Why Krugman Is Wrong!

Talk about a fundamentalist preacher! Paul Krugman continues to rely upon his inerrant interpretation of the dogmatic Keynesian worldview as he condemns those “sinners” that have followed another path from the one he draws strength from.

Krugman’s New York Times column on Monday chastises those that take an alternative view: “More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer.” (See “The Pain Caucus”, http://www.nytimes.com/2010/05/31/opinion/31krugman.html.)

He goes on: “What’s the greatest threat to our still-fragile economic recovery? Dangers abound, of course. But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.”

Amen, brother! Alleluia!

Right out of the creed! When you need to protect your economic doctrine, bring out unemployment and the unemployed. This goes back in history at least to Keynes and the Paris Peace Conference in 1919 when there was a fear about the spread of the Bolshevik revolution throughout Western Europe. (See my book review from October 25, 2009 of “John Maynard Keynes and International Relations”, http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)

To support his argument, Krugman claims that America would be creating a situation not unlike that of Japan in the 1990s if the United States followed the “conventional wisdom” he disdains. “We are, however, looking more and more like Japan….[Recent data] suggests that we may be heading for a Japan-style lost decade, trapped in a prolonged period of high unemployment and slow growth.” (See the article by William Galston, “the Case Against Keynes (With Some Questions for Krugman, Too)” at http://www.tnr.com/blog/william-galston/75228/the-case-against-keynes-some-questions-krugman-too.)

The problem is that Krugman (and other fundamentalist Keynesians) interprets the Japanese situation—and the current situation in the United States—and the current situation in Europe) as “a rare real-world example of Keynes’s famous ‘liquidity trap’ in which monetary policy loses its effectiveness.” (See the Galston article.) The Keynesian solution to such a dilemma is to engage in “pump-priming” government expenditures that, through a cumulative multiplier effect that substantially increasing private demand, initiates a self-sustaining process of economic recovery.

The difficulty with this is that it does not take into account the huge amounts of debt that may have been accumulated through the earlier credit inflation that caused people and businesses to increase their financial leverage and risk taking. It was this credit inflation that ultimately led to the financial collapse that put the economy into the current situation. The other side of a credit inflation is a debt deflation.

The problem? People and businesses (including commercial banks) may find themselves so in debt with loan and interest payments far in excess of their own cash flows that they stop spending because they must repay or write-off large chunks of debt. They choose to become as liquid as possible because they must continue to live and finance their daily needs as much as they can through any wealth they may have accumulated. They do not become liquid because of they are afraid or unwilling to commit to the purchase of investment goods. They become liquid to survive.

Within such an environment, the Keynesian solution of pump-priming which leads to credit inflation becomes the only real response because it leads to inflation. To Krugman, Galston argues, “The root of the Japanese crisis is deflation, and the only remedy is a credible shift to a long-term inflationary policy.”

Although not stated in the “liquidity preference” arguments for such a policy, inflation reduces the debt burden because it reduces the real value of the debt. Inflation is always a way to get out-of-debt. The problem is, inflation encourages more financial leverage and more financial risk taking. This is what we in the United States have been doing for the last fifty years. And, ultimately it does not prevent the problem of a financial correction, it just postpones it.

Getting ones financial books in order is not necessarily a bad thing. It appears that Ireland is pulling out of its crisis situation after enduring “one of the worst recessions of any developed economy since the Great Depression.” (See the Bloomberg article: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a_gxU5nfACkg.)

Also, the United States in the 1990s presents an example fiscal prudence which contributed to a period of sustained economic growth. The Clinton administration pulled off a very successful policy of deficit reduction which was accompanied by the longest post-World War II period of economic expansion on record. So it can be done.

Other countries around the world are showing the fruits of fiscal discipline in the face of the economic slowdown of the past three years. Even with the turmoil in Europe, manufacturing seems to be recovering around the world, in the U. S., in the U. K., in Canada (where the Bank of Canada just raised interest rates yesterday over concerns about its robust economy), and in Australia, Brazil, China, India, and Japan.

The lingering problem connected with the buildup of debt is the “debt overhang” that remains once the peak of the credit cycle has passed. Yes, there may be liquidity problems connected with reversing out of the expanding economy into an economy that is contracting. Any reversal of direction will experience a dislocation of markets. But, the liquidity problem is a short-run phenomenon. Once the short-term problem is eradicated, the issue becomes one of getting the balance sheets of individuals, businesses (including commercial banks) back into a more conservative structure. And this can take time and can hinder the strength of the recovery.

But, unless one is inflating the country out of its debt load, this re-structuring of the balance sheets must take place for the recovery to become a healthy recovery. There will be pain during this time. But, living beyond ones means for fifty years creates a situation that is uncomfortable for some. Unfortunately, the people that are hurt are not generally the people that really profited from the credit inflation that caused the excesses.

Perhaps focusing on longer term financial discipline might be better for workers over time rather than concentrating on every little short-term wiggle in unemployment. Certainly, the countries that are paying more attention to longer-run issues (like China) are going to put a lot more economic pressure on those countries that only focus on the short run (like the United States and Europe). For more on this see “How China is Changing the World” http://seekingalpha.com/article/206830-how-china-is-changing-the-world.