I mention this ten-year-old sarcastic foray into economics because Krugman has struck again, this time in a New York Times Magazine article, “How Did Economists Get It So Wrong?”  It turns out, according to the 2008 Nobel Prize winner, that economists falsely claim that capitalism is “perfect”:

Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation.

That was not the only problem with economists, as Krugman sees it.  Not only did they have a wrong-headed faith about free markets, but they also had forgotten the Great Lessons of Keynesianism:

Keynes did not, despite what you may have heard, want the government to run the economy. He described his analysis in his 1936 masterwork, “The General Theory of Employment, Interest and Money,” as “moderately conservative in its implications.” He wanted to fix capitalism, not replace it. But he did challenge the notion that free-market economies can function without a minder, expressing particular contempt for financial markets, which he viewed as being dominated by short-term speculation with little regard for fundamentals. And he called for active government intervention — printing more money and, if necessary, spending heavily on public works — to fight unemployment during slumps. [Emphasis added.]

He adds:

It’s important to understand that Keynes did much more than make bold assertions. “The General Theory” is a work of profound, deep analysis — analysis that persuaded the best young economists of the day. Yet the story of economics over the past half century is, to a large degree, the story of a retreat from Keynesianism and a return to neoclassicism.

One should read Henry Hazlitt’s classic The Failure of the “New Economics” to see something other than the fawning prose that Krugman writes about Keynes. There is so much nonsense in these two paragraphs that it would take a large volume to refute it all.  I will concentrate on just a few things.

First, it is amusing to see Krugman write that Keynes was concerned about economic “fundamentals,” given that Keynesian theory treats all capital and, indeed, all assets as being homogeneous.  There are no economic fundamentals in the Keynesian system; indeed, Keynes (and Krugman) call for inflation, which is general in scope, as a way to end unemployment in specific economic sectors.

Second, like Keynes, Krugman has declared that printing money will solve nearly any economic problem (although he has not used the specific Keynes quote on inflation, that it “turns stones into bread”).  As Hazlitt noted in his classic, Economics in One Lesson, inflation always leads to economic disaster.

Third, as the ATBC so aptly points out, it is inflation that creates the boom-and-bust cycles.  If inflation is the cause of the problem, then even more inflation cannot be the solution.

Krugman is correct when he says Keynes made “bold assertions,” but one searches The General Theory in vain for something profound.  As Hazlitt noted, there is nothing in the book that is both true and original: What is true is not original, and what is original is not true.

Krugman is right that economists “got it wrong.”  However, it was not a religious belief in free markets that caused the trouble, but rather government intervention, something Krugman never seems to mention in any of his columns.

The mercantilists of the 1600s raised this error to the pinnacle of national policy. Always bent upon heaping up hoards of gold and silver, they made war on their neighbors and looted their treasures. If England was richer than France, it was, according to the mercantilists, because England had more precious metals in its possession, which usually meant in the king’s coffers.

It was Adam Smith, in The Wealth of Nations, who exploded this silly notion. A people are prosperous to the extent they possess goods and services, not money, Smith declared. All the money in the world—paper or metallic—will still leave one starving if goods and services are not available.

The “money is wealth” error is the affliction of the currency crank. From John Law to John Maynard Keynes, great populations have hyperinflated themselves to ruin in pursuit of this illusion. Even today we hear cries of “we need more money” as the government’s monetary authorities crank it out at double digit rates.

The good economist will recognize that money creation is no short-cut to wealth. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.

Those words are still true, if only because our political and financial “leaders” want us to believe that they can end the current recession if the Federal Reserve System creates “liquidity.”  Thus, we see the Fed doing whatever it can to push more money into the economy.

One reason that the “money is wealth” fallacy has thrived for so long is that many people – including academic economists – fall prey to another fallacy, the fallacy of composition (discussed last week).  In the case of money, it is especially pernicious.

Assume, for example, that I had a printing press in my house which could crank out undetectable counterfeit money.  I could print huge amounts and purchase whatever I pleased.  No doubt, I would be better off (as long as the authorities did not discover what I was doing), but others would be made worse off.

First, and most important, is the nature of money.  Money is a good that is used to trade for other goods, and by making trade easier (and more abundant), it is a productive asset.

However, as Adam Smith understood, money itself is not wealth; instead, it is a good that we use in order to obtain wealth.  (Pieces of government-produced green paper do not qualify as historical “money.”  Government’s monopoly on money has led to its debasement.)

Second, money follows the same economic laws that govern all other goods.  The more money created, the less its marginal value.  (In other words, money is subject to the Law of Decreasing Marginal Utility.)  Many economists have missed this point.

In typical academic classes, money is described as a quantity variable.  Double the amount of money and the “price level” doubles as well, but the monetary increase has brought about no real harm.  Other academic models note that an increase in the amount of money will increase the amount of wealth (call it “Gross Domestic Product”), even if it also raises the “price levels.”

While such models are easy to teach (and to use for solving math problems), nonetheless they are inaccurate at best and dangerous at worst.  They do not demonstrate what really happens when the amount of money in an economy is increased.  If the process of creating more and more money by fiat (called inflation) goes on unchecked, as it did during the past decade, then not only does the value of money on the margin fall, but its growth triggers an unsustainable boom that ultimately collapses in a bust.

This process has repeated itself time and again, which demonstrates that most policy makers do not understand that money is not wealth.  The lesson still has not been learned.

Next Week: The Fallacy of Production for its Own Sake