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My Encounter with Paul Krugman

October 12, 2010

Tags The FedFree MarketsBusiness CyclesInterventionism

Murray Sabrin and Paul Krugman.jpg

Paul Krugman wears many hats — Princeton University professor, New York Times columnist, Nobel Laureate in Economics (2008), prolific author of scholarly books and journal articles, and now president of the Eastern Economic Association. The EEA is a regional scholarly group that publishes a journal and holds an annual academic conference in New York City every other year. The EEA is housed in the Anisfield School of Business, at Ramapo College, where I have taught Corporate Finance, and Financial Markets and Institutions for the past 25 years.

On September 29 there was a brief ceremony dedicating the Anisfield School of Business as the new home for the EEA. Prior to the dedication, there was a ribbon-cutting ceremony marking the official opening of the Global Financial Trading Lab, which was made possible by a generous gift from Mr. and Mrs. Anisfield. After these two events, Krugman delivered a 40-minute address on the "liquidity trap" and its "discontents," followed by a lively Q&A session.

Krugman is an engaging speaker, droll at times, very serious occasionally, and frustrated as hell that the Obama administration is not taking his advice to spend like no other time in history on the basis that there is "insufficient demand" in the economy to close the "output gap." According to Krugman, the economy is operating below its "full potential," and therefore it is the federal government's duty to take up the slack, because individuals and the business sector are "holding back."

Krugman's thesis, which he articulated in his lecture, has been repeated over and over in his Times column — policymakers are too timid to really turn on the spending spigot because of their "failure to understand" the liquidity trap. According to Krugman, although the Federal Reserve's zero-interest policy has flooded the nation's banks with newly printed dollars, lack of spending by the private sector is causing companies to lay off workers, which in turn causes aggregate demand to decline, and thus the downward spiral is never ending or causing a tepid recovery at best — unless the federal government steps up to the plate to boost aggregate demand. That, in a nutshell, is Krugman's view of the state of the economy.

Many years ago I either read an article by Murray Rothbard or heard him speak at a conference discussing economic policy. He pointed out that any explanation of economic events that does not include the importance of prices as a market-clearing mechanism is a useless exercise. In his lecture, Krugman did not mention how market prices would balance the output throughout the structure of production with the demand of market participants. There was no recognition on his part that the housing bubble bid up prices in virtually all sectors of the economy and the only way to return to sustainable prosperity is for all markets to clear. That means, of course, real and nominal wages falling, housing prices dropping, and goods-and-service prices adjusting to reflect real demand — not juiced-up demand — in the economy.

In short, a period of adjustment is necessary to eliminate the distortions in all markets caused by the Fed's easy-money policy. Krugman had no explanation of why the bubble occurred other than to say it happened. He apparently has no understanding of the Austrian School insight about the cause and effects of monetary and credit inflation.

The only time Krugman mentioned prices in his lecture was to point out that price inflation is very low now and does not pose a "threat" because there is so much "slack" in the economy. The Commodity Research Bureau index has been rising steadily since the Fed turned on the monetary spigot full blast two years ago, and the prices of precious metals are signaling that either inflation is coming back, or the dollar will plunge further in value, or there will be a deflationary depression and investors want a "reliable store of value." No matter how you slice it, the Fed's unprecedented monetary inflation, the trillion dollars plus deficits as far as the eye can see, and the bloated federal budget are causing concerns around the world about the health of the US economy.

Although economists tend to "get it right" at the micro level, demonstrating how prices clear markets to avoid both shortages and surpluses, they tend to go into another universe when it comes to analyzing the macro economy. This was clearly evident throughout Krugman's talk. He hung his hat on the "paradox of thrift" as an explanation of the economy's weak recovery — namely, that saving by an individual may be good for him, but if everybody saves, that is bad for the economy because there will be less aggregate demand. He claims that this is an example of the fallacy of composition. In short, Krugman asserts, what was good for an individual may not be good for "society." (See Robert Murphy's critique of the "paradox.")

"No matter how you slice it, the Fed's unprecedented monetary inflation, the trillion-dollar-plus deficits as far as the eye can see, and the bloated federal budget are causing concerns around the world about the health of the US economy."

Economist Robert Higgs has written a definitive critique of what he calls "vulgar Keynesianism" (VK) — the proposition that the economy is comprised of "lumps" of output that can be manipulated by the federal government to obtain the "right level" of national income and employment.Download PDF Krugman is the most vocal proponent of VK, claiming, namely, that the technocrats in the White House and the federal bureaucracy have the skills and the knowledge to direct the economy toward full employment.

Krugman totally ignores the role of entrepreneurs in the economy. Uncertainty is plaguing the business community because public policy has become so uncertain! The battle over tax rates in Congress, Fed policy, currency-exchange rates, trade issues, regulatory changes, and other factors are making it more and more difficult for businesses to undertake any reliable strategic planning. None of these were mentioned by Krugman as reasons why the economy is sluggish at best.

Another weakness of Krugman's economic paradigm is his lack of appreciation for the role of the savings and investment that is necessary before consumption can take place. As Ludwig von Mises observed,"The most ingenious technological inventions would be practically useless if the capital goods required for their utilization had not been accumulated by saving." But for Krugman it is demand and only demand that drives the economy. However, as Austrian School economists have explained for more than 100 years, an economy "grows" when entrepreneurs save — refrain from consumption today — in order to invest in different stages of the structure of production so that the supply of consumer goods will steadily increase over time at lower prices, thereby spreading the benefits of a free-market economy to all. Even the unemployed and disabled receive the benefits of the free market as "deflation" spreads throughout the economy.

Thus, it is the free market that causes more prosperity, not government spending, which is based on expropriating the income and wealth of the public. Government spending can never cause a sustainable rise in real incomes, because governments do not invest in the "right" lines of production that will satisfy real consumer demand. Moreover, government depends on coercion to obtain its revenue; therefore its actions do not reflect the optimal choices of the people.

As Rothbard pointed out in The Case for a 100 Percent Gold Dollar,

The market economy and the modern world's system of division of labor operate as follows: a producer supplies a good or a service, selling it for money; he then uses the money to buy other goods or services that he needs. Let us then consider a hypothetical world of pure laissez-faire, where the market functions freely and government has not infringed at all upon the monetary sphere. This system of selling goods for money would then be the only way by which an individual could acquire the money that he needed to obtain goods and services. The process would be: production→"purchase" of money→ "sale" of money for goods.

The elegant and insightful presentation by Murray Rothbard of how an economy works should disabuse Krugman and others that government spending is a tonic for what ails the economy. What ails the economy is an old story: interventionism — massive government spending and money printing.

The US economy is currently undergoing a massive readjustment to the easy-money policies of the Federal Reserve — a fact dismissed by Krugman as an irrelevant causal factor of the bubble and the "Great Recession." However, Krugman said we knew how to end inflations in the past: raise interest rates to nip the price spiral. Now, he asserts, monetary policy is ineffective and federal spending must accelerate to lower unemployment and put other factors of production back to work.

During the Q&A I asked Krugman about Keynes's foreword to the German edition of The General Theory, where he wrote,

The theory of aggregated production, which is the point of the following book, nevertheless can be much easier adapted to the conditions of a totalitarian state [eines totalen Staates] than the theory of production and distribution of a given production put forth under conditions of free competition and a large degree of laissez-faire. This is one of the reasons that justifies the fact that I call my theory a general theory.

Krugman dismissed the idea that Keynesianism was best suited for totalitarianism and he ignored my inquiry about the fact that the mess we are in is precisely because the US government has pursued Keynesian policies for the past eight decades.

At the dinner following his lecture I pointed out that the United States — under both Republicans and Democrats — has been following the Keynesian model for eight decades, and he said Clinton did not, because he raised taxes in 1993. I said a deal was hatched between the Clinton administration and the Federal Reserve under Alan Greenspan — the Fed chairman at the time — to goose the money supply if taxes were raised to cut the deficit. He shrugged. I also told him that Reagan gave us "military Keynesianism" in the 1980s.

Krugman is a smart fellow but obsessed with government spending as a means to create prosperity. His focus on the idea that demand drives an economy is a naive view of how an economy works. This makes me wonder what they teach in the MIT economics department, where Krugman earned his PhD.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.

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