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Krugman’s Fantasy World

Francis Cianfrocca has an interesting critical look at why Paul Krugman’s call for a massive Keynesian stimulus is the wrong policy. His thesis is right: Krugman and many other economists are stuck in a world of rigid mathematical models that have little bearing on the way the world actually works—which is one of the causes of this mess in the first place. Those models keep getting proven wrong, but Krugman’s ideology is blinding him to their faults.

Take Krugman’s belief in the “Keynesian multiplier”. The Keynesian multiplier argues that for every dollar spend in government infrastructure spending, $1.50 in economic growth is realized. If this seems like “voodoo economics” to you, it’s because it largely is. Why sound investments can produce economic multipliers, the chances of the government making those sound investments is rather small.

The Keynesian multiplier might work if government was good at allocating investments in a rational manner. The problem is that government is based on political realities rather than economic ones. So, instead of allocating money on a rational basis (i.e. to where it’s actually needed), Congress allocates money based on the political clout of the campaign contributors. So, there’s no Keynesian multiplier in practice even if all of Krugman’s models say that there should be one: the government’s political mode of allocating resources is not economically efficient, and never will be. As Cianfrocca notes, the real problem is much different:

Let’s note that Krugman is a sober, first-rate economist, but also a woolly-eyed, low-grade political hack. He firmly believes that government is better qualified than private actors to direct the country’s economy, and has advocated a Federal government share of 28% of GDP, compared to the current 22% or so. Since he understands economic efficiency as few do, the conclusion is that he’s committed to the social outcomes that come with government control, as opposed to the free-marketer’s commitment to maximizing utility. But that’s a side point.

But why is the economy performing below capacity in the first place? Many reasons, too many to list here. And why won’t it simply recover on its own, as it has many times in the past? Here things get a bit more interesting. Like many economists, Krugman points to Keynes’s “paradox of thrift”: in uncertain times, ordinary people defer consumption and businesses postpone investments. The economy shrinks below capacity, because of people’s desire to save money.

It’s hard to escape the sense that the best economists and the President of the United States are blaming ordinary people for the economic crisis. If only we’d spend our money instead of save it, we wouldn’t be in such a big mess.

Cianfrocca goes on to argue that the “stimulus” won’t work because people don’t want to spend right now—the intuitively know that they are overleveraged and the country is highly overleveraged, and all this spending is just going to make things worse. Cianfrocca is right on that point.

He’s right because perceptions matter. He correctly points out that all this public indebtedness is exacerbating people’s own personal fears. Only 38% of people believe the stimulus will aid the economy, and that number will drop over time as the stimulus fails to produce any lasting growth. The more consumers feel like the economy is going down the tubes, the less they will spend. The less consumers spend, the fewer businesses will stay afloat, pushing unemployment up and feeding the cycle even more.

That doesn’t even count the pernicious effect of government regulation and liability rules which further decrease business’ willingness to invest and create new jobs. With passage of laws like the Lily Ledbetter Fair Pay Act, businesses may now be sued for alleged paycheck discrimination stemming out of events that happened years in the past. This makes every employee a potential timebomb and increases the overall cost of labor. The more Congress kowtows to the unions and enacts “employee-friendly” bills, the more likely it is that jobs will be lost. This spurs Congress to legislate even more to “save jobs” and the cycle continues. The resurgence of union political power could not come at a worse time.

Krugman’s fantasy world in which government rationally allocates money so that it grows the economy has little to do with the realities of our political system. Instead, what Krugman proposes will further erode public confidence in our government. The stimulus bill is an example of Congress giving special breaks to those with the most influence—and those with the most influence tend to be rich special interests rather than small businesses or ordinary citizens. People feel that their government is broken, and they are right.

No matter what the mathematical models predict, psychology is crucial. Krugman’s fantasy is a fantasy because he makes basic and incorrect assumptions about the way the economy functions. His Keynesian spending will not fix the “paradox of thrift” because part of what is fueling people’s unwillingness to spend is the state of government finances. Borrowing trillions more and running up the national debt is not going to make that better, it will make it much, much worse.

A real stimulus would involve the same sort of conditions we regularly impose on other countries in our situation. If we were Argentina, the IMF would be telling us to slash our spending and get our balance sheets in order. That we’re perfectly comfortable telling other countries to go through painful austerity while our government does the opposite sends exactly the wrong message. That isn’t to say government spending is all bad, but the first order of business should be to more rationally allocate the spending we have without adding trillions more in debt.

What is most dangerous about Krugman’s fantasy is that it will never end. The more existing stimulus measures push down the economy, the more Krugman would call for yet more spending. The result would be the same as it always has been: massive hyperinflation due to massive public debt. Krugman’s policies won’t work, and Krugman’s natural response to their failure would be to call for ever more.

We can’t indulge in such fantasies. Desperate times call for desperate measures, and unless we start austerity measures now, the pain is only going to get worse.

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