Deconstructing Krugman

Deconstructing Krugman

By Francis Cianfrocca - February 17, 2009

Since the beginning of the economic crisis Paul Krugman has been the loudest advocate for a down-the-line, damn-the-torpedoes Keynesian approach. He continues to press this point in his op-ed column at the New York Times.

Krugman knows his economics (and if you forget about that, his Nobel Memorial Prize will remind you). He's been writing cogently and presciently since nearly the beginning of the financial crisis (which long predates the economic one) about the clear and present danger of falling into a deflationary spiral.

Paul Krugman knows how mathematical models work as well as anyone. His problem is that he has a much more pedestrian understanding of how people work. This problem typifies the whole Obama Administration, which pays close attention to Krugman at his perch in Princeton, and professes to revere data rather than ideology.

In his latest column, Krugman cites an analysis by the Congressional Budget Office to the effect that over the next three years, the US economy will underperform its capacity by $2.9 trillion. (Of course, no color on the methodology or the approach of the study, but he's writing an op-ed piece, not an academic paper.) Let's take that large number on faith. It works out to about 7 percent of GDP.

This is the starting point from which Krugman goes on to call for government stimulus spending of about an equal size. Let's deconstruct the thinking a bit.

Orthodox economic modeling holds that fiscal spending by the government will create additional GDP of the same amount, multiplied by a factor that is generally taken to be about 1.5. So ideally for Krugman, we should enact a stimulus of about $1.3 trillion over two years, with no tax cuts at all. (I'll get to the tax cuts in a minute.)

That's nearly twice the size of the program that Obama asked Congress for. If you strictly believe the models, then Obama made a horrible mistake. And in fact, Krugman excoriates the President for trying to solve two incompatible problems together: fixing the economy, and following through on the promise of a nonpartisan (or perhaps monopartisan) politics.

As a point of interest, Krugman also faults President Roosevelt on similar grounds: he believes that the New Deal failed not because it was too invasive, too destructive of private incentives, and added too much uncertainty to the business climate. Rather, he thinks the New Deal didn't go nearly far enough.

Needless to say, people like Krugman (including much, perhaps most, of the academic economics establishment outside of Chicago and George Mason University) have nothing but contempt for the ideas of the political opposition, which he scornfully calls "deep voodoo." In this view, Obama reached for bipartisanship and is on course to wreck the economy, by not being bold enough and by adding tax cuts to entice Republican support. To Krugman, Obama has already wasted his electoral mandate.

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.

This is where devotion to mathematics gets the better of those who would do better to try to understand people. Krugman is very concerned that the liquidity trap we're arguably in will degenerate into a sticky and persistent deflationary spiral, with far lower output for years to come (an American "lost decade").

The President faces a different trap. By believing the mathematics and not the people, he's come out in favor of a huge spending plan that runs deeply counter to what nearly every American now feels deep in her marrow: that this is a time for saving, not for borrowing and spending.

And there's something very important about this that even an economist needs to account for. Because the overall mood of the country prohibits a quick return to spending and investment, the multiplier effect of the stimulus will be muted. It will perform far below expectation. On top of that, its effects will not stimulate the economy in any permanent way, but will rather dissipate as soon as the stimulus does.

The standard argument against cutting or abating taxes as a tool of countercyclical policy, is that people will save rather than spend the money. Keynesianism targets current-period GDP as the measurement that matters above all, so saving more in a recession is a Bad Thing.

But the people don't want higher GDP. They want stronger balance sheets, amid a sense that hard times are ahead. If anything, the stimulus debate has exacerbated this sense. Why? Because the people want to save more money, but they see their elected leaders proposing to borrow and spend more, and they think: "these people have no idea what's really going on."

So this will attenuate the effects of fiscal stimulus even more. It's going to be a big bust. While people are cutting their own consumption in order to reduce their personal indebtedness, they're disgusted to find the government increasing their public indebtedness at a heroic rate. They'll respond to this by cutting consumption even more.

The bottom line, as Krugman seems to imply, is that we're far from the end of fiscal stimulus spending. If we're to replace 7 percent of lost GDP for the next three years or even longer, the fiscal-deficit spending will keep coming, far more than is being discussed now. Stimulus will NOT catalyze sustainable growth directed by the private sector.

The economic wizards are so intent on following their models and ignoring the people, that they will waste tremendous resources trying to postpone a reckoning that is fated to come. What we really should be talking about is mortgage finance. We have to figure out how to reduce the burden of mortgage debt on millions of people (including people that can perfectly well afford their payments, but are unaware of the creeping effects of deflation on their purchasing power).

That's going to be a mean and ugly problem, requiring a socialized solution that will put bank nationalizations to shame and totally disgust the American people, who care about moral hazard in a deep way that mathematics can't hope to model.

My fear is that, having botched this stimulus so badly, our political leadership won't have the credibility to solve the mortgage problem. And that would seal the deal on a deflationary future.

Mr. Cianfrocca is a businessman and investor based in New York City.

This article was originally published at The New Ledger.

Francis Cianfrocca

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