There are a lot of people in need of some urgent economics101…
“Krugman Is 100% Wrong” About Deficits and Govt. Spending, RCM’s Tamny Says Posted Aug 28, 2009 12:54pm EDT by Aaron Task
It may surprise those of you concerned about the $9 trillion deficit America faces over the next decade, but “deficits saved the world,” Nobel-prize winner Paul Krugman declares
in his NY Times column today. “In fact, we would be better off if governments were willing to run even larger deficits over the next year or two.”Krugman goes on to say the U.S. economy is big enough to handle a $9 trillion deficit, suggesting “the dangers are political, not economic.”
John Tamny, editor of RealClearMarkets.com, might agree about the political danger but says “Krugman is 100% wrong” about the deficits. “The economy is recovering despite the stimulus, not because of it.”
Taking a page from the Austrian School of economics vs. Krugman’s Keynesian, Tamny argues the government “should have done nothing” in the face of the economic crisis last year, for the following main reason:
- Government spending “crowds out” private enterprise and rising deficits raise the risk of a run on the dollar.
- Stimulus spending causes people to become unproductive because it shows enterprise isn’t rewarded. “It’s a disincentive to work,” he says, making a similar argument about unemployment benefits.
- Bailouts impede capitalism by rewarding failure and giving capital to non- or unproductive businesses, as we’ll discuss further in another segment.
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We could ask “who John Tammy is?” Krugman is a Nobel price winner in economics. But that would be the easy way out. So a few observations:
Government spending crowds out private spending
This is the easiest one to deal with. Which private spending? How would that work? The Normal argument is that increased government spending raises interest rates and claims on resources, which makes borrowing and using resources (labour, capital etc.) for private expenditures more expensive.
Does the last year and a half strike you as a period in which the private sector really wanted to expand, but couldn’t do so because government expenditures increased the cost of credit or other resources? Not quite. This is only a viable argument in times when the economy is running close to full capacity, not in an economy with 10% (the real figure probably a lot higher still) unemployment and falling, not rising interest rates and decreasing private expenditures as leveraged balance sheets are unwound.
Companies can’t get credit because banks are retracting, not because the government is borrowing. And the bank retraction would be a whole lot more serious without government intervention…
In fact, since government can borrow at much lower interest rates than the private sector, and the private sector was overleveraged anyway, public spending makes sense, also keeping in mind that for instance investment in education and infrastructure not only have benefits in the short-term (employing resources) but increase the economic structure for the long-term as well. And arguably, public investment has been much neglected in the US the last couple of decades (as even superficially comparing Asian airports or European trains with those in the US might indicate.)
Stimulus spending causes people to become unproductive
And a collapsing economy doesn’t? In fact, government expenditures keep at least some resources employed (especially important for labour, long-term unemployed tend to lose skills, motivation, contacts, etc. which makes them much more difficult to employ after prolonged unemployment, as ample experience from Europe in the 1980s showed).
Bailouts impede capitalism
No, this time, they have preserved it. The idea that markets always and everywhere work smoothly and sort things out by themselves is just that, an idea. And not one that is particularly well founded by theory or facts. Most of the credit crisis occurred as a consequence of malfunctioning markets (the market for risk or mortgages, for instance), so Tammy has it backwards. Many of these malfunctions were exploited by a few to enrich themselves beyond anything remotely reasonable.
Bailouts and public spending prevented the economy from spiralling downwards in a vicious balance sheet-deflationary spiral in which
- worsening balance sheets decrease spending
- forcing further asset sales to repair balance sheets (only think of the stockmarket freefall earlier, or foreclosures).
- forced asset sales lower asset prices and worsen balance sheets further (especially of financial institutions, as assets serve as collateral for loans) , especially dangerous as many balance sheets were so leveraged (think of the collapsing investment banks, leveraged 30+ to 1)
- worsening bank balance sheets forces them to retrench even more, further restricting credit flows, reducing spending further
- and decreased spending causes production to decrease, making more people unemployed, further decreasing spending and further worsening balance sheets.
These vicious cycles had to be broken. The government and central bank were the only parties able to do that. The jury is still out whether they have succeeded.
The whole point is, the John Tammy’s of this world are firmly planted in certain textbooks, in which markets always clear, never malfunction, and government intervention is always the problem, never the solution. But the real world is quite different from that imaginary one..
We have argued many times that the root of most of these problems is the widespread belief in the perfect nature of markets. Markets do fail, and the credit crisis provides ample, spectacular, and distressing examples. One of the best reads is John Kay’s “The truth about markets”. Highly recommended.