Tuesday, December 2, 2008

Why Keynesians are Wrong

When you are reading a Keynesian, be sure of this: you are reading an apologist for big government. All of their proposals involve greater power and involvement by federal government. Their arguments are solid and their points convincing, until you learn to spot the fallacies they slip into the equation. Their fallacies are postulates that underly their system, and sustained by blind faith. When you point out the fallacy of the postulates, the entire superstructure of their conclusions comes crashing down.

Our case study is Paul Krugman, currently running op-eds for the New York Times defending Keynesian policy, in fact, recommending more of it. According to Krugman, opposition to Keynes is founded mainly on ignorance, the inability to understand. Liberals always assume the stupidity of their opponents. If people were only as smart as them, of course they would agree! The long and short of Krugman's Keynesian argument is calling for a large fiscal expansion to prevent today's economy from going into free fall.

Krugman breezily dismisses our national debt, saying "it’s basically money we owe to ourselves". Good, I actually like that analogy. It brings to mind a picture of a man busily spending a few hours a week paying off loans he made to himself: "Must pay myself off, you know, otherwise I could go broke!" As if he could increase or decrease his own wealth level by writing checks to himself. The only real result of his action is to waste his own precious time. If Krugman truly believes that our debt is money we owe ourselves, he would agree with me that we should simply cancel our own debt and cease the silly charade.

According to Krugman, there is no trade-off between present and future goods, so saddling our posterity with massive national debt is not a problem at all. Getting our economy out of trouble now is actually doing the future good too,. even if they have to foot the bill for our current spending.

Krugman cannot actually prove his case, so he relies on an indirect negative proof: trying to prove the negative impact of not doing what he wants. In short, he argues, failing to provide massive bailouts is what deepened the Great Depression of the 1930s and the Japanese Depression of the 1990s. He points out in 1937 in America and 1996 in Japan, a cut in government spending in an attempt to balance budgets, lead to a subsequent downturn in the economy. We face the same problem today.

The real danger we face is a "liquidity trap", which is "a situation in which the monetary authority has cut interest rates as far as it could, yet the economy is still operating far below capacity." As he puts it, right now consumers are saving more at the same moment that businesses are cutting back investment. "That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more."

OK, so now let's examine the fallacies:

First, the "gap" he refers to: between consumer savings and business investment. The "gap" is based on the idea that consumer savings provides the capital for business investment Greater savings provides the fuel for future economic growth, but there is a time lag between savings and business growth. Krugman is arguing that we can bridge that time lag "gap" through governmental deficit spending today.

This savings-investment cycle is a basic component of the economic theory you get in intro economics textbooks. Unfortunately, it does not apply to our situation today. Our economy is not based on a savings-investment cycle anymore, but rather, is based on a debt-investment cycle. This is the reason why our current financial crisis is so debilitating to our real economy: when the economy is based on debt and deficit spending, a contraction in lending destroys economic activity.

Think of it in common sense terms: why do businesses today require loans to function? A business should be able to cover payroll and daily operations out of its cash flow and savings. A business that cannot meet expenses out of its cash flow and savings is a failing business! Loans can prop it up for awhile, but expenses must be covered out of cash flow eventually, or the business is not viable. Propping such businesses up is throwing good money after bad, and will bring down the lender along with the failed business. Further, the more debt a business takes on, the harder it will be for it to move into profitable viability.

America as a whole is trapped in this debt cycle. Rather than putting our money to good use spending and investing, we are constantly struggling just to keep up with our debts. And rather than letting nonviable business fail, to be recycled by the productive economy, our federal government is propping them up, with our money! Or rather, with our promise to pay back its loans.

This idea of constantly relying on the future reveals another blind-spot fallacy in the Keynesian economic faith. In 1932, deferring debt to the future might have been a good idea, but today, we can no longer have a blind faith in unlimited future growth. Our demographic collapse is upon us. Keynesian faith is built on a world of abstractions, like "an economy operation below capacity". The problem is, our economy will be operating "below capacity" for the foreseeable future. The Baby Boom generation is getting old, getting sick, retiring, dying. They did not replace themselves, demographically speaking, meaning, they did not have enough children. Their children's generation, the Gen X'ers, is smaller than their own, and the children of the Gen X'ers is even smaller still. Except for the massive cohort of legal and illegal immigrants that has flooded the country since 1965, our population level is falling, and our productive capacity is falling with it. And, Liberal hopeful thinking to the contrary, the fact is, the immigrant hoards are not contributing to the advanced economy of the future. Rather than helping the economy, immigration policy is saddling America with another underclass. Wages for working Americans have been frozen or falling for a generation, as the American worker is undermined by cheap immigrants, cheap imports, and outsourcing to cheap foreign countries. Great for the "economy", bad for actual Americans.

This is the ultimate blind spot of Keynesians: the loss of focus on real people, lost in their world of fantasy economic abstractions. A generation of free trade and globalization has been great for "the economy", while being a total disaster for the American standard of living and real wealth base. The real basis of America wealth producing economy has been undermined for a full generation now, leaving us a nation of "service economy" paper pushers, shuffling around a decreasing supply of real wealth.

Thus, Krugman's ultimate argument, that we should continue to defer debt into an every-more-prosperous future, is bunk. The future is not ever-more-prosperous, especially if we continue to saddle our future with ever-more-massive debts. There is no ideal way out of this predicament. We have built up and entire way of life on false premises, it is no longer sustainable. We sooner we shed ourselves of our destructive illusions, the better. Our best hope is an orderly adjustment to new economic and social realities. The more we cling to outdated slogans and strategies, the worse it will be when the day of reckoning comes.

Krugman's article:

Deficits and the Future

Right now there’s intense debate about how aggressive the United States government should be in its attempts to turn the economy around. Many economists, myself included, are calling for a very large fiscal expansion to keep the economy from going into free fall. Others, however, worry about the burden that large budget deficits will place on future generations.

But the deficit worriers have it all wrong. Under current conditions, there’s no trade-off between what’s good in the short run and what’s good for the long run; strong fiscal expansion would actually enhance the economy’s long-run prospects.

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.

But circumstances right now are anything but normal. Consider what would happen next year if the Obama administration gave in to the deficit hawks and scaled back its fiscal plans.

Would this lead to lower interest rates? It certainly wouldn’t lead to a reduction in short-term interest rates, which are more or less controlled by the Federal Reserve. The Fed is already keeping those rates as low as it can — virtually at zero — and won’t change that policy unless it sees signs that the economy is threatening to overheat. And that doesn’t seem like a realistic prospect any time soon.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

The second episode took place 60 years later, in Japan. In 1996-97 the Japanese government tried to balance its budget, cutting spending and raising taxes. And again the recession that followed led to a steep fall in private investment.

Just to be clear, I’m not arguing that trying to reduce the budget deficit is always bad for private investment. You can make a reasonable case that Bill Clinton’s fiscal restraint in the 1990s helped fuel the great U.S. investment boom of that decade, which in turn helped cause a resurgence in productivity growth.

What made fiscal austerity such a bad idea both in Roosevelt’s America and in 1990s Japan were special circumstances: in both cases the government pulled back in the face of a liquidity trap, a situation in which the monetary authority had cut interest rates as far as it could, yet the economy was still operating far below capacity.

And we’re in the same kind of trap today — which is why deficit worries are misplaced.

One more thing: Fiscal expansion will be even better for America’s future if a large part of the expansion takes the form of public investment — of building roads, repairing bridges and developing new technologies, all of which make the nation richer in the long run.

Should the government have a permanent policy of running large budget deficits? Of course not. Although public debt isn’t as bad a thing as many people believe — it’s basically money we owe to ourselves — in the long run the government, like private individuals, has to match its spending to its income.

But right now we have a fundamental shortfall in private spending: consumers are rediscovering the virtues of saving at the same moment that businesses, burned by past excesses and hamstrung by the troubles of the financial system, are cutting back on investment. That gap will eventually close, but until it does, government spending must take up the slack. Otherwise, private investment, and the economy as a whole, will plunge even more.

The bottom line, then, is that people who think that fiscal expansion today is bad for future generations have got it exactly wrong. The best course of action, both for today’s workers and for their children, is to do whatever it takes to get this economy on the road to recovery.

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