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Paul Krugman May Be the World's Last Flat Earth Keynesian Economist

Economics / Economic Theory Jan 31, 2013 - 07:49 PM GMT

By: Money_Morning

Economics

Keith Fitz-Gerald writes: Nobel Prize-winning economist and New York Times columnist Dr. Paul Krugman is at it again.

A favorite of the Keynesian crowd, he claimed earlier this week that fixing the deficit is important but added that "doing it now would be disastrous." He also observed that the 10-year U.S. debt situation isn't really all that bad.

At least he's consistent. I'll give him that.


For five years now Dr. Krugman has argued that increasing U.S. government spending is vital to our nation's recovery. And for five years he's been dead wrong.

Since this crisis began, the United States has spent trillions...more money than any nation in history. In the process, it's gone from being the world's biggest creditor to the biggest debtor of all time.

In fact, our national debt is now so high that people literally can't count the zeros. So most have thrown up their hands in exasperation and given up trying.

Now, to be perfectly clear, I don't believe Dr. Krugman is stupid. Far from it - you don't win Nobel Prizes for being an idiot. However, I do believe that he's trapped in the past--an acolyte of sorts to failed economic policies and doctrine that dates to the 1930s.

Some people, like University of Chicago Finance Professor John H. Cochrane, are more pointed, noting that if Krugman were a scientist, he'd be akin to a "flat-earther," an "AIDS-HIV disbeliever" or somebody who believes the continents don't actually move.

This makes him very dangerous in the scheme of things because Dr. Krugman's solution is that "we" just haven't spent enough money...yet.

I don't know how he can make that argument with a straight face.

Where Krugman Gets It Wrong
Here's the thing. If Dr. Krugman's ideas and his understanding of modern finance were accurate, our economy would be screaming along at 6%-8% a year, and the debt we've accumulated already would have led to some sort of government-spending utopia.

That obviously hasn't happened. Our nation hasn't had a budget for years, and doesn't look set to come up with one any time soon. Unemployment remains chronically high and we haven't created a fraction of the jobs actually lost since this crisis began. Various studies suggest there are 15 million-20 million people who are underemployed.

Manufacturing has cratered and confidence is slipping. Our financial markets are still appallingly overleveraged and the risks associated with them are more concentrated than ever.

It's no wonder, under the circumstances, that the economy recently slipped back a notch and that GDP contracted by 1% for the first time since Q2 2009, according to the government's latest data.

Krugman has got to understand this, so there's something else driving the man. But what?

I think what Krugman's really hammering on is the implied belief that the government should take charge of all capital markets because private business is incapable of effectively investing for society's good.

In other words, he's dismissing the science of empirical economic data and proof for the fallacy of imperfect information and social engineering. At the same time, he's completely ignoring the dangers of easy money.

In as much as he subscribes to Keynesian economics and its 1930s roots, he's either forgetting or deliberately dismissing another view from the pages of history, that of NY Senator Elihu Root, who warned against the dangers of easy money in 1913, the year the Fed was created.

Root correctly observed 100 years ago that the "expansive" policies of his time would "enlarge business with easy money" but ultimately lead to a crash when "credit exceeds the legitimate demands of the country." And he pointed to the panics of 1837, 1857, 1873, 1893 and 1907 as examples. I can only imagine what he'd say today.

So why can't Krugman make the same jump? I don't know, but I find it absolutely galling that he cites treasury markets, low interest rates and Japan as evidence that he's correct in his thinking.

Apparently he's willing to overlook the fact that the only reason our treasury markets haven't gone crazy is that Team Bernanke has them on life support with no plans to pull the proverbial plug. If anything, spending more money as Dr. Krugman advocates would accelerate the madness.

Bloomberg reports the latest round of bond buying will top $1.14 trillion by the end of 2014. There's a reason why the global derivatives industry is now valued at as much as $1.5 quadrillion. It's because no amount of spending can compensate for the cumulative failure of decades of bad fiscal policy. The markets know this even if, evidently, policy makers don't.

They also know that stimulus spending never works on anything other than a short-term basis. No nation in recorded history has ever bailed itself out by doing what our leaders are doing today.

Spending even more money now would be like giving an addict more drugs on the assumption that it will help him kick the habit later. The private markets have always been and will always be more effective "investors" than central government planners.

As for low interest rates, bear out the presumption that more spending is okay, that notion too is badly flawed.

Stimulative spending depends on the government's ability to convince people to involuntarily reallocate their capital from one bubble to another.

By keeping rates artificially low, the Fed is forcing money from bonds and cash into stocks which is why the markets have rallied. Don't get me wrong, I like rallies just as much as everybody else does. It's what happens "next" that I have a problem with.

Spending more money perpetuates the illusion of wealth by fueling borrowing. Borrowing, particularly at the government level, in turn strips capital from private markets and further bloats the public sector.

Krugman has noted this isn't bad for the dollar. No, it isn't, but it's not exactly great, either. The reality of the situation isn't so much that Dr. Krugman's policies are working, but rather our leaders don't have the political willpower to make the right decisions.

Being wrong in consensus is easier than being right. That's why it's easier to put off difficult decisions even when doing so means higher consequences in the future.

But, back to the issue at hand. The dollar has survived the most inflationary assault in modern financial history relatively unscathed to date because there is no alternative currency on the planet. The Euro is a great big question mark. The Swiss Franc isn't liquid enough, and the Yen is an unmitigated disaster.

So far the Chinese haven't let the Yuan take on the burden, knowing full well that they don't want to play this game which, I think, is the ultimate irony considering how capitalist the world's biggest communists have become.

As for his insistence that Japan is an example of why policies like his and yet more spending is the answer, I can't imagine that Dr. Krugman truly believes that.

The Nikkei has fallen 71.5% from its peak, its domestic economy is in tatters and China recently brought that nation to its knees in a buyer's strike that crippled already fragile exports without even trying.

Japan's combined public, private and corporate debt is approaching 500% of GDP. How's is that rewarding out of control spending??!! To my way of thinking, Japan's "success" is hardly worth emulating.

Here's How to Really Fix Our Problems
Instead of spending more money on the assumption we'll deal with the problems for having done so later, as Dr. Krugman advocates, what we need to do is cut spending radically.

Our government needs to get out of the way and free up the true capital needed for growth. We need to let dead financial institutions die, including, if necessary, parts of our nanny state itself.

At the same time, we need desperately to return to a strong, fixed-value dollar. From 1790 to 1970 we had one, and the U.S. economy grew at an average annual rate of 3.94% according to Louis Woodhill, who noted as much in Forbes last August.

That stands in stark contrast to the 2.81% average annual growth rate for the "fiat" period of 1970 to the present, when our dollar has been allowed to float freely against other currencies and the Fed has been able to print money at will.

Krugman, like other classic Keynesians, has argued for a weak dollar on the assumption that it helps exports and thereby strengthens the economy.

Here, too, the data suggests otherwise. Woodhill noted that dating back to 1950 when the Bureau of Economic Analysis began tracking such things, presidential terms that coincide with strong rising dollar periods reflect average real GDP growth of 3.21% a year. Presidential terms when the dollar is stable produced average real GDP growth of 3.58% a year, while presidential terms when the dollar was falling chalked up a much lower 2.23% average real GDP growth.

And finally, Krugman has argued that the rising inequality of wealth and the irrationality of the markets are primary causal factors behind the mess we're in. So, logically, he wants to spend more money as a means of equalizing both.

He should know better. Higher capital risks equal higher capital returns.

If the government seizes capital, which is effectively what it is doing by printing and diverting expenditures, it lowers both the return on investment and, not coincidentally, the incentive to invest in the first place.

This is why businesses are not spending money and the government cannot kick-start lending at the consumer level, no matter how hard it tries. People have been so badly scarred by the financial crisis that they don't want more debt -- even if it's free.

The other flaw in Dr. Krugman's argument is that cheap capital and government spending does not constitute effective investment. In fact, it creates "malinvestment."

This is a term from the Austrian school of economics that refers to pricing distortions caused by unstable money that actually causes businesses to invest in the wrong assets at the wrong time.

The housing bubble is perhaps the best example in modern times of what I am talking about in this instance. Fueled by an orgy of debt, unregulated derivatives and congressional leaders who determined that housing was a right not a privilege, billions in capital was diverted. For lack of a better term, it was "malinvested" and the results should not have been surprising in the least.

Imagine what would have happened if that money had been appropriately invested in real manufacturing, with real products and real jobs?

The truth of the matter is that more spending would be tremendously counterproductive and our deficits are already a problem. The 10-year picture is not okay...it's terrible. We crossed the point of marginal gain a long time ago.

Then again, there's always the little green men.

As Dr. Krugman noted on CNN August 8, 2011, defense against space aliens via ditch digging and bulwark building would create a viable economic build-up that would end "this slump [in] 18 months." If they never arrive, he posited, we'd still be better off economically for having prepared.

I'm not so sure.

Source :http://moneymorning.com/2013/01/31/paul-krugman-may-be-the-worlds-last-flat-earth-economist/

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