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Seeking Alpha contributor Michael T. Snyder wrote an article titled Why 'New York Times' Economist Paul Krugman Is Partly Right But Mostly Wrong. Let's go through the arguments one by one.

False prosperity

The false prosperity that the United States and Europe have been enjoying has been fueled by unprecedented amounts of debt. [Snyder]

There is no economic concept called 'false' prosperity. Yes, household borrowing has increased enormously, but this is private debt, and the result of private decisions. Many people still have to wake up to the fact that the collective outcome of private decisions don't always lead to a social optimum. Markets can fail as well.

We have argued that the run-up of the household debt is largely the result of stagnating median wages (median wage earners have enjoyed very little of the benefits of increased labor productivity since the 1970s), which resulted in increased credit demand to sustain living standards, and financial deregulation, which made supplying credit easier.


we have not seen any real "austerity" yet. Even though there have been some significant spending cuts and tax increases over in Europe, the truth is that nearly every European government is still piling up more debt at a frightening pace. [Snyder]

This is almost completely wrong. There has been unprecedented austerity in a number of eurozone countries producing such bad results that even the IMF (which argues for austerity basically in any economic crisis) has warned against it.

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(The relation between austerity and growth for European countries). See also a paper by Christina Romer

You see here a clear correlation between those embarking on the fastest austerity, having the worst results in terms of growth. Yes, most of them, like the U.S., are still "piling on debt," as Snyder has it. But that doesn't mean they're not embarking on austerity, there are real spending cuts and tax increases, even in the U.S. (albeit mostly on the state and local level). Simply changing the definition of austerity won't do here.

You can see below that despite alarms about government out of control and similar stuff, public employment in the U.S. is declining, contrary to all other post crisis periods, and public spending is a drag on economic growth, not a stimulus.

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Note that the bump in the second graph around month 16 is the temporary hiring of census workers.

It's even worse, what really matters is public debt/GDP for the sustainability of public debt. If austerity has, as Krugman has argued for years, such a bad effect on GDP as to completely wipe out any progress on the public debt amount, then it isn't very useful, to put it mildly.

Brad DeLong and Lawrence Summers have written quite a useful paper explaining that this idea isn't at all far fetched and it is more than just a theoretical possibility. Under certain conditions, austerity can be self-defeating even in terms of restoring public finance health. This is the reality on the ground in places like Greece.

One of the variables here is the phenomenon that the longer plants and employees remain idle, the bigger a fraction of these will 'withdraw' from future economic capacity, effectively reducing future production capacity, growth, and the tax base. Early intervention to maintain demand and prevent this from happening is quite important (Krugman argued early on that the stimulus was way too small, and this turned out correct as the plunge in economic activity turned out to be way bigger than feared when the stimulus bill was produced).

For those who think this is a mere theoretical phenomenon concocted by economic professors in ivory towers, we invite you to look at the development of the labor force participation rate in the U.S., which has been sharply down since the financial crisis. How many of these 'discouraged' workers will return to the workforce?

Public debt
Snyder does have a point in worrying about the rising public debt. However, the big budget deficits are mostly the result of a soft economy (depressed activity automatically reduces tax intake and increases spending). The stimulus added only a fraction to that. The health of public finances is determined by structural factors, not temporary ones.

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While alarm about bond vigilantes have been running for at least three years by the likes of the WSJ editorial page and people like Niall Ferguson, the U.S. can still borrow for 10 years at below 2% interest. For sure, the government must be able to invest in projects with a better return than that. Investment in infrastructure, R&D and education often do generate returns bigger than that.

Investing in these would thereby not only maintain demand (and prevent the 'decaying' of human capital and plant from happening), it would also boost the long-term productive capacity of the economy. There is also no reason why the U.S. could have healthcare costs at least a little bit more in line with the rest of the developed world, and this is the most crucial variable:

The U.S. healthcare system is possibly the most inefficient in the world: We spend twice as much per person on health care as other advanced countries, but we have worse health outcomes, including a lower life expectancy.

The CEPR Health Care Budget Deficit Calculator shows that if the U.S. can get health care costs under control, our budget deficits will not rise uncontrollably in the future. But if we fail to contain health care costs, then it will be almost impossible to prevent exploding future budget deficits. [CEPR]

Another unusual piece of data about the U.S. public finances is the very low level of tax intake. Bruce Bartlett of the NY Times writes:

According to the Congressional Budget Office, federal revenues will be 15.8% of G.D.P. this year. The postwar average is about 18.5%, and taxes averaged 18.2% during the Reagan administration; indeed, at their lowest point in 1984, federal revenues were 1.5% of G.D.P. higher than they are now.

Simply letting the Bush tax cuts expire would already go a long way into reducing the deficit and we're with Bartlett here that the case for further tax cuts surely must be pretty weak. Corporate tax income stands at 1% of GDP, for instance, any further reduction isn't likely to produce significant effects). Krugman himself has offered the introduction of a sales or value added tax as another possibility, he's not entirely blind to the budgetary arithmetic, he simply argues it isn't the priority right now.

One thing to keep in mind is also that most of the debt simply is to ourselves.

Where Krugman is right
There is little doubt that Krugman is right insofar as the diagnosis of the economic crisis is a lack of demand. Households ran up huge amounts of debts (because they shared little in the gains in labor productivity and debt was the only way to share in the increased prosperity).

They did this largely on the back of rising house prices and some really dubious bank practices with regards to mortgages. Banks were extremely lax in selling mortgages because they could repackage them into complex products and get them off of their balance sheets. Volume was the name of the game (hence 'robo signings'), not maintaining standards.

When house prices imploded, household debt remained and household balance sheets were ravaged, losing some 9 trillion dollars in the process (probably more by now). As a result, households started to reduce borrowing and spending and firms (despite having near record profits and sitting on $2 trillion in cash) basically did the same. Why invest in additional production capacity when the demand for the output isn't there.

The danger is a downward spiral in the economy, like what happened in the 1930s. Especially since bank balances were also greatly affected. If run unhampered, this could have easily turned into a debt-deflationary spiral, creating unprecedented levels of economic pain.

This is no garden variety recession, it has all of the same mechanics of the 1930s depression and the Japanese 'lost' decades after the bursting of the Nikkei and real estate bubbles at the end of the 1980s. A normal recession is usually caused by the central bank in order to cool off inflation, but the essence of the balance sheet recession we're in now is that monetary policy is largely powerless.

Rates are already close to zero and even with these rates, the private sector saves way more than it invests. This situation is called a liquidity trap in which the economy behaves quite a bit differently from normal.

(click to enlarge) Gross Private Sector Savings minus Gross Private Sector Investment

So if the private sector start to save more than it invests, even when interest rates are effectively zero and can't fall further (so inducing investment through monetary policy is near exhausted), how is the spending gap going to be closed? If not closed at least to a considerable degree, the economy risks spiraling down like the 1930s, as the spending of one is the income of others.

Richard Koo, who is an expert on the (very similar) Japanese deleveraging process from 1990 onwards has argued that only public spending works in a balance sheet recession and without it, Japanese GDP would have fallen 40-50%.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Why NYT Columnist Paul Krugman Is Mostly Right