Krugman Underestimates Economic Effects Of Increased Inequality

Nov. 16, 2011 3:54 AM ET8 Comments

We've been studying the work of Paul Krugman a bit lately, as he provides a nice focal point for debate on the current economic situation, he's controversial, and his blog provides a near real-time view of the man at work.

We've written in a lengthy article that we believe his model of the economy, which is a neo-Keynesian (or Hicksian IS-LM) view of the world is able to explain a number of present day economic phenomena.

Most notably, its Keynesian core provides explanations for:

  • The nature of the economic crisis (a lack of demand)
  • The persistence of the crisis (positive feedback loops are holding equilibrium restoring mechanisms in check)
  • The low interest rate on US bond, despite record deficits and debts (large output gap)
  • The absence of accelerating inflation in the face of unprecedented 'debt monetization' (liquidity trap)

Although his model of the economy is able to explain these phenomena pretty well, it doesn't mean that we're always agreeing with Krugman. We think he's wrong to attack the rising inequality only from a moral point of view. We think he underestimates the economic effects of increased inequality and we think he's going on about China just a bit too much.

The economic effects of rising inequality

Krugman, while strongly attacking the rising inequality from a moral point of view (everybody is entitled to his or her opinion..), doesn't see it having played much of a role (if any) in the crisis.

We beg to differ. There is a simple economic reality that savings is positively correlated to income. The higher the income, the more people tend to save. Since Krugman sees the crisis mainly as a lack in demand, one would expect him to see the rising inequality as a contributing factor, but he doesn't.

In reacting to Steve

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