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Paul Krugman's Chart Explaining How Deficits "Saved the World"

Last week, I wrote about the crudeness of so-called Keynesian economic theory in which one assumes that all assets and capital “investment” are “homogeneous” in character, which means that their only contribution to the economy is from the money that is spent in their creation and continued operation. This view contrasts with the Austrian paradigm, which emphasizes the structure of production within an economy and the unsustainability of capital that is malinvested during a boom.

Unfortunately, too many people in high places are prone to believe what on its face is unbelievable: running huge federal deficits somehow is a good thing for the economy. The latest outburst comes from Paul Krugman, who recently claimed that deficits “have saved the world.”

Krugman reports a quote from a Goldman Sachs analyst who pointed out that at the present time, private savings is greater than private investment. In his July 15, 2009, New York Times blog, the 2008 Nobel Prize winner writes:

That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.

He concludes by stating,

… absent the absorbing role of budget deficits, we would have had a full Great Depression experience. What we’re actually having is awful, but not that awful—and it’s all because of the rise in deficits. Deficits, in other words, saved the world.

Unfortunately, Krugman has confused cause with effect. The supposed imbalance between savings and planned investment is not causing an economic downturn; it is the result of the downturn. Likewise, the reluctance of people to spend as they did before is not causing a recession, but rather is occurring because of the recession.

In the Keynesian world, it is all so simple. People spend and the economy does well. However, if people don’t spend money like before, then the economy is in the doldrums and needs to be bailed out by government spending.

Once upon a time, people would have seen through this nonsense, but since Keynesian theory dominates the academic world and, unfortunately, the investment world, too many people are beguiled by such beliefs. However, for all of its supposed simplicity, the Keynesian theory is loaded with fallacies and just plain bad ideas.

First, and most important, deficits have not “saved the world.” They only have extended the unsustainable “boom” (or, more appropriately, what is left of the boom) and are postponing the day of reckoning. Second, they are guaranteeing that future generations are going to be faced with the devil’s bargain of either having to tax themselves mightily to pay off the debt or to repudiate it with inflation. Neither is a satisfactory outcome.

Keynesians seem to believe that a boom can be sustained forever, providing that governments fill in with extra spending. However, that is extremely unsound thinking. As Ludwig von Mises and the Austrians long ago noted, the very nature of the crisis at the end of a boom is built upon the fact that a boom cannot be sustained because the longer the boom goes on, the greater the malinvestments.

Indeed, the only way out of the crisis is for the malinvestments to be liquidated or diverted to other, more sustainable, uses. Once the fundamentals of an economy are put back into balance, a recovery can begin.

Unfortunately, because of the action taken by presidents Bush and Obama, as well as the Federal Reserve System, the excesses of the original boom still have not been fully shaken from our economy. That means that the recession still has a way to go before it hits bottom, which means bad news for a lot of Americans.

One wishes that the nation’s policymakers would realize that their actions to sustain the boom not only are ineffective, but downright harmful. Likewise, the “second stimulus” only would keep the malinvestments from liquidating and put off that awful day of fiscal reckoning in the future. And it will arrive, and Washington cannot do anything about it.

It takes some sophistication to follow Henry Hazlitt’s economics lesson and trace the consequences. Under the new supply and demand conditions, if prices cannot rise beyond a certain arbitrarily set level, supplies will run short, since people have no incentive to conserve and entrepreneurs have no incentive to divert goods from where they are relatively plentiful to the stricken area where they are relatively scarce.

Similarly, most people think the minimum-wage law is a good thing because they dislike that unskilled workers are paid very low wages. What could be more humanitarian than to set a floor beneath which wages cannot fall? If they thought like economists, they would realize that a mandatory minimum wage set above the marginal productivity of unskilled labor creates unemployment or less-desirable jobs for the workers it is intended to help.

But lately an idea has been floating around that anyone should be able to see through because it has no superficial logic whatsoever. It goes like this: The government hasn’t been able to spend $500 billion fast enough to stimulate the economy, so the only thing to do is . . . give the government even more money.

Huh? How does that make sense?

The Obama administration, for now, seems to grasp the weakness of this reasoning, but the same cannot be said for some members of Congress. There is talk of a second “stimulus” package. We shouldn’t discount the possibility that the congressional backers of a new bill know it’s a ridiculous idea but that they stand to benefit from passing it anyway. That’s how incentives work in the political system.

The first “stimulus” package under Obama was no such thing. As has been noted many times, any money the government spends must be acquired from somewhere in the economy first through borrowing or taxation. While moving money around may stimulate a given activity, it comes at the price of the other activities to which that money would have been directed. And since bureaucrats, not entrepreneurs, direct the “stimulus” projects, this redirection of scarce capital is detrimental to consumer welfare. If the projects served consumers and thus were profitable, they would have been undertaken privately and more efficiently than bureaucracies could have accomplished them.

The money in the earlier bill was supposed to be used for what we were assured were “shovel-ready projects.” But the truth seems to be that precious few were shovel-ready. They won’t get started for a year or more.

Edward Lazear writes in the Wall Street Journal, “By June 26, about $56 billion [out of about $500 billion] was spent on the stimulus from the American Recovery and Reinvestment Act of 2009, passed Feb. 17. A large proportion of that actually reflects mere transfers from the federal government to state governments, so the amount that has gotten into the economy is significantly lower.”

What Were They Thinking?

Thus even if the “stimulus” plan had been sound in theory, back-loading the spending to such an extent undermined its stated purpose: immediate job creation. It makes you wonder what the bill’s architects had in mind. Did they actually believe what they were saying? If so, their actions make no sense. When the bill passed in February, the unemployment rate was 8.1 percent, Today it is 9.5 and rising. That doesn’t seem terribly stimulating. Obama might claim he saved some number of jobs, but he wouldn’t be able to prove that.

Administration spokesmen are now asking for patience, but they are the ones who created a public expectation of quick stimulus. They have only themselves to blame for the disappointment showing up in the popularity polls.

Outside advocates of stimulus, such as Paul Krugman, will say the unabated rise in unemployment only proves what they said all along: The spending package was too small. But that is not a satisfying rebuttal. First, as noted, if government agencies can’t disburse a half-trillion quickly enough to jolt the economy, logic compels us to conclude that they can’t disburse a trillion. Should they fly around in helicopters and drop the money? (That wouldn’t work — people would do unpatriotic things like save or pay off debts.)

Second, economic theory refutes the Krugmanian claim. Since government can spend only what it has first taken from someone else (by borrowing or taxation), the spending can’t create jobs on net. So even if the government-created jobs were real jobs — in the sense that they ultimately contributed to consumer well-being according to consumers’ own priorities — they were created at the cost of other productive jobs that would have been created in the absence of government intervention. Resources are scarce; government spending displaces private economic activity. There is no way around that.

If the Stimulus I was a bad idea, Stimulus II is even worse.