The Keynesian Debacle

Paul Krugman

Quoting Britain’s National Institute of Economic and Social Research, Nobel Laureate Paul Krugman pointed out that Britain and Italy are faring worse in the current recession than they did during the Great Depression of the 1930s.

Krugman contends it is because they have fallen into an austerity trap.

Lampooning the idea of belt tightening, Krugman contends in “The Austerity Debacle” that we have learned a lot about economics in the last 80 years but that “the policy elite decided to throw hard-won knowledge out the window”.

Krugman, a mouthpiece for the Keynesian crowd, apparently hasn’t learned enough yet.

Allow me to explain where Krugman and his Keynesian cohorts flew off the railroad tracks…

Keynesian Macroeconomics: A Simplified Mini-Primer

The heart and soul of Keynesian macroeconomics is a little concept called “counter cyclical fiscal policy“. It rolls right off the tongue at high-brow dinner parties when ya wanna impress rich widows for… welll… you know.

It is just a fancy way of saying that big government should deficit spend during a recession to stimulate demand to grow the economy; but that big government should reduce spending or raise taxes to reduce demand when “aggregate demand rises rapidly”… that’s what causes inflation.

Applying counter cyclical fiscal policy keeps a national economy on an even growth trajectory and prevents the type of extreme feast-or-famine economics that was commonplace before the 1930s.

Its a great idea that makes sense… and works.

But like all great ideas, such as communism, what looks good on paper can fall flat on its face when implemented incorrectly. That is what has happened to Keynesian macroeconomics today.

The Missing Puzzle Pieces

Krugman and the Keynesians must have glossed over or misunderstood these things:

  • The private-sector drives economic growth, not governments
  • Keynesian macroeconomics, at best, tweaks a national economy
  • You pay down recession incurred debt during good economic times

Its that last ‘pay-down’ part that is the Achilles’ heel of Keynesian macroeconomics as practiced today. Long term it is generally ignored by Keynesians and world governments.

No self-respecting Keynesian would say the word “debt” unless they absolutely have to. For example, in Krugman’s article “The Austerity Debacle” the “D” word is never uttered.

The Keynesian Collapse

Both Europe and the United States have piled debt on top of debt for the last 80 years without paying it down in the good times… and there were plenty of good times.

We got away with it because of strong economic growth driven by general population growth. Macroeconomics and/or government fiscal policy had little to do with it.

Instead, in the U.S. and Europe, increased revenues taken in during good economic times were simply redirected into massive social programs. That and “mandatory spending” swallows up over 80% of the U.S. federal budget. It was probably justified by some economist’s bogus multiplier factor.

In calendar year 2011 the federal government spent $1.2 trillion more than it took in. Despite what Krugman says, on a $3.6 trillion budget you don’t get any more Keynesian than that during a recession!

When debt grows faster than the economy and inflation’s ability to mitigate its effects then eventually you have to do some belt tightening, or “fiscal consolidation as economists quaintly put it.

Recession or no, when you don’t pay attention to your bills then you don’t have a choice over when or where you can chose to pay them. That is what is happening to the U.S. and Europe now.

The last time the United States seriously attempted to pay down debt was after WWI in the 1920s. We kinda, sorta started a halfhearted attempt to pay down debt after WWII but then just gave up and haven’t tried ever since.

Until we do fiscal consolidation, Keynesian macroeconomics is more harmful than good right now. We must take our medicine to get well.

Conclusions

Yes, we are in a recession and Keynesian counter cyclical spending to increase demand is a logical and accepted method to fix the problem.

Unfortunately, the federal government has taken to many decades to face up to fiscal reality and the 2008 recession has only made things worse.

But once your debt level gets so large that the interest payments alone are a drag on the national economy and government spending exceeds 20% of GDP then fiscal consolidation is the only answer. Ya gotta pay the piper.

Yes, that is painful and, yes, it will drag down an economy in the short term.

But the longer we wait before we bite the bullet, the more devastating the long-term consequences.

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About azleader

Learning to see life more clearly... one image at a time!

Posted on Feb 7, 2012, in Debt, Debt crisis, Deficit, economics, Keynes, macroeconomics, news, Paul Krugman, Politics, U.S. Economy. Bookmark the permalink. 11 Comments.

  1. I understand where you’re coming from and agree 100% that the system only works if you pay off the recession incurred debt during the good times. However I disagree with you on the subject of government spending. You claim that government spending can’t cause growth, however you just need to look at the likes of China or South Korea to see how state-owned or government backed companies can drive economic growth. Also you claim that government spending exceeding 20% of GDP is a tragedy, however Scandinavian countries (arguably some of the most economically successful in recent years) regularly have government spending of between 55% and 60%.

    • Thanks for commenting.

      I think China’s growth isn’t caused by government spending… its caused by supplying the world with cheap labor.

      Imho, all of China’s wealth comes from exports. No practical government directed spending is enough to cause outsiders to buy your products. It can help, but not control.

      I believe if you review economic data over time that you will find that tweaking an economy is the best that government fiscal policy can ever achieve.

      That is true both under democracies and under autocratic governments like China.

      Regarding 20% GDP… what works in economically small Scandinavian countries definitely does NOT work in a large economy like the United States.

  2. You forgot that during the end of the Clinton administration, the US was running $200 billion surpluses, and paying down the debt. At the time it got called the Social Security “lock box.” Bush W comes along as the country lapses into recession and signs big tax cuts and needs to ramp up the defense and security due to 9-11. This was actually Keynesianism in practice big time. But you are right about the downfall of pure Keynesianism. If you read his book you will see we are supposed to run balanced trade, and no permanent trade deficits. When the Chinese entered the WTO, the Chinese Labor Deflation Dragon hit the world economy, and we have no theory that knows how to solve this problem, be it Keynesianism or even massive money printing. We will be muddling for years, but will make it. The US has dealt with worse and gotten better. We need a real leader to take us to that spot, and America is waiting.

    • It is a popular misconception that Bill Clinton paid down the debt. That never happened.

      The last time the national debt was paid down was in 1956 and 1957 when it was paid down by $4 billion(1.4%). That was 55 years ago.

      You are correct that George W. was Keynesian in his economic policies and it resulted in doubling the national debt. Just because he is a Republican does not make what GW did proper policy.

      Your point about the Chinese and their effect on our economy is very astute. I’m clueless how to deal with it to, but pure Keynesian macroeconomics isn’t it.

  3. This is a Great Topic, forgot to mention that. And glad you are discussing it. The pundits are nauseating. Cannot bear to watch or read them any longer. Much prefer your blog approach.

    • I believe a fundamental flaw in Keynesian macroeconomics is that it has no mechanism that reacts to excessively high debt.

      Debt is treated as if it can and should be ignored under any conditions.

      The idea of counter-cyclical fiscal policy is solid, but it needs a built-in regulator that reacts to excessively high debt.

      • On debt a little known fact happened this month. At the recent Treasury auctions, the United States officially became a country where the accumulated debt exceeded the production of the whole economy. The US this month is now at over 100% of debt to GDP, first time in history, and scary.

      • Whether or not the U.S. has debt in excess of 100% of GDP depends on what you mean. The national debt has two combined parts:
        1 – “Debt Held by the Public”
        2 – “Intragovernmental Holdings”

        As of yesterday the ND stood at $15.4 trillion combined. According to the BEA the GDP was $15.1 trillion for 2011. We’ve flirted with 100% of GDP most of the 2nd half of 2011.

        However, “Intergovernmental holdings” is debt a government owes to itself. For example, the entire Social Security Trust fund was borrowed and spent so ii is now held as “intragovernmental holdings”.

        In economic circles, the only debt that REALLY counts is “Debt Held by the Public”. As of yesterday that was $10.7 trillion. That puts our actual debt-to-GDP level at 69.4%… not 100%.

        A debt-to-GDP level of 69.4% is high, but not excessively high debt according to economists. It needs to get to 85% before economists and investors get worried.

        When you read that Greece has debt at 140% of GDP or Japan has debt at 220% of GDP they are talking only about “debt held by the public”.

      • How come only here do I see the 69% number? Do not the takings from the Social Security Trust need to be paid as future liabilities? If so that is real debt it seems. If we really are at 69% why does the main stream press, and all the pundits and pols keeping pointing to the over 100%. There is some Treasury posting about a recent auction that lead folks to the we are over 100% mark. When it comes to debt, I agree that it depends on what it was spent on. A brain surgeon chalking up $300,000 will be able to pay it off and make a great living. So maybe the person paid 7% but the ROI must be 14% or more, so the debt was a good move.

      • Indeed, Randel, you are right… Social Security and Medicare Trust Fund borrowings are liabilities. That is why they are included as part of the total national debt.

        However, they are also interest bearing investments that benefit taxpayers because they grow in value.

        Intragovernment holdings are not considered part of “sovereign debt”. The government could default intragovernmental holdings without hurting outside investors.

        “Sovereign debt”, debt owed to other governments and to outside investors, is the type of debt that counts most against a government’s credit rating and worries investors. That MUST be paid back.

        The lower 69% figure is the U.S. federal government’s sovereign debt.

        U.S. sovereign debt is considered high but comfortably manageable by most economists.

      • This is an incredible detail that needs to be more widely distributed. There is so much hoopla that we will become or are Greece. This is a game changing fact. I wonder why the media do not talk about it more, unless as usual it falls into the are of the arcane for commercial news networks. Thank you for the extra discussion.

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