Where Krugman Went Wrong
By Antal Fekete - September 15, 2010

Paul Krugman, writing in The New York Times on September 5 under the title "1938 in 2010", chastizes president Obama's economists once more for doing what they have promised not to do: to repeat the mistakes of president Roosevelt's economists in 1937 in pulling back fiscal stimulus too soon. According to Krugman, while president Obama's policies have limited the damage from the financial crisis to the economy, they have been too timid in opening the spigots to make money flow, as shown by levels of unemployment that is still disastrously high and increasing. He advocates applying more stimulus, nay, a burst of deficit-financing of the same order of magnitudes as that during World War II, which can amount to roughly twice the value of GDP, or $30 trillion.

The drive of Krugman's argument is that even an exorbitant increase in the national debt would be safe. It would not put the nation in danger of bankrupting itself — just as it didn't in WW II — because the accumulated debt could be easily paid off with the aid of the high level of economic growth that only such an extreme stimulus could generate. He says that the war debt was paid off painlessly during the post-war boom. The economy was able to thrive without continuing deficits, thanks to the improved financial position of the private sector. The moral of the story, he says, is that when the economy is deeply depressed, the usual rules don't apply.

Austerity is self-defeating: when everybody is trying to pay down debt at the same time, the result is depression and deflation, and debt problems grow even worse. Conversely, it is possible — indeed necessary, he says — for the nation as a whole "to spend its way out of debt" and then proceed "to spend its way back to prosperity". A temporary surge of deficit spending, on a sufficiently high scale, can cure the problems brought about by past excesses. It is precisely deficit spending on such a scale that is needed to create the economic boom that would lay the foundation of long-run prosperity.

It may be admitted that Krugman's argument has a certain intellectual appeal, much like Keynes' siren song about pump-priming in 1936 had. However, the parallel between retiring debt after WW II and his proposed retirement of debt after a $30 trillion spending spree by the government is invalid. Why? Because in 1945 the U.S. was still on a gold standard with the result that gold could be invoked to act as the ultimate extinguisher of debt. However, in 1971 the last vestiges of the international gold standard were thrown to the winds, leaving the world without such a tool. In spite of suggestions of Friedman that the irredeemable dollar could fill the golden shoes, it has failed miserably to be serviceable as the ultimate extinguisher of debt. Witness the fact that, ever since 1971, the total debt in the world could only increase, never to decrease — save default. And increase it still does with a vengeance. That has given us the Debt Moloch. The only way we can avoid the fate of being devoured by it alive is to go back to the gold standard — a solution which, surely, Krugman wouldn't think of advocating. Krugman's placidity and complacency in the face of the Debt Moloch is explained by his wrong interpretation of the historically low interest rates prevailing, and his apparent ignorance of the mechanism whereby government debt is monetized. A word as to each of these two perceptions is in order.

1. Keynesian economists offer a false interpretation of the artificially low interest rates at which the government is borrowing as a test of soundness of government credit, and as a measure of safety of investing in it. Therefore, they insist, all is well with our fiscal affairs. They go further. They treat low rates as a green signal on the road to mega-deficits. But in fact the government's credit is far from being sound. Upon comparison with more prosperous times, when our debt and tax burden was relatively small, when total debt was being reduced year in and year out, when public credit was as solid as it could be, the interest rates on government borrowing were much higher than they are now. Government bonds were bought by genuine investors using genuine savings. Bond speculation was unknown and non-existent. The government was compelled to borrow in a competitive market. Excessively low interest rates on government securities are not a sign of health. On the contrary: they are symptomatic of a depression. They are evidence of the fact that funds to be lent go begging. There is a widespread lack of confidence in business circles. The lethargy of businessmen prevents them from expanding production and making new investments. They do not see how profits could be made that beat the rate of interest, however low the latter might be.

2. Keynesian economists are also guilty of deliberately obscuring the mechanism whereby the debt of the government is monetized by the banking system. They want to create the impression that the public, that is, individual investors at home and abroad buy the government paper for purposes of saving. The truth, however, is that individuals have long since stopped saving in the form of government paper, which they look at as "certificates of guaranteed confiscation". Their role has been taken over by bond speculators who make a killing on their holdings of bonds when interest rates go down, and they make a killing on their short positions in bond futures when interest rates go up. In either case, they make their profits at the expense of the public. Recall that such profiteering is ruled out under the gold standard — the only agent that can stabilize interest rates and bond prices.

But — and this is what Keynesians are hiding from the people — by far the largest part of government debt is held by the banking system. To the extent that banks finance government borrowing, future (as opposed to present) savings are being used, with disastrous consequences. The government sells its bonds to the banks; the banks use these as assets and create demand deposits against them, thus acting as an intermediate agency for converting the government's promises to pay in the distant future into bank deposits that can be used immediately as cash. The ratio of reserves to deposits declines. The banks put their credit-clearing facilities and their cash at the disposal of the government. This procedure is called "monetizing government debt". It cannot continue indefinitely: it can only continue until surplus bank reserves have been exhausted.

Monetization of government debt by the banking system is a thoroughly bad policy. It is the engine of inflation as deposit currency payable on demand is created against the government's promises to pay in the distant future. It is the classical example of borrowing short and lending long.

But it could also be an engine of deflation. Here is what happens. Bond speculators are watching. When the banks get overextended as they approach the limit set by their ratio of reserves to deposits, the speculators dump the bonds en masse causing a steep rise in the rate of interest. The corresponding drop in bond prices wipes out the entire capital and surplus of all banks simultaneously, as it happened in 1920 and, again, in 1980. The banks still have not recovered from the latter episode. So many, if not all of them are zombies, operating by the grace of government on negative capital. The abrupt and steep rise is followed by a slow, extended fall in interest rates. Such a fall has the effect of destroying capital across the board, as the liquidation value of debt rises. The banks are not exempt from capital destruction. The upshot is prolonged deflation feeding upon itself. This is the true explanation of the Great Depression of the 1930's, and this is the story behind Great Depression II now unfolding.

It must also be remembered that taxes have to be levied to repay the government debt. Here Krugman has another "blind spot". Higher taxes dull the efficiency of the private sector in creating wealth. As the government repays its debt, money will accumulate as surplus reserves in the banks and will then start scrambling in search for outlets. The only way these surplus bank reserves can be used is for the people or the government to borrow from the banks again. Thus deficit spending breeds more deficit spending and debt breeds more debt, not less. Bank capital is at risk when the rate of interest rises but, for different reasons, it is also at risk when the rate of interest falls.

Keynesians are fond of saying that government debt does not matter because "we owe it to ourselves". This is a vicious notion. The next generation will have to pay heavy, repressive and disturbing taxes, not to themselves, but to pile up surplus bank reserves. The wealth that future generations have yet to produce will be used to retire the currency now being issued against it. To achieve this "miracle of turning the stone into bread", people are being put into debt-slavery to the banks, and into tax-slavery to the government. This is a recipe for perpetual deflation, or for perpetual inflation, or a mixture of both. It is not a recipe for future prosperity.

Only an austerity program can stop the runaway debt tower, and that only under a gold standard. It is to be regretted that Krugman has, as Keynes had before him, completely failed to grasp the role of the gold standard as the regulator of the level of debt in the economy that would sound the alarm if safe levels of indebtedness were exceeded — just as he is missing the curative effects of the gold standard.

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