Monday, November 01, 2010

The Krugman Fallacy

This started as a Facebook comment, but got long enough to post as a separate article on here.

It's in reply to an editorial by Paul Krugman in the NY Times:

The key thing to bear in mind is that for the world as a whole, spending equals income. If one group of people — those with excessive debts — is forced to cut spending to pay down its debts, one of two things must happen: either someone else must spend more, or world income will fall.

Krugman's being disingenuous. He says that globally, spending equals income, and if you don't spend, others don't get income; and that people with high debt levels stop spending, which is a Bad Thing(tm).

However, where does the borrowed money come from? Either from "quantitative easing", which means it really does come from nowhere, or from capital markets, which is money that was saved and invested (i.e. not spent) by others.

Spending your way out of a recession is a short-term fix. Long-term, the world needs fiscal responsibility (not necessarily austerity, but responsibility), so that people do save money and put it into banks and treasury bills, so that the capital markets do have liquid cash to lend to businesses. 

(The severity of the financial crisis was not due to a lot of lost money - it was due to the financial institutions' unwillingness to extend credit to businesses, even ones in good fiscal shape. Global business does not work on cash up front, it works on promises backed by banks, and when banks stop supporting the promises, the entire machinery seizes up. That was the main problem - the billion-dollar losses only impacted the banks' employees and shareholders.)

In this crisis, quantitative easing kinda-sorta did the job it was supposed to, in the short term. But its usefulness is limited to emergency relief. If you keep pumping liquidity into capital markets via quantitative easing, you just get hyperinflation.

Krugman says that government should pump money into the economy, if the private sector is too scared to spend. That's fine, but where does the money come from? Either from quantitative easing, which has been stretched to the limits already (because that's what the US and the Eurozone have been doing), or from capital markets. Where do capital markets get the money? Either from quantitative easing, or from private sector savings.

Krugman's advice for the US is to spend on public works, driving up internal consumption. That's money that will never be compensated by liquidity gathered from outside the US economy. (Germany pumped money into its economy briefly, before switching to austerity; and it actually managed to stimulate industrial production and export growth. The tax revenue from that, the influx of liquid cash into the German economy, will probably outweigh the money spent on the stimulus.)

Krugman advocates debt relief for homeowners, saying that it will do less damage to the economy than mass foreclosures. He's technically right, but the argument doesn't reflect the big picture: without great damage, there will be no change in behavior, and without a change in behavior, the mistakes that led to the global crisis will simply be repeated.

You can blame the greedy and unethical investment bankers all you want - and don't get me wrong, they are complete bastards and deserve every last morsel of hatred they are getting - but all of their evil schemes would never have worked if it was not for the greed and short-sightedness of the everyday consumer, who wants a McMansion and a BMW and a 60-inch plasma TV, and ignores the fact that he can't actually afford any of it. Politicians won't say it, for obvious reasons, but the underlying cause of the financial crisis is not the greedy lenders - it's the greedy borrowers.

The failure of the financial oversight mechanisms to prevent the bubble is so apparent because the mechanisms themselves are so obviously necessary: nobody ever actually expected the lenders to not be greedy. It was always assumed that their greed will expand to fill any available volume. That greed can be checked by two means: government regulation, and the common sense of the borrowers. Yes, government regulation failed. That is no excuse for borrowers to escape responsibility for their own common sense.

Back to Krugman's arguments. For capital markets, and by extension the globalized economy as a whole, to be efficient and healthy in the long term, there needs to be a supply of genuine assets, genuine liquidity. Any kind of deficit spending must be covered by money borrowed from people (or companies) who saved it. People who have actual asset-equivalent that is not being used right now, and can be given to someone else to use for a time.

These savings only appear when the private sector spends less than it earns. It's a crucial and irreplaceable component of a healthy financial system. It's not about morality, mr. Krugman - it's about mechanics.

22 comments:

Giustino said...

Spending your way out of a recession is a short-term fix.

Not necessarily. The availability of state subsidies can aid industries that go on to create revenue by themselves. At least of the tech front, most tech companies have benefitted immensely from government funding. The technology is typically created in state labs or universities and then licensed out to startups (who also have state backing) who go on to sell it to people who do have their own capital.

From the perspective of the industry I write about, Krugman is right. The state support allows large investments in capital equipment, R&D, that supports organic growth downstream. But that's just biotech. Maybe other industries don't operate that way.

(The severity of the financial crisis was not due to a lot of lost money - it was due to the financial institutions' unwillingness to extend credit to businesses, even ones in good fiscal shape.

Because financial institutions themselves were extremely indebted, and based their finances on over-valued assets and they were able to become that way because of lack of government oversight.

Global business does not work on cash up front, it works on promises backed by banks, and when banks stop supporting the promises, the entire machinery seizes up. That was the main problem - the billion-dollar losses only impacted the banks' employees and shareholders.)

But a lot of private companies had part of their financial resources invested by those investment "banks," and when they were unable to access that capital, they were in big trouble -- many companies went under, most exposed firms had to "restructure" AKA lay people off.

Giustino said...

Krugman's advice for the US is to spend on public works, driving up internal consumption. That's money that will never be compensated by liquidity gathered from outside the US economy.

That money would keep those performing the public works employed. Having a stronger infrastructure would also benefit the US economy in a global sense. You mention Germany: Germany has invested heavily in infrastructure in the east. You can invest in Germany, because things in Germany (mostly) work. Who wants to do business in an inefficient country?

The reason the US even has an infrastructure to support its economy is thanks to public works projects. Who built the interstate highway system? Eisenhower, and he was a Republican (this was before the Milton Friedman/invisible hand era). Who has bankrolled most of the industries in which the US excels?

The state.

Krugman advocates debt relief for homeowners, saying that it will do less damage to the economy than mass foreclosures. He's technically right, but the argument doesn't reflect the big picture: without great damage, there will be no change in behavior, and without a change in behavior, the mistakes that led to the global crisis will simply be repeated.

Ah, so you are among the 'let them fail' crowd.

You can blame the greedy and unethical investment bankers all you want - and don't get me wrong, they are complete bastards and deserve every last morsel of hatred they are getting - but all of their evil schemes would never have worked if it was not for the greed and short-sightedness of the everyday consumer, who wants a McMansion and a BMW and a 60-inch plasma TV, and ignores the fact that he can't actually afford any of it.

Those are the values of the material culture in which we live.

Politicians won't say it, for obvious reasons, but the underlying cause of the financial crisis is not the greedy lenders - it's the greedy borrowers.

It's a way of life in the US. One of the reasons I left the US was because I was in debt (around $5,000). I paid that off, but to many Americans $5,000 is a drop in the bucket. It is considered normal to be deeply in debt. But what would happen to the global economy if America's lust for goods really diminished. What would happen to the companies that build the McMansions and sell the plasma TVs and BMWs?

These savings only appear when the private sector spends less than it earns. It's a crucial and irreplaceable component of a healthy financial system. It's not about morality, mr. Krugman - it's about mechanics.

Obama did not spend as much as Krugman wanted. From a tech standpoint, more funds would have been beneficial. More grants = more research projects = more demand for tools from private sector to carry out research. In addition, more research = more diagnostics = more money for private pharma companies.
But that's my myopic view of things. Good post.

Flasher T said...

The availability of state subsidies can aid industries that go on to create revenue by themselves.

Yes, which is why I said it's a fix, not a useless waste of money. But you can't keep doing that to stimulate growth indefinitely; and the US has been doing it for a while already.

I agree that biotech benefits immensely from state funding, it's very hard to do fundamental research on a commercial basis. But even then, you're talking about research and discovery - not commercialization of the work, not turning it into a marketable product and selling it.

But a lot of private companies had part of their financial resources invested by those investment "banks,"

If they got greedy and put crucial liquid assets into high-yield investment funds, sure. That's part of the bad behavior I'm talking about. Companies that kept their cash in certificates of deposit were under no threat (and guaranteeing that was a big part of the necessity of the bank bailout).

Having a stronger infrastructure would also benefit the US economy in a global sense.

I'd be more inclined to agree if the US political scene of the moment could be trusted to actually use the money correctly. Look at what's happening with the high-speed rail project. Massive public works on the scale of FDR, Eisenhower and the German reunification require a lot of political will and/or social consensus. Obama was supposed to be an FDR-caliber figure, and look what happened.

I don't doubt that public works can kickstart an economy, but I severely doubt the US's ability to execute such a project at this stage. Especially when it's being funded by ludicrous amounts of deficit spending, with no clear idea of how that debt will ever be paid back. (Eisenhower paid down the WWII national debt by a 94% income tax on the upper bracket.)

Ah, so you are among the 'let them fail' crowd.

I'm among the "take responsibility for your own mess" crowd. It's tragic that letting them fail is the only apparent way to knock some sense into consumers who have no understanding of cause, effect, or algebra.

Those are the values of the material culture in which we live.

Bullshit. Those are the values of a specific (and singularly unlovable) demographic. Neither you or I live in that culture. I have not used a credit card in five years. You drive a twenty-year-old minivan.

What would happen to the companies that build the McMansions and sell the plasma TVs and BMWs?

Let's find out.

Flasher T said...
This comment has been removed by the author.
moevenort said...

how nice too see that the good old neoliberal ideology still makes you blind, Antyx. But don´ worry, you don´t seem to be the only Estonian with the ideology disease. Fortunately in other countries there are a lot more people who have learned to use their brain in a different way than you: they are able to think instead of parroting ideologic neoclassic Ansip, Laar, or Milton Friedman shit. I really hope for Estonia, that the critical voices of people like Rainer Kattel from Tallinn University or other experts are taken more serious and that people like Ansip and his supporters like you disappear into the cave they have come from. It would be better for the future of Estonia. and of ourse: nobel price winner and Profesor Krugman is right and you small Estonian BA- graduate are wrong. You should not write about topis which are out of your intellectual abilities.

Flasher T said...

*shrug* Your own government still disagrees with you, and is the healthiest economy in the EU by a huge margin.

moevenort said...

it´s not correct: here is a short description of German reality, boy: a huge majority of the German citizens perceive the Merkel government as the worst government for the last 50 years. one reason is their constant neoliberal propaganda, which has no roots in German political culture and is perceived to have an negative impact for Germany and whole Europe. Everything this government claims about economic growth etc. is pure propaganda and PR-speech. Although I admit that this government is at least not as terrible as the Ansip shit in Estonia.

but for your education just some information about current German politics:

according to nearly all political analysts and opinion polls of the last months, the Merkel government is in fact the government with the lowest reputation in Germany for the last 50 years: according to all polls this government would have massive difficulties to get at least 1/3 of the votes, if their would be elections right now, while the opposition (social democrats, green party, and the socialist party of Oskar Lafontaine would have no difficulties to get more than 60%. Merkels Coalition partner, they Free Democrat party (the only real neoliberal party in Germany) would even have difficulties to reach the 5% burden to re-enter the parliament.

all these facts caused much speculation in Germany about how long this governemnt will actually hold and if there will be an attempt within the conservative party to get rif of Angela Merkel.

Merkel herself made the next upcoming regional elections in the Baden- Würtenberg region ( a region governed by her party without interruption for the last 60 years to a general plebiszit about the future of her government. But in fact, this does not lokk good for her neither. according to all polls, the results will be davastating: for the first time in German history it could even happen there, that the green party will become strongest there in a regional election (traditionally the German greens are much more left winged than the Estonian Green party) if this will really happen, this will be like an earthquake for the political scene in Germany

the reason for this is a big infrastructure project in this region, which was attempted to push through by the local government against massive protest of the huge majority of the local population. as a consequence, there have been massive demonstrations with several hundred thousand participants from all parts of the population ( including left-winged and conservative people,pensioners and high school people) At one occation, these peaceful demonstrations clashed with police forces, who massively used violence even against teenager and pensioners. the tv pictures of this incident, have gone through whoel Germany and caused a massive debate about the state of democracy, the arrogance of the political class and the need for more participatory democracy in Germany. As Angela Merkel, declared this infrastructure project to her project, many people in Germany blame her directly for the police violence. Additionally, there is also big unrest among the population about the social policy of the Merkel government, which is perceived as unsolidaric and unfair by a majority of the citizens. All together, its not exaggerated to say, that probably no federal government of Germany for many decades was faces with such a massive loss of credibility.

you should inform yourself better instead of talking shit.

moevenort said...

btw: what kind of limited understanding of democracy you East European boy have, if you honestly believe that a citizen in a democratic country always has to agree with the government? is this still the authoritarion soviet style education in your brain? or is this already the consequence of postdemocratic Ansip-brainwashing?

Flasher T said...

Learn to read, little neonazi kid. I don't give a flying fuck if Merkel could get re-elected (and I don't trust anything coming out of your mouth anyway, since you seem to trust the opinion of disingenuous jerkoffs like Kattel and Krugman). I also don't give a flying fuck if you agree with her, because your opinion is irrelevant.

She's in office now though, and has been, and her "neoliberal" policies are what made Germany the EU's healthiest economy. That makes her right, and you wrong.

moevenort said...

little boy,the difference is that Krugman is a nobel price winner and a well-regarded expert. while you are just a small town boy from Estonia with a worthles BA degree from a province university - so guess who has more credibility. play in your league and ruin your country even more as it is already ruined with your primitive darwinist ideology if you like. I know Tartu University quite well: the last thing students learn there is thinking with their own brain. what they learn is parroting an ideology. just like in soviet time, only with different ideology now. it´s like with your prime minister: twenty years ago he was licking the asses of the communist party, now he praising neoliberal ideology like a priest. to make it clear. your country is irrelevant and primitive small town boy like you is irrelevant as well. the only thing which is interesting from a psychological point of view is how people in Estonia still follow like slaves to an ideology every intelligent citizen in Europe has dismissed long ago. I guess in some years, we will come as tourist and we will watch this phenomenon in your country as we are watching animals in the zoo.

and for your education as you don´t believe my words, little boy:

here: http://www.spiegel.de/international/germany/0,1518,http://www.spiegel.de/international/germany/0,1518,720735,00.html720735,00.htm

and here:

http://www.spiegel.de/international/germany/0,1518,720807,00.html

and here:

http://www.spiegel.de/international/germany/0,1518,719133,00.html

thats the real mood in Germany. not your sick propaganda.

Flasher T said...

LOL.

You want to put your real name behind that statement, little neonazi troll moevenort? I use my real name. I stand behind my words. That makes me both more relevant and infinitely more credible than you.

Where did you get your degree, moevenort? Are you a PhD in economics? Or did you just take a seminar from Rainer Kattel at Tallinn University?

Krugman may have a Nobel prize, but right now he's a newspaper columnist. Whereas the people executing the policies I'm talking about are the leaders of the world's healthiest economies. Their success trumps Krugman's theories.

moevenort said...
This comment has been removed by the author.
moevenort said...

what "success" are you kid talking about? do you mean that Orwell- propaganda newspeak? the pr? who is benefiting from the economic development at the moment? some big transnational companies or the citizens? Don´t you see declining living standards and income in Europe? the raising unemployment everywhere? have look at the social situation in your own country, smalltown boy. there you can see enough about realities. in what propaganda bubble are you living, idiot? how blind a of ideology a single idiot can be...

Flasher T said...

What's your real name, moevenort?

moevenort said...

it´s probably hard to get for you, but German people are extraordinary sensitive to privacy issues. especially in the internet. we are not running around like stupid kids, posting every shit on useless company websites like facebook etc. like you do. we care about privacy and we don´t like our personal data to get exploited by advertisement companies working with facebook, google or someone else - its another planet here, little boy

moevenort said...

and about economy: hjave you kid never learned to differentiate between news and PR?

Flasher T said...

What's your name?

Flasher T said...

You can email me your name and the details of your economics degree at antyx@antyx.net. I promise to not disclose it publicly. If you really are a credible economics expert, I will apologize in a new post here on AnTyx, for everyone to see.

moevenort said...

you know my name boy, it´s moevenort - the name of a baeutiful place on Rügen Island, at the East german Baltic Sea coast. a place without idiots. xD

Flasher T said...

What's the name on your academic thesis?

Jens-Olaf said...

moevenort,
I am very sensitive about posting comments anonymously (why? differnet story with a bad outcome)
Cause you are using insult. And that does not equal your comments with others who are using their real names.

Giustino said...

I always thought Moevenort was the bad guy in the Harry Potter books.

AddThis

| More