Krugman, Summers and the First Keynesian
Paul Krugman has used the occasion of Larry Summers' speech at the IMF to lay out his economic views, or let us rather say, his economic fallacies. As we already mentioned, the fact that Krugman liked Summers' speech proves ipso facto that it was a bunch of arrant nonsense. Krugman has subsequently proved us right beyond a shadow of doubt. A great many long refuted Keynesian shibboleths keep being resurrected in Krugman's fantasy-land, where economic laws are magically suspended, virtue becomes vice and bubbles and the expropriation of savers the best ways to grow the economy. It is important to keep in mind in this context that most of what Keynes wrote in the General Theory wasn't original - it was mainly a rehashing of the underconsumption and inflationist fallacies propagated by his less famous predecessors. As Henry Hazlitt remarked in his detailed refutation of Keynes ("The Failure of the New Economics"):
"I have analyzed Keynes's General Theory in the following pages theorem by theorem, chapter by chapter, and sometimes even sentence by sentence, to what to some readers may appear a tedious length, and I have been unable to find in it a single important doctrine that is both true and original. What is original in the book is not true; and what is true is not original. In fact, as we shall find, even much that is fallacious in the book is not original, but can be found in a score of previous writers."
If one looks back at the history of economic thought, the earliest proponent of what we know as Keynesian errors today was probably John Law, the infamous Scotsman who almost single-handedly managed to ruin the economy of France (in fact, all of Europe was thrown into a depression lasting decades as a result of Law's monetary experiment). He was convinced that what the economy lacked was spending and so endeavored to provide it with the necessary means - in spades. The result was a giant asset bubble and crack-up boom that left the economy in utter ruins when it ended.
Although Law's scheme involved speculation in the shares of what turned out to be a company that was worth much less than advertised, at the heart of the operation was a monetary scheme based on his previously developed theories. The plan involved the printing of oodles of unbacked paper money which Law thought would spur a revival of France's moribund economy and concurrently fix the government's tattered finances. As is almost always the case with inflationary schemes, it appeared to work initially. In fact, it seemed to work almost too well (if Tonto had been around, he would have noticed that something was wrong). The world's first millionaires were created, for a brief time at least (most of them ended up as paupers, similar to Law himself).
The problem with all such schemes is essentially that scarce resources end up being invested unwisely, as inflation makes it appear as though they were more plentiful than they really are. Once the inevitable collapse comes, these unwise investments are unmasked and it become obvious to all that capital has been squandered.
John Law - the world's first Keynesian (Image via Wikimedia Commons)
One of the ultimately worthless paper promises issued by Law's Banque Generale (Image via Wikimedia Commons)
The Logic of Nonsense
What we noted above regarding wise and unwise investment is an important point to keep in mind when considering Krugman's rehashing of Keynesian fallacies. Krugman writes:
"Larry's formulation of our current economic situation is the same as my own. Although he doesn't use the words "liquidity trap", he works from the understanding that we are an economy in which monetary policy is de facto constrained by the zero lower bound (even if you think central banks could be doing more), and that this corresponds to a situation in which the "natural" rate of interest - the rate at which desired savings and desired investment would be equal at full employment - is negative.
And as he also notes, in this situation the normal rules of economic policy don't apply. As I like to put it, virtue becomes vice and prudence becomes folly. Saving hurts the economy - it even hurts investment, thanks to the paradox of thrift. Fixating on debt and deficits deepens the depression. And so on down the line."
We already discussed that the idea that the natural interest rate can become negative is a fallacy. To briefly summarize, for the natural rate to go negative, time preferences would have to go negative too, as interest rates are merely the ratio between present and future goods. However, a situation in which human beings value attaining the same satisfaction in a more remote future more highly than attaining it in a nearer future is simply unthinkable (capitalistic saving, i.e., abstaining from present consumption, always aims at obtaining more goods and/or services in the future).
All this liquidity trap and paradox of thrift stuff makes no sense whatsoever. Savings are not lost to the economy, they are the sine qua non without which capital accumulation and production are not possible. Virtue doesn't become vice in an economic downturn and economic laws don't change. As William Anderson points out in a recent article, the problem with this thinking is that it ignores capital theory. Attempts to revive the economy with deficit spending and inflation will never stimulate all factors of production simultaneously and to the same extent. The moment one considers the heterogeneity of capital it becomes clear that such interventions must lead to distortions which result in the boom-bust cycle (the housing bubble that expired in 2007/8 provides us with an excellent recent example for this).
Krugman elaborates further, once again invoking space aliens in the process:
"This is the kind of environment in which Keynes's hypothetical policy of burying currency in coalmines and letting the private sector dig it up - or my version, which involves faking a threat from nonexistent space aliens - becomes a good thing; spending is good, and while productive spending is best, unproductive spending is still better than nothing."
It is simply incorrect that unproductive spending is better than nothing. Recall what we said above about wise and unwise investment. Deploying scarce resources in unproductive fashion is not 'better than nothing', it will simply consume capital and destroy wealth. Krugman continues along these lines, seemingly eager to enlist everyone in his plan to waste as much capital as possible:
"Larry also indirectly states an important corollary: this isn't just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future. That last bit is an important qualification. But suppose that U.S. corporations, which are currently sitting on a huge hoard of cash, were somehow to become convinced that it would be a great idea to fit out all their employees as cyborgs, with Google Glass and smart wristwatches everywhere. And suppose that three years later they realized that there wasn't really much payoff to all that spending. Nonetheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would otherwise have been idle.
OK, this is still mostly standard, although a lot of people hate, just hate, this kind of logic - they want economics to be a morality play, and they don't care how many people have to suffer in the process."
So wasteful spending is a good thing unless it stores up trouble for the future - Krugman says that this is an important qualification, only to proceed to show us in the next breath that he actually does not feel constrained by any such qualification at all. Presumably he put that filler sentence in there so that when people in the future take a look at what he recommended in the past, he can claim to have 'qualified' his demand for wasteful spending (recall his vocal demand for a housing bubble before housing bubbles turned out to be uncool, which continues to cause him well-deserved embarrassment). When the latest scheme to 'rescue' the economy by inflation and deficit spending fails, he will be able to dig up this 'important qualification' (as if there could be any wasteful spending that doesn't store up trouble for the future).
The idea that idle resources need to be pressed into service is also due to Krugman having no inkling of capital theory. In the Keynesian view of the world, capital is a self-replicating homogeneous blob, some portions of which are currently accidentally idled and only need to be prodded back into action with the help of government spending. This is not so. Capital is not only heterogeneous, much of it is highly specific and inconvertible. What appears to be unnecessarily idle are simply the remnants of previous malinvestments. It may no longer make economic sense to employ the capital concerned. Workers who used to be employed in lines of production the products of which are no longer in demand may be holding out, hoping for the sector to come back rather than accepting a lower wage in a different occupation.
As an example, consider the housing sector that was at the center of the previous boom. If building companies have invested in enough machinery to erect two million houses per year, but I has turned out that there is only demand for 400,000 houses, it wouldn't make sense to employ the superfluous machinery and construct two million houses per year anyway. People that were employed in construction may need to retrain or move and be willing to accept less remunerative work. It is certain that e.g. far fewer roofers are needed today than during the building boom. Renewed credit expansion is likely to affect different sectors of the economy, but if it leads to another artificial boom in the same sector, it will merely prolong the life of malinvested capital and delay the necessary adjustments. Krugman argues along Keynesian lines that 'stuff the government has dropped into coal mines should be dug up', but neglects that this activity doesn't come without costs (or rather, erroneously argues that the costs don't matter).
Krugman avers that this logic is hated because people are informed by a warped sense of morality. The problem has nothing to do with morals though, the problem is that there is simply no logic discernible. Krugman offers the most illogical ideas and then proceeds to call them logic as if that could somehow dignify them and mitigate the fact that they are offending common sense.
More Bubbles Please
Believe it or not, it gets still more absurd. Not only does Krugman conclude that it is supposedly advisable to engage in unproductive spending because it is better than nothing, he also believes that Summers' speech contains an unspoken demand for more bubbles. And why not? After all, he has already concluded that prudence is folly, so why not throw prudence overboard, lock, stock and barrel? Never mind that this is what policy makers are already doing, so there hardly seems a great need to egg them on. According to Krugman:
"We now know that the economic expansion of 2003-2007 was driven by a bubble. You can say the same about the latter part of the 90s expansion; and you can in fact say the same about the later years of the Reagan expansion, which was driven at that point by runaway thrift institutions and a large bubble in commercial real estate.
So you might be tempted to say that monetary policy has consistently been too loose. After all, haven't low interest rates been encouraging repeated bubbles? But as Larry emphasizes, there's a big problem with the claim that monetary policy has been too loose: where's the inflation? Where has the overheated economy been visible?
So how can you reconcile repeated bubbles with an economy showing no sign of inflationary pressures? Summers' answer is that we may be an economy that needs bubbles just to achieve something near full employment - that in the absence of bubbles the economy has a negative natural rate of interest."
The seemingly insoluble questions Krugman grapples with are not as difficult as he makes them out to be. The problem is that what he calls inflation is only one of its many possible effects. Where the effects of inflation on prices first appear is a matter of the specific historical circumstances. Given strongly rising economic productivity, a huge expansion in international trade (and let us not forget, the transformation of the former communist command economies into market economies), it should be no great surprise that the effects of the huge credit expansion and money supply inflation of recent decades showed up in asset prices rather than consumer prices (incidentally, a very similar thing happened during the boom of he 1920s, during which economists also ignored a major credit and money supply expansion because consumer prices were tame due to strong increases in productivity).
This does not mean that other negative effects of these inflationary credit bubbles didn't put in an appearance. They all caused a distortion of relative prices and were thus all marked by massive capital malinvestment. Successive credit expansions led temporarily to higher employment even as capital was misallocted, but a steadily worsening underlying structural situation has become evident as these booms have inevitably turned into busts. So what solution does Krugman have to offer? He evidently thinks coercion and theft are the best way forward:
"Of course, the underlying problem in all of this is simply that real interest rates are too high. But, you say, they're negative - zero nominal rates minus at least some expected inflation. To which the answer is, so? If the market wants a strongly negative real interest rate, we'll have persistent problems until we find a way to deliver such a rate.
One way to get there would be to reconstruct our whole monetary system - say, eliminate paper money and pay negative interest rates on deposits. Another way would be to take advantage of the next boom - whether it's a bubble or driven by expansionary fiscal policy - to push inflation substantially higher, and keep it there. Or maybe, possibly, we could go the Krugman 1998/Abe 2013 route of pushing up inflation through the sheer power of self-fulfilling expectations."
Or putting it differently: do what John Law did and destroy what's left of the economy. The elimination of paper money (i.e., cash), would force people (whether they like it or not) to keep their money in what are essentially insolvent fractionally reserved banks that have proved beyond a shadow of doubt that they cannot be trusted. This poses no problem for Krugman, because it would make it easier to steal people's savings via the imposition of negative interest rates (i.e., a regular penalty to be deducted from their hard earned money).
Krugman then expresses his advance surprise at why anyone would be outraged by this combination of abject economic nonsense and outright theft. After all, it would amount to nothing but the good old 'euthanasia of the rentier' once recommended by Keynes:
Any such suggestions are, of course, met with outrage. How dare anyone suggest that virtuous individuals, people who are prudent and save for the future, face expropriation? How can you suggest steadily eroding their savings either through inflation or through negative interest rates? It's tyranny!
But in a liquidity trap saving may be a personal virtue, but it's a social vice. And in an economy facing secular stagnation, this isn't just a temporary state of affairs, it's the norm. Assuring people that they can get a positive rate of return on safe assets means promising them something the market doesn't want to deliver - it's like farm price supports, except for rentiers.
What Krugman proposes here is indeed tyranny. The liquidity trap is a figment of the Keynesian imagination anyway - no such thing exists. A positive rate of return on savings doesn't need to be 'promised' by anyone, it would be the natural state of affairs in a free market economy. Krugman then jumps to yet another conclusion, namely that in light of the above, the size and growth rate of the public debt would of course no longer matter at all:
"Oh, and one last point. If we're going to have persistently negative real interest rates along with at least somewhat positive overall economic growth, the panic over public debt looks even more foolish than people like me have been saying: servicing the debt in the sense of stabilizing the ratio of debt to GDP has no cost, in fact negative cost.
I could go on, but by now I hope you've gotten the point."
Well, we can at least be grateful that he didn't go on.
Too much debt? No problem, just impose negative interest rates!
Summary and Conclusion:
According to Paul Krugman, saving is evil and savers should therefore be forcibly deprived of positive interest returns. This echoes the 'euthanasia of the rentier' demanded by Keynes, who is the most prominent source of the erroneous underconsumption theory Krugman is propagating. Similar to John Law and scores of inflationists since then, he believes that economic growth is driven by spending and consumption. This is putting the cart before the horse. We don't deny that inflation and deficit spending can create a temporary illusory sense of prosperity by diverting scarce resources from wealth-generating toward wealth-consuming activities. It should however be obvious that this can only lead to severe long term economic problems.
In fact, the last credit boom, in which policy makers fully implemented what Krugman and other Keynesians proposed, has done enormous structural damage. Not even the biggest spending spree and money supply expansion of the entire post WW2 era has been able to divert enough wealth into bubble activities to create a full-blown pseudo-'recovery' so far. Krugman's conclusion seems to be that more of the same is needed. In other words, we are supposed to repeat what clearly hasn't worked before, only on a much greater scale.
Finally it should be pointed out that the idea that economic laws are somehow different in periods of economic contraction is a cop-out mainly designed to prevent people from asking an obvious question: if deficit spending and inflation are so great, why not always pursue them?