, therefore, the de­mand for money could never be infinite. The existing level of consumption, in turn, will require a certain level of investment. As long as productive activities are continuing, there is no need or possibility of lasting unemployment, regardless of the degree of hoarding.

Indeed, Rothbard believes (and so do I) that there really is an alternative explanation for what Krugman calls a "Liquidity Trap," and that further borrowing and spending by government only will exacerbate the current situation. Like Krugman, I tend to despair, but I am fearful because I believe government is spending and borrowing too much, not to little.

Is Deflation the Enemy, or Is It Inflation?

Like all Keynesian True Believers, Paul Krugman believes that the worst enemy of the economy is deflation. In his view, deflation causes unemployment and inflation reduces it, and he repeats that canard in this recent column.

Not surprisingly, Krugman claims that unless the Fed under Ben Bernanke engages in massive new money creation (and, of course, spending), the economy is doomed:

Today, Mr. Bernanke is the Fed’s chairman — and his 2002 speech reads like famous last words. We aren’t literally suffering deflation (yet). But inflation is far below the Fed’s preferred rate of 1.7 to 2 percent, and trending steadily lower; it’s a good bet that by some measures we’ll be seeing deflation by sometime next year. Meanwhile, we already have painfully slow growth, very high joblessness, and intractable financial problems. And what is the Fed’s response? It’s debating — with ponderous slowness — whether maybe, possibly, it should consider trying to do something about the situation, one of these days.

The Fed’s fecklessness is, to be sure, not unique. It has been astonishing and infuriating, as the economic crisis has unfolded, to watch America’s political class defining normalcy down. As recently as two years ago, anyone predicting the current state of affairs (not only is unemployment disastrously high, but most forecasts say that it will stay very high for years) would have been dismissed as a crazy alarmist. Now that the nightmare has become reality, however — and yes, it is a nightmare for millions of Americans — Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let’s talk about the evils of budget deficits.

In response, I will include material from Murray N. Rothbard's America's Great Depression, a recent article by Robert Higgs, and something I wrote for the Mises Institute two years ago. First, we look at what Rothbard has to say regarding deflation:

With the supply of money falling, and the demand for money increasing, generally falling prices are a consequent feature of most depressions. A general price fall, however, is caused by the secondary, rather than by the inherent, features of depressions. Almost all economists, even those who see that the depression adjustment process should be permitted to function unhampered, take a very gloomy view of the secondary deflation and price fall, and assert that they unnecessarily aggravate the severity of depressions. This view, however, is incorrect. These processes not only do not aggravate the depression, they have positively beneficial effects.

There is, for example, no warrant whatever for the common hostility toward "hoarding." There is no criterion, first of all, to define "hoarding"; the charge inevitably boils down to mean that A thinks that B is keeping more cash balances than A deems appropriate for B. Certainly there is no objective criterion to decide when an increase in cash balance becomes a "hoard." Second, we have seen that the demand for money increases as a result of certain needs and values of the people; in a depression, fears of business liquidation and expectations of price declines particularly spur this rise. By what standards can these valuations be called "illegitimate"? A general price fall is the way that an increase in the demand for money can be satisfied; for lower prices mean that the same total cash balances have greater effectiveness, greater "real" command over goods and services. In short, the desire for increased real cash balances has now been satisfied.

Furthermore, the demand for money will decline again as soon as the liquidation and adjustment processes are finished. For the completion of liquidation removes the uncertainties of impending bankruptcy and ends the borrowers' scramble for cash. A rapid unhampered fall in prices, both in general (adjusting to the changed money-relation), and particularly in goods of higher orders (adjusting to the malinvestments of the boom) will speedily end the realignment processes and remove expectations of further declines. Thus, the sooner the various adjustments, primary and secondary, are carried out, the sooner will the demand for money fall once again. This, of course, is just one part of the general economic "return to normal."

In other words, Rothbard says that deflation will help the adjustment process in which the economic fundamentals get back into balance. Given that Krugman operates on the theory that all assets are homogeneous, he is incapable of understanding anything else.

Prof. Higgs notes this about Keynesians and inflation and deflation:

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.

In this article, I noted that the current crisis came about because of the Fed's reckless money creation, so it certainly is NOT possible that the Fed can SOLVE the problem with more inflation:

The central issue is that the Fed pushed a policy of inflation, with much of the new money going into the mortgage markets; there is no way to avoid the painful and terrible corrections that must follow such fiscal foolishness. (Now we finally see massive commodity-price increases, which have occurred because there is nowhere for the new money to go but directly into commodities and consumer goods.)

Anyone who believes that the Fed can pretend that heavily damaged mortgage securities are worth more than toilet paper and literally build a $200 billion loan portfolio upon them does not understand finance. Just because Ben Bernanke declares something to be "valuable" does not bestow value upon it.

The simple issue is not lack of liquidity. It is the fact that billions — make that trillions — of dollars were malinvested in markets where the increasing values could not be sustained. To pump near-worthless dollars into this mix does not solve anything; it only ensures that the coming day of reckoning will be even more unpleasant than it would have been otherwise.

So, if the Fed follows Krugman's demands, we can look forward to even more secondary contractions and more malinvestments. The "day of reckoning" won't arrive all at once; it will become a permanent part of our economic landscape.

Krugman and the "Liquidity Trap"

One thing I appreciate about Paul Krugman's columns is that he clearly explains the Keynesian paradigm, and does it in short space. One of his favorite themes in his promotion of Keynesianism has been the "liquidity trap." Here is what he says about this term:

In my analysis, you’re in a liquidity trap when conventional open-market operations — purchases of short-term government debt by the central bank — have lost traction, because short-term rates are close to zero.

In other words, interest rates are at about zero (or what he calls the "zero-bound,"), which means that typical monetary policy in which the Federal Reserve System increases bank reserves which then can be lent to businesses for capital expansion is ineffective. When that happens, Keynesians then recommend the government follow "fiscal policy," in which the government borrows (or prints money) and spends it directly in the economy as a "stimulus."

Krugman is quite consistent on this point. He goes by the following syllogism:

• Spending drives the economy, and there must be a certain level of spending to keep the economy afloat;
• Private investors are not borrowing enough even though there are lots of bank reserves, which means the economy is in a "liquidity trap";
• Therefore, to boost spending, government must directly spend by borrowing or getting the Federal Reserve System to purchase government bonds directly, which will "stimulate" the economy and allow us to "spend our way out of the" depression.

In a recent post on his NYT blog, Krugman again claims that the rules are different because much of the world is in a "liquidity trap."

However, there is a different approach, as is laid out by Murray N. Rothbard in his classic America's Great Depression. I include Rothbard's description and criticism of the "liquidity trap" in this link. It is quite long, so I don't include the text in this post. However, it is worth reading if you wish to understand that theoretical basis for the current government policies, and a good antidote to them.

Krugman and the Hoover Fallacies

One of the economic myths that Paul Krugman, along with most politicians, journalists, and academics, promotes is the outright lie that Herbert Hoover organized his presidency to promote free market economics. Furthermore, he tells us (ad nauseum) that during the last three years of his presidency, Hoover did nothing to stop the Great Depression, leaving it up to Franklin Roosevelt and his New Deal to mitigate the effects of the downturn.

Thus, when Krugman refers to someone as a "Herbert Hoover," he is saying that he or she is not embracing the Keynesian paradigm and, instead, claims that we must "be responsible" in not spending beyond our means. Yes, Krugman believes that such "responsible" behavior actually is irresponsible, at least during a depression.

Thus, in his recent blog post, "Fifty-One Herbert Hoovers," Krugman claims that spending cuts by state and local governments are dragging down the economy:

...I think it’s fair to say that state and local cuts largely offset federal stimulus.

And David Broder thinks this is a good thing, that Washington should be more like the states.

What amazes me is that Broder doesn’t even seem to be aware that there’s an argument on the other side, let alone that most economists are dismayed by the effects of fiscal austerity. If Broder is a guide to Beltway conventional wisdom — which he usually is — we’ve got a big problem. (Emphasis mine)

Krugman even has a graph that "proves" his point:



First, Krugman is more correct than he realizes, if he claims that the states are emulating Hoover. Murray N. Rothbard (a much better economist than Krugman could claim to be) laid out Hoover's many government interventions in his classic, America's Great Depression. However, I don't think that is what Krugman wants us to believe.

Second, Krugman seems to be living in Wonderland if he believes that state and local governments can spend money they don't have. (This is why he is demanding that the federal government print a lot of money and give it to the states.) Third, if one looks at the graph, one can see that the economy recovered after the 2001 recession when state spending was down. (No doubt, Krugman will claim that state and federal spending, which increased during the recession of 2001, was the reason for the recovery.)

Now, the "recovery" after 2001 turned out to be a faux recovery, or what I called a "boomlet," which I predicted would end in a worse downturn. However, to Krugman, boom conditions can last forever, just as long as government provides enough "free" money to keep the punchbowl filled. Unfortunately, that is not the case.

There is another point as well. One of the reasons that we are not seeing a real recovery (and only one of the many reasons) is that state governments have become hostages of public employee unions. (Steven Greenhut has written a great book on this subject, appropriately called Plunder.)

State spending has become extremely voracious, and states are raising taxes left and right to fund their generous pensions and pay that unions extracted when the economy seemed to be in better shape. The notion that states raise even more taxes to continue spending at a drunken rate is irresponsible, and the notion that most economists believe that such actions would be good for the economy is pretty pathetic. If most economists believe this nonsense, then the academic profession is in worse shape than I had thought.

Note: I am blogging from the Austrian Scholars Conference at the Ludwig von Mises Institute in Auburn, Alabama.

Is Jim Bunning Immoral?

Paul Krugman today has chosen to write about Sen. Jim Bunning's recent attempt to hold up the extension of unemployment benefits, and it is clear his column could have been written by a DNC ghostwriter or by an editorial writer at the New York Times. What also is clear that this column was not written by an economist; it is pure political partisanship created by a political operative.

However, there was one difference between Krugman's column and the many other pieces of undisguised partisanship that has filled the airwaves and editorial pages: Krugman claims that the extension of benefits aids the economy. Don't take my word for it; here is the Nobel Laureate in his own words:

What Democrats believe is what textbook economics says: that when the economy is deeply depressed, extending unemployment benefits not only helps those in need, it also reduces unemployment. That’s because the economy’s problem right now is lack of sufficient demand, and cash-strapped unemployed workers are likely to spend their benefits. In fact, the Congressional Budget Office says that aid to the unemployed is one of the most effective forms of economic stimulus, as measured by jobs created per dollar of outlay.

This is classic textbook Keynesianism with some political partisanship included. We are in recession, according to Krugman, because we are not spending enough money. Give money to people, let them spend it, and out of this comes economic recovery.

Lest one think I exaggerate, here is Krugman in his own words, displaying both his partisanship and his Keynesianism:

But that’s not how Republicans see it. Here’s what Senator Jon Kyl of Arizona, the second-ranking Republican in the Senate, had to say when defending Mr. Bunning’s position (although not joining his blockade): unemployment relief “doesn’t create new jobs. In fact, if anything, continuing to pay people unemployment compensation is a disincentive for them to seek new work.”

Krugman goes on to call this position "immoral," so the only way to interpret that is to say that according to the Economics of Paul Krugman, the only moral position one can take today is that of John Maynard Keynes. (I guess this is Krugman's version of a Keynesian theocracy.)

I would like to provide some counterarguments. First, Bunning said forthrightly that not only was he not against extension of benefits, but that he also was following President Barack Obama's dictum that we "pay as we go," and that there had been no budget allocation for this $10 billion expenditure. While Krugman and the Democrats (and most of the media) were declaring, "It's only $10 billion," Bunning replied that if Democrats could not even demonstrate some fiscal discipline in a relatively small amount of money, then they were incapable of dealing with the larger budget issues that threaten to swamp our entire country in a sea of unpayable debt.

Second, Kyle is correct; studies have demonstrated that indefinite extension of unemployment benefits also keep people from finding new jobs and ending their term of unemployment. Furthermore, as Murray N. Rothbard wrote in America's Great Depression, which clearly runs counter to Krugman's inflationary Keynesianism, that continued government spending only extends the downturn and makes it worse. He writes:

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don't interfere with the market's adjustment process. The more the government intervenes to delay the market's adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression. Yet, government depression policy has always (and would have even more today) aggravated the very evils it has loudly tried to cure.

He goes on to list the various ways that government makes things worse, and it is a textbook description of everything that Krugman claims will end this economic nightmare:

1. Prevent or delay liquidation. Lend money to shaky businesses, call on banks to lend further, etc.

2. Inflate further. Further inflation blocks the necessary fall in prices, thus delaying adjustment and prolonging depression. Further credit expansion creates more malinvestments, which, in their turn, will have to be liquidated in some later depression. A government "easy money" policy prevents the market's return to the necessary higher interest rates.

3. Keep wage rates up. Artificial maintenance of wage rates in a depression insures permanent mass unemployment. Furthermore, in a deflation, when prices are falling, keeping the same rate of money wages means that real wage rates have been pushed higher. In the face of falling business demand, this greatly aggravates the unemployment problem.

4. Keep prices up. Keeping prices above their free-market levels will create unsalable surpluses, and prevent a return to prosperity.

5. Stimulate consumption and discourage saving. We have seen that more saving and less consumption would speed recovery; more consumption and less saving aggravate the shortage of saved-capital even further. Government can encourage consumption by "food stamp plans" and relief payments. It can discourage savings and investment by higher taxes, particularly on the wealthy and on corporations and estates. As a matter of fact, any increase of taxes and government spending will discourage saving and investment and stimulate consumption, since government spending is all consumption. Some of the private funds would have been saved and invested; all of the government funds are consumed. Any increase in the relative size of government in the economy, therefore, shifts the societal consumption-investment ratio in favor of consumption, and prolongs the depression.

6. Subsidize unemployment. Any subsidization of unemployment (via unemployment "insurance," relief, etc.) will prolong unemployment indefinitely, and delay the shift of workers to the fields where jobs are available.

Why the great divide between Rothbard and Krugman? Krugman believes that recessions simply are episodes of reduced spending while Rothbard and the Austrians hold that recessions are the inevitable result of massive malinvestment of capital and resources. To Krugman, a recovery simply happens, and that in the interim, government needs to replace private spending by any means possible.

Austrians, on the other hand, recognize that there can be no substantive recovery until the original malinvestments are liquidated and the economy returned to a structure of production that is sustainable. Thus, if anyone is being dishonest, it is Krugman, who really, according to the Austrians, is advocating that the depression be extended and deepened.

Now, I am sure that Krugman and his Keynesian (and leftist) supporters would argue that Krugman wants the depression to end and that the Austrians want it to continue so they can enjoy watching people suffer. For years, Krugman has framed his arguments in such a manner to which anyone who disagrees with him does so because of innate hatred for humanity.

Yet, as we enter what is a third year of this depression with no end in sight and with the government continuing to prop up malinvestments through borrowing and printing money, just who is being immoral? Krugman is advocating a Big Lie. Had presidents Bush and Obama listened to the Austrians instead of the Keynesians, we would be out of this downturn and headed for a real recovery. Instead, the economy flounders and will continue to flounder.

So, whether or not Krugman and his allies want to claim that Bunning took his stand because he is evil, nonetheless, Bunning was right; the extension of these benefits, paid by money that will be borrowed or printed, only will extend the problem. Thus, Krugman is advocating the very policies that make our situation worse. Who is being immoral?