Krugman Worries About Deficits, What Changed? - Bezek's Daily Briefing

About: iShares 20+ Year Treasury Bond ETF (TLT), Includes: VNQ
by: Ian Bezek

Paul Krugman now opposes deficits.

What changed since he recommended "years" of deficit spending three months ago?

Economists still greatly overestimate their abilities.

Moving forward, expect a world with more volatility as central bankers and economists abandon efforts to stabilize asset prices.

Nobel prize-winning economist Paul Krugman is back with a seemingly timely message for the incoming Trump administration:

However, if you have a decent memory, you may find that headline surprising. The same Paul Krugman, you may recall, had this insight less than three months ago:

So, what's the deal? Should we ignore the "debt scolds" such as Paul Krugman, and support Trump's deficit-financed infrastructure spending? Or should we listen to Paul Krugman and criticize Trump for policies that would expand the budget deficit?

The US Debt clock a few short years ago. Source.

Krugman V Krugman

Last year, Krugman argued, summarizing his view, that the economy was in the process of recovering. Full employment wasn't "too far off," and inflation was starting to gain strength.

However, Krugman still felt that risks were to the downside. Getting trapped in a deflationary spiral would be worse, it was suggested, than letting the economy run too hot for a bit:

[T]here's a risk of getting it wrong in either direction - not raising rates soon enough to head off some rise in inflation, on one side, versus raising them too soon on the other.

And the decisive argument, it seems to me and others - although not, alas, to the Fed - is that these risks are asymmetric. Waiting too long risks embarrassment and some cost of wringing out the extra inflation, but moving too soon risks long-term stagnation. Wait until you see the whites of inflation's eyes! (I coined that phrase, by the way.)

That was Krugman in late 2016. However, 2017's Krugman is a far more somber fellow, saying that: "[R]unning big deficits is no longer harmless, let alone desirable."

What changed? According to Krugman now, we've reached full employment. This means that, he says, deficit spending would serve now to crowd out private sector investments, harming the economy. If you've heard that talking point before, it's because Republicans have been using it for years.

The second critique is that - contrary to Trump's stated intentions - Krugman thinks Congress will use its powers to cut taxes on the wealthy rather than build infrastructure.

It'd be easy to criticize Krugman for flip-flopping. He wanted "years" of deficit spending just three months ago when he thought Clinton would be president. Now that Trump has the power, deficits are suddenly intolerable.

The Real Problem: Economists Don't Know The Future

But let's be more charitable and assume Krugman isn't flip-flopping for reasons related to political expediency. Perhaps Krugman arrived at this new view simply because we reached "full employment" over the past three months.

The US unemployment rate has declined from 4.9% to 4.7% since Krugman changed his view:

A 4.9% unemployment rate was sufficient to justify "years" of deficit-financed infrastructure spending. Krugman talked about the risks and rewards of too much or too little stimulus policy. However, at 4.9%, the unemployment rate was high enough to unequivocally justify huge public works projects.

Now, however, at 4.7%, we've reached full employment. There's no shortage of good jobs anymore. The US economy is full steam ahead, and the government must ease off the throttle to avoid crowding out private investment, Krugman warns. Anyone else feeling the whiplash?

As someone with an economics degree myself, this is simply nonsensical. The economics field knows very little in the grand scheme of things. Our macroeconomical models are, in general, deeply flawed and rarely have any statistically significant predictive abilities. Human economic activity is hard to boil down to strict mathematical laws.

The idea that a 0.2% change in the unemployment rate should reverse a nation's fiscal policy 180 degrees is laughable. Say what you want about the short-comings of laissez faire economics, this sort of overly managed technocratic alternative is much worse. When even economists seem to flip on a dime, how are businessmen and politicians supposed to make sensible decisions?

The Great Financial Crisis showed that the banking industry's financial models were greatly inadequate. The mediocre at best recovery since 2009 has shown the shortcoming of modern economic thinking. Krugman is a prize-winning economist and famous columnist. Yet he appears to be engaging in rank political hypocrisy. That, or he sincerely believes government policy should flip on a dime when the unemployment rate drops 0.2%. Neither explanation is reassuring.

What's An Investor To Do?

As an economist by education, it's easy to find some sort of black humor in our field's leading lights embarrassing themselves. However, as investors, it's disheartening, since these flawed economic thinkers and their theories impact policy.

Under a hands-off economic system, the economy had a regular business cycle, with repeating booms and busts. It was volatile and uneven, but a reading of history gave you a strong guide as to what would come next.

Now, we've got a system where the economists and central bankers have tried to crush volatility and create permanently stable asset prices. Planners think they have much more control over the economy than they do. Only in an academic's mind can one be so certain that a 4.9% unemployment rate is too high, while a 4.7% one is just right.

After several decades of technocratic political control, neoliberalism is giving way to popular political uprisings around the world. It's not unreasonable to think a similar overthrow of entrenched economic theory comes next. Put another way, I doubt Trump, the Brexiters, the populist parties in southern Europe, etc., will be hiring Krugman-esque economists as their advisors.

I remember writing about a Bloomberg survey late in 2016 that polled dozens of analysts. Not a single one thought 10-year treasuries (NYSEARCA:TLT) would close the year above 2%. The rate exceeded that level by a wide margin by year-end.

Expect many more such unexpected outlier economic results in coming years. There's a good chance we're entering a much more volatile period. That's not to take a deeply bearish stance - the it's all going to crash view of the world is almost always wrong and costly to your net worth.

However, it's a good time to check your portfolio for potential shocks. I look at REITs (NYSEARCA:VNQ) borrowing money at 5% to buy 6-7% cap rate properties. A fine business model in a volatility-suppressed world. In one where central banks let the chips fall as they may, not so much.

Same for companies with negative tangible book values and declining revenues/net incomes borrowing yet more money to buy back stock. It worked great for the last 10 years, but the next 10 could look a whole lot different.

In general, it seems investors have become too comfortable. We expect the next few years to not be a whole different from 2010-2016. However, we're entering a very different period both economically and politically. The fact that Krugman just did a 180 in fewer than three months gives you a taste of the sort of rapid swings we're more likely to see going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.