Paul Krugman on Keynes

As a friend of ours remarked when sending us the link to Paul Krugman's December 29 editorial, 'he's trying to get in the last word for the year'. The editorial is entitled 'Keynes Was Right' and it is at least somewhat reassuring that it appeared on the NYT's 'opinion pages', because that is all it amounts to – an opinion.

The editorial starts out with the following claim:


The boom, not the slump, is the right time for austerity at the Treasury.” So declared John Maynard Keynes in 1937, even as F.D.R. was about to prove him right by trying to balance the budget too soon, sending the United States economy — which had been steadily recovering up to that point — into a severe recession. Slashing government spending in a depressed economy depresses the economy further; austerity should wait until a strong recovery is well under way.“

 

(emphasis added)

No-one should be particularly surprised that Krugman once again asserts that government is 'not spending enough' – that has been his song and dance seemingly forever. We say 'seemingly' mainly because he sotto voce condemned government spending when the previous administration engaged in it. So the Keynesian advice on deficit spending seems only applicable when the administration is not a Republican one. However, we don't want to quibble too much over Krugman's inconsistencies, which are in the main a result of his occupation as a political hack. We are here to quibble with his economics. As regards the Nobel Prize, it is routinely handed to people in support of interventionism and statism, so we think of it rather as a contrary indicator these days. Some good economists may occasionally receive a Nobel prize, but receiving the prize is not per se proof positive that the recipient is a good economist – it is more likely to signify that the recipient is considered palatable to the welfare/warfare state establishment.

Now, the Keynesian dictum that government should be 'austere during the boom', in fact should use the boom to accumulate a war chest so to speak, that can then be deployed during the slump in the form of government spending is regularly thrown out as a kind of nostrum that brooks no dissent.

Quite often people will declare: 'if only the government had implemented Keynes' instructions correctly, then we wouldn't have to worry so much now that the – unfortunately necessary – deficit spending rips such an ugly big black hole into our national finances'.

Indeed, anyone looking at a chart that shows how the growth of the nation's public debt  has progressed in recent years will probably wonder when the time  of 'Greecification' will arrive.

 


 

There have been two official recessions over the past decade – over the same span, the total public debt has nearly tripled. Its growth accelerates with the advent of recessions, but certainly fails to decelerate once they are officially over – click chart for better resolution.

 


 

What one will probably not be induced to think is that the government has somehow failed to 'spend enough' during the slump – but it certainly hasn't stopped spending like a drunken sailor once the slump officially ended.

Of course we would tend to agree with Krugman that the 'official end of recession' does not indicate an end to the economic malaise.

The above claim about the 'proper implementation of Keynes' recipe' reminds us a bit of the claims about the 'proper implementation of communism'. One surprisingly often comes across people who assert  – even while they are sitting in a comfy chair, cellphone and i-Pad lying in grabbing distance on the table before them, in short, while they are surrounded by the fruits of the free market – that 'communism would be the best possible system, if only it had been implemented correctly'. Or failing that, if only the communists had succeeded with their promise to deliver the 'new superman' they promised would be born once the revolution succeeded, i.e., if they had  been up to the task of altering that pesky hindrance to social engineering commonly known as 'human nature'.

It is easy to demolish such intellectual errors, but it is at the same time scary that a full two decades after the socialist commonwealth imploded in irredeemable moral and financial bankruptcy such claims are still paraded as though they were incontestable truths.

Alas, what is wrong with the idea of the government establishing a surplus during the boom that it then can deploy during the bust?

Before going into this  we should mention that anyone regaling us with this nostrum should first explain why there is such a thing as a boom and a bust. Krugman and his fellow Keynesians always make it sound as though the bust were some sort of natural catastrophe, akin to an unforeseen collision with an asteroid from deep space. They don't even question the boom – after all, Keynes insinuated that it should be possible to attain an 'eternal boom' by means of interventionist policy, especially lowering of the interest rate below its natural level by the monetary authority.

Now let's consider what would happen if the government were to accumulate a fiscal surplus during the boom. If it withheld the funds it accrued from circulation  (it could in practice do this by depositing them with the central bank and leaving them there), then its policy would counteract the effects of the credit and money supply inflation that actuates the boom. In other words, such a policy would exert a deflationary effect by 'sterilizing' a portion of the money supply. Once the boom faltered, spending these monies would have the opposite inflationary effect and would serve to lower the purchasing power of money.

What this spending could however not achieve would be to alleviate the scarcity of capital, this is to say it could not provide any additional capital goods. If the government were to spend the funds on 'shovel-ready' (as they are today called) public works, then capital would have to be withdrawn from other employments. In the market economy, capital is as a rule employed wherever it serves to provide the satisfaction of the most urgent wants of consumers. Hence this withdrawing of capital goods for public works projects would impair these want-satisfactions.

If on the other hand the government were to spend the tax revenues it receives during the boom on various goods in order to hoard them so they can be employed later on when the slump arrives (raw materials, intermediate capital goods or consumer goods for the workers to be employed in its planned investment projects), it would not counteract the boom but accentuate and intensify it. This would lead to an even worse economic crisis.

Let us not forget, government spending on capital goods will always be in competition with wealth creators who are bidding for the same scarce means of production. It therefore impairs their ability to generate wealth.

In other words, the allegedly 'correct' way of implementing the Keynesian recipe is not going to work either. Of course there is not even a question of implementing it, since the government did manifestly not produce any surpluses during the boom, quite the contrary. So the Krugman recommendation at present amounts to 'spend more anyway'.

However, there can be no increase in 'aggregate spending' achieved in this manner, since the only way the government can spend more is by either raising taxes or borrowing the money. In both cases the private sector's ability to spend and invest is curtailed to the exact same extent to which the government's spending power is increased. The third method is to inflate the money supply further (in reality a mixture of all these methods has been and continues to be employed). This is even worse, as it brings about all the attendant effects of inflation. In an economy that is already severely impaired by successive episodes of credit booms and the capital consumption they have engendered, this inflationary policy can at best bring a short term flare-up of economic activity that delays the slump but only makes it worse in the end, as even more scarce capital is malinvested and wasted.

Incidentally this seems to be precisely the position the US economy now finds itself in after several years of enormous money supply inflation and deficit spending – namely on the precipice of an even worse slump (even though the precise timing of its commencement is uncertain).

Similar to the post-revolutionary assembly of France and its policy of inflating the issue of assignats, the central bank has engaged in several inflationary pushes (first by lowering interest rates sharply and engaging in various 'extraordinary' liquidity provision measures, and later by the two iterations of 'quantitative easing', or more colloquially, money printing) that have brought about the temporary illusion of a return to prosperity by distorting various prices (although not necessarily those prices that the central bank wished to see distorted, like e.g. those of houses), but as soon as the inflationary measures were halted, these effects immediately began to subside again. This was evident in the prices of securities (such as stocks and junk bonds) and commodities, and it has also become evident in the behavior of leading economic indicators.

 


 

The ECRI weekly leading index, late 2007 to end 2011 – both iterations of 'QE' resulted in a pick-up in economic activity, but it proved ephemeral – as soon as the inflationary policy paused, the leading indicators turned down again – click chart for better resolution.

 


 

A view of the WLI's growth rate over the same span. Traditionally, a fall to minus 6 has been regarded as an early warning of recession (although it should be added that the Economic Cycle Research Institute uses other indicators than the WLI as well in order to determine whether it should call  for recession or expansion) – click chart for better resolution.

 


 

Now, Krugman alleges that in 1937, the government made a decisive mistake by attempting to balance the budget (it never did by the way, although it reduced the deficit considerably) 'before a strong recovery was established'. One wonders by dint of what data point the government should have concluded that no such recovery had been established at the time. Between 1934 and 1936, GDP had grown by over 10% per annum:

 


 

GDP, annual rate of growth, 1930 to 1940. According to the doctrine that the government should begin to run a surplus during the boom, GDP growth of over 10% per year for two years running didn't qualify why exactly? – click chart for better resolution.

 


 

It is not entirely wrong that the decision to curb deficit spending and tighten monetary policy somewhat (the Fed increased reserve requirements in late 1936 and again in mid 1937) triggered a renewed slump. The question is however whether it would have been possible to 'keep the boom going' by continuing to inflate and deficit-spend. Leaving aside the later transformation of the economy into a command economy geared for war which must be subjected to a separate analysis (we refer you to 'The Myth of War Prosperity' for details), the answer is a resounding 'no'.

An economic bust that follows on the heels of an inflationary boom once the expansion of credit is curtailed (in this case the end of the artificial inflationary boomlet of 1933-1937) is a sure sign that capital has been malinvested and needs to be liquidated, or where this is possible (in the case of non-specific capital), transferred to new uses.

There is no question of keeping an artificial boom going forever – the boom consumes capital, and sooner or later one either decides to abandon the credit expansion and allows the slump to proceed, or one continues with the credit expansion until the entire underlying currency system breaks down. There is no third alternative. The erroneous view that government spending somehow magically adds to the capital stock has already been discussed above: it cannot possibly achieve that.

Krugman continues:


„Unfortunately, in late 2010 and early 2011, politicians and policy makers in much of the Western world believed that they knew better, that we should focus on deficits, not jobs, even though our economies had barely begun to recover from the slump that followed the financial crisis. And by acting on that anti-Keynesian belief, they ended up proving Keynes right all over again.“


Which should provoke a hearty 'huh'? What on earth is he talking about? First of all, some governments no longer even have a choice in the matter, if he should refer to the governments of the euro area. It is either stop (or rather, slow down) spending or go completely bust this very instant. It has little to do with their 'anti-Keynesian beliefs'. To allege that there is any government in the Western world that hews to 'anti-Keynesian beliefs' is the height of absurdity. In fact,  precisely because they have inter alia used the excuse of Keynesian counter-cyclical deficit spending at every opportunity has it finally come to pass that several of them are de facto insolvent and all of them are drowning in debt and unfunded obligations from now til kingdom come.

The problems encountered by some investors in government debt and by the governments accruing these giant debt burdens have been foreseen by Ludwig von Mises, who wrote in Human Action (1949):


“Now, the irredeemable perpetual public debt presupposes the stability of purchasing power. Although the state and its compulsion may be eternal, the interest paid on the public debt could be eternal only if based on a standard of unchanging value. In this form the investor who for security's sake shuns the market, entrepreneurship, and investment in free enterprise and prefers government bonds is faced again with the problem of the changeability of all human affairs. He discovers that in the frame of a market society there is no room left for wealth not dependent upon the market. His endeavors to find an inexhaustible source of income fail.

There are in this world no such things as stability and security and no human endeavors are powerful enough to bring them about. There is in the social system of the market society no other means of acquiring wealth and of preserving it than successful service to the consumers. The state is, of course, in a position to exact payments from its subjects and to borrow funds. However, even the most ruthless government in the long run is not able to defy the  laws determining human life and action.

If the government uses the sums borrowed for investment in those lines in which they best serve the wants of the consumers, and if it succeeds in these entrepreneurial activities in free and equal competition with all private entrepreneurs, it is in the same position as any other businessman; it can pay interest because it has made surpluses. But if the government invests funds unsuccessfully and no surplus results, or if it spends the money  for current expenditure, the capital borrowed shrinks or disappears entirely, and no source is opened from which interest and principal could be paid. Then taxing the people is the only method available for complying with the articles of the credit contract. In asking taxes for such payments the government makes the citizens answerable for money squandered in the past. The taxes paid are not compensated by any present service rendered by the government's apparatus.

The government pays interest on capital which has been consumed and no longer exists. The treasury is burdened with the unfortunate results of past policies.”

 

Krugman agitates for more squandering of capital, but this can produce nothing but another 'short term fix'. In the end, inexorable mathematical certainties will creep up on those who attempt to delay the necessary correction forever by spending more and more – just ask the Japanese, who are fast approaching that juncture and have so far absolutely nothing to show for their deficit spending binge – unless one thinks the building of countless 'bridges to nowhere' was a worthwhile undertaking.

Krugman continues:

 

“In declaring Keynesian economics vindicated I am, of course, at odds with conventional wisdom.”

 

The depends whose 'conventional wisdom' he is referring to. Judging from the postings of his coterie of sycophants and the opinions uttered by the vast majority of mainstream economists, what represents the 'conventional wisdom' is not so clear-cut.

Krugman:


“In Washington, in particular, the failure of the Obama stimulus package to produce an employment boom is generally seen as having proved that government spending can’t create jobs. But those of us who did the math realized, right from the beginning, that the Recovery and Reinvestment Act of 2009 (more than a third of which, by the way, took the relatively ineffective form of tax cuts) was much too small given the depth of the slump. And we also predicted the resulting political backlash.”

 

While we completely disagree that the empirical data prove one thing or another, since they describe merely a slice of economic history that is subject to a multitude of complex and unquantifiable factors (if there had been an 'employment boom', Krugman would of course also have crowed that he was right), the above is the typical Keynesian excuse: under Obama, the federal deficit exploded to roughly 10% of GDP and the total public debt since the beginning of his term has increased by nearly 50% (!), but it is of course 'not enough'. The reality is probably that no amount of spending would have been enough.

The public backlash is understandable: the policy of spending til the cows come home is regarded as unsustainable, and rightly so. The citizenry knows that one day it will have to pay for all this extravagant spending – whether by taxation or inflation. As Bob Hoye remarked so trenchantly: 'it has been noticed that unlimited government requires unlimited funding'.

Krugman continues:


“So the real test of Keynesian economics hasn’t come from the half-hearted efforts of the U.S. federal government to boost the economy, which were largely offset by cuts at the state and local levels. It has, instead, come from European nations like Greece and Ireland that had to impose savage fiscal austerity as a condition for receiving emergency loans — and have suffered Depression-level economic slumps, with real G.D.P. in both countries down by double digits.

This wasn’t supposed to happen, according to the ideology that dominates much of our political discourse. In March 2011, the Republican staff of Congress’s Joint Economic Committee released a report titled “Spend Less, Owe Less, Grow the Economy.” It ridiculed concerns that cutting spending in a slump would worsen that slump, arguing that spending cuts would improve consumer and business confidence, and that this might well lead to faster, not slower, growth.”


The 'real test' of Keynesian economics can in any event not come from empirical data, least of all three years worth of them.  The 'real test' comes from inquiring whether the economic theory makes sense or not. As Henry Hazlitt  pointed out in his  line-by-line refutation of Keynes 'General Theory', it doesn't. (see 'The Failure of the New Economics', pdf). As regards Greece and Ireland, we would note that spending has in neither nation actually been curtailed much. For the most part European 'austerity' measures still concentrate on raising taxes, which if we have read Krugman's various screeds correctly so far can only be a good thing (even in the  one discussed here he argues against tax cuts – in Krugman's upside-down worldview, the government bureaucracy knows better how to spend the wealth of a nation's citizens than the citizens themselves do).

As to Ireland, we should perhaps point out that it is currently one of the very few euro-land economies that still show positive PMI data. Granted, its GDP growth is nothing to write home about (see below), but industrial production has been recovering. No-one denies that the economic situation remains difficult, but this can probably largely be blamed on the foolish decision to bail out bankrupt banks with government funds.

 


 

Ireland's annualized quarterly GDP growth – nothing to crow about, but the situation has clearly improved, if only in terms of rate of change so far – click chart for better resolution.

 


 

Ireland's industrial production has clearly improved in the meantime – click chart for better resolution.

 


 

Krugman continues:


“This wasn’t supposed to happen, according to the ideology that dominates much of our political discourse. In March 2011, the Republican staff of Congress’s Joint Economic Committee released a report titled “Spend Less, Owe Less, Grow the Economy.” It ridiculed concerns that cutting spending in a slump would worsen that slump, arguing that spending cuts would improve consumer and business confidence, and that this might well lead to faster, not slower, growth.

They should have known better even at the time: the alleged historical examples of “expansionary austerity” they used to make their case had already been thoroughly debunked. And there was also the embarrassing fact that many on the right had prematurely declared Ireland a success story, demonstrating the virtues of spending cuts, in mid-2010, only to see the Irish slump deepen and whatever confidence investors might have felt evaporate.

Amazingly, by the way, it happened all over again this year. There were widespread proclamations that Ireland had turned the corner, proving that austerity works — and then the numbers came in, and they were as dismal as before.”


We don't disagree that in the short term, a decrease in government spending  could lead to a resumption of the economy's healing process, i.e., a slump. Alas, the question is anyway only whether it should occur sooner or later, not whether it should occur at all. The sooner it happens, the less devastating it will be.  While the Republican party usually only gets religion about fiscal spending when the administration is not Republican, one should be glad that it does get religion once in a while.

As to Ireland, as noted above, the numbers did clearly not 'come in as dismal as before'. We're not sure where Krugman gets his data from –  maybe he's confusing something. There's no mention of Iceland by the way, or any of the Baltic nations. We wonder why (not really – Krugman always cherry-picks his  supporting factoids).

Krugman again:


“Yet the insistence on immediate spending cuts continued to dominate the political landscape, with malign effects on the U.S. economy. True, there weren’t major new austerity measures at the federal level, but there was a lot of “passive” austerity as the Obama stimulus faded out and cash-strapped state and local governments continued to cut.

Now, you could argue that Greece and Ireland had no choice about imposing austerity, or, at any rate, no choices other than defaulting on their debts and leaving the euro. But another lesson of 2011 was that America did and does have a choice; Washington may be obsessed with the deficit, but financial markets are, if anything, signaling that we should borrow more.”


There are many plausible explanations for the fact that interest rates are at rock-bottom levels  – what they definitely don't signify is that the 'markets are signaling that the US treasury should borrow more'.  No-one can tell with certainty where the threshold is that makes markets suddenly change their mind about the creditworthiness of a government. What we do know (inter alia by observing what happened in the 'PIIGS') is that there is such a threshold and the change in conditions is as the euphemism goes usually 'non-linear'. Greek bond yields were happily ensconced a few tens of basis points above German ones one day, and found themselves hundreds of basis points higher a few weeks later.

Krugman continues:


“Again, this wasn’t supposed to happen. We entered 2011 amid dire warnings about a Greek-style debt crisis that would happen as soon as the Federal Reserve stopped buying bonds, or the rating agencies ended our triple-A status, or the superdupercommittee failed to reach a deal, or something. But the Fed ended its bond-purchase program in June; Standard & Poor’s downgraded America in August; the supercommittee deadlocked in November; and U.S. borrowing costs just kept falling. In fact, at this point, inflation-protected U.S. bonds pay negative interest: investors are willing to pay America to hold their money.”


The fact that certain things haven't happened yet is not proof that they will not ever happen. As noted above, there are many plausible explanations for low US government bond yields, but they do not mean that the government can hope to continue to get away with expanding the public debt willy-nilly. We still recall that numerous people were arguing along similar lines when the Nasdaq index was trading at 5,000 points – 'it hasn't declined yet, and that proves it never will'. This line of argument is of course abject nonsense.  There is also no proof whatsoever that economic actors will be enticed by a large amount of government spending to take the types of decisions that will ultimately lead to a renewed accumulation of capital – which is the only way prosperity can be restored. In fact, the exact opposite is likely to happen – owners of capital will be very wary of how the government intends to make good on its debts in the future. It is more likely that they will consume their capital than let it be confiscated by future taxation or inflation.

Krugman ends his jeremiad as follows:


“The bottom line is that 2011 was a year in which our political elite obsessed over short-term deficits that aren’t actually a problem and, in the process, made the real problem — a depressed economy and mass unemployment — worse.

The good news, such as it is, is that President Obama has finally gone back to fighting against premature austerity — and he seems to be winning the political battle. And one of these years we might actually end up taking Keynes’s advice, which is every bit as valid now as it was 75 years ago.”


Actually, although it seems to have passed Krugman by, the unemployment rate has actually declined a bit and economic data have improved. While this is likely to be fleeting, it is incorrect to state that 'the situation has been made worse'. In fact, the gridlock has probably contributed to making it slightly better, as there was for the first time some genuine hope that the spending orgy might come to an end.

Naturally, what Krugman regards as 'good news' we would regard as unalloyed bad news. Luckily we're not so sure that 'Obama is winning the political battle'. We're not even sure if there is a genuine political battle over government spending – no-one with the  exception of Ron Paul and perhaps a handful of others really wants to 'cut' spending after all. The debates are all over the rate of growth at which it will expand in the future. 

As regards Keynes, he's as wrong today as he was 75 years ago. Time did absolutely nothing to improve his confused grab-bag of inflationist and interventionist underconsumption theories (all of which had been enunciated in one or another form by his predecessors and thoroughly refuted long ago). Governments and etatistes certainly still like him for the intellectual fig leaf he provides to the enemies of the free market economy, but his ideas should be opposed by everyone who thinks that an unhampered market economy is the best way to achieve economic progress.

 

Charts by: Federal Reserve of Saint Louis Research, ECRI, Tradingeconomics.com


 

 

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3 Responses to “Keynes Was Not Right”

  • This entire mess centers around banking and levered bank capital creating an excess of lending, as you well know. I have read Irving Fishers Theory of Debt Deflation, which seems to be on a lot of economists minds. But, Fisher misdiagnoses the problem, which was there was too much credit money created which caused a boom and mal-investment. Thus, the dual system of debts, debts to the bank and debts of the bank which constitute the money supply is really the problem. Some call this fractional reserve, but I call it a state sponsored credit scheme. There wouldn’t be any bank balances disappearing if we didn’t have a group endowed to create the money supply in the first place. Thus Fisher and Keynes created theories to treat the symptoms rather than the disease. Government can’t hoard surpluses because it would remove the money from the system and immediately cause the depression it supposedly stopped.

    Henry Ford or some guy in his time said that if the average American knew how modern banking worked, there would a revolution by sunrise the next morning. I doubt 1 out of 5000 people have a clue, even people that seem to understand the basic problem. Krugman is writing for the Times for a reason, NYC being the largest center of credit banking on earth other than London. The entire structure of the government/banker game crumbles if this mess is stopped. This is why there isn’t a solution in Europe, as the financial system is used to game the population not engaged within the game.

    • Note though that the expansion of money substitutes (either in form of bank notes or deposit money for which no standard money existed) was also practiced by fractionally reserved banks before this became a state-sponsored scheme. The cartelization of the banking industry and the creation of central banks has merely made it into a much much bigger scheme that was able to expand money from thin air with nary an interruption so far (the purely private fractionally reserved banking systems of the past regularly imploded when the bank runs by depositors began).
      It still has created the boom-bust sequence as described by Mises, only the busts these days arrive when the inflationary expansion merely slows down (it doesn’t even need to go in reverse), because the system is so desperately overleveraged. The problem this system is now increasingly running into is that too much real capital has been consumed in the successive credit expansions. It has become almost impossible to restart this phony ‘growth’, i.e. the bubble activities that marked the previous episodes of capital misallocation.
      Anyway, I do agree with your characterization generally speaking. By divorcing money from the market and making it possible to create ever more deposit liabilities from thin air, a huge problem has been created – with no ‘good way’ left of solving it, this is to say that there is no longer any painless solution possible.

  • jfraasch:

    Great post.

    Here’s the thing, and you hit it a little bit. According to Keynes/Krugman, stimulus in the form of spending borrowed funds should lead to continued economic growth, the perpetual expansion, as you put it.

    However, after almost 3 decades of this deficit spending, we have seen numerous recessions. This, in and of itself, proves both Krugman and Keynes wrong. Government “stimulus” provides only temporary relief to overal GDP but not to the more general economy. It takes away more than it puts in.

    Your point on Europe reaching the point of no return is right on. They legally (EU law) cannot spend any more borrowed funds. They have spent and borrowed for so long in order to avoid the severe downturn that is coming that they have bankrupted themselves.

    If this economic crisis and response has taught us anything, it’s that we bought the cancer instead of the car crash. The second phase of the crisis is just beginning.

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