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.

Do savings really cause depressions?

One of the constant themes in Keynesian (and Krugmanian) economics is the evil of savings, and how government must manipulate the currency and the banking system in order to discourage people from saving money. On a number of occasions in his columns and blog posts, Krugman has invoked the hoary "paradox of thrift" which uses the Fallacy of Composition to declare that while it might be OK for a few individuals to save a few bucks here and there, it is disastrous if everyone saves at once.

In a recent blog post, Krugman once again claims that if the rate of savings goes up, GDP automatically goes down and the economy plunges into recession. (The post is primarily about the methodology of comparative statics, which all economists use in one way or another, but nonetheless his example is very telling. It is one thing to use comparative statics to demonstrate the effects of a tax on coffee and quite another to use the same method for savings and GDP, as they are not the same thing even though Krugman wants us to believe that we examine these things in exactly the same way.)

This example "proves" that if people save money, then GDP must fall. When people save money, Keynesians argue, not all of it is invested immediately, so when some current spending is eliminated but is not immediately spent as investment, there is a lull in which the economy is dragged down. Furthermore, they argue, once the economy starts to plunge, unless government immediately disrupts the pattern by spending and also inflating (which undermines savings), then aggregate demand will fall and investors will fail to create new capital, since they don't anticipate demand for the products it will help produce.

The Keynesian Multiplier, along with graphs such as what Krugman trots out, are shown as "proof" of this point. The Multiplier is expressed as 1/savings rate (Marginal Propensity to Save) which also can be expressed as 1/(1 - Marginal Propensity to Consume).

For example, say the MPC is 80 percent (or 0.8) and the MPS, then would be 20 percent (or 0.2). In other words, people in an economy would spend 80 percent of their income and save 20 percent. Thus, the Multiplier would equal 1/0.2 or 5. However, if people saved only one percent of their income, then the Multiplier would be 1/0.01 or 100, which "proves" that the less we save, the more prosperous we will be.

(I must admit that this reminds me of the saying we had when I was in high school, which began with "The more you study, the more you know," and finally was able to end, after some "logical" progressions, to "The less you study, the more you know. So why study?")

An obvious questions arises: If savings is bad, why not have a zero savings rate, which then would give us a multiplier of infinity? Keynes, when faced with that same question, declared that at that point, inflation would skyrocket, although he did not explain why that would be a bad thing, given that Keynesianism is based upon the "magic" of inflation, anyway.

This economic viewpoint, however, is based upon a nuanced view of capital, that it is homogeneous AND that the value of capital formation is in the spending that takes place, not with capital itself. And, Keynesians argue, because increased savings lower the value of the Multiplier, that the "solution" is for people not to save (or save as little as possible) and depend upon government or the central bank (or both) to manufacture the money needed for capital investment out of thin air.

All of this crashes, however, if capital is heterogeneous. Furthermore, if capital can be malinvested -- and Austrians argue that will be the case when capital is created via inflation -- then the Keynesian scheme is destined to end in disaster.

That is what we are seeing now. For more than two decades, the government has followed the pattern of inflating, running into malinvestments, inflating the economy into "recovery," and then dealing with future crashes that are larger. We have seen the Tech Bubble and collapse, the Housing Bubble and collapse, and now the governments around the world have created the Sovereign Debt Bubble which is destined to collapse.

Krugman can use all of the graphs and math that he wants, but he cannot get around the sticky problem of heterogeneous capital, nor does he have an answer for malinvestments. His M.0. has been to state his case and then attack anyone who disagrees, claiming that their disagreement is based upon their fundamental desire for people to suffer and to be out of work. That is not economics, but then Keynesianism is not economics, either.