Paul Krugman’s Economic Blinders
Posted on May 14, 2012 by Mitch Green
By
Michael Hudson
Paul Krugman is widely appreciated for his
New York Times
columns criticizing Republican demands for fiscal austerity. He rightly
argues that cutting back public spending will worsen the economic
depression into which we are sinking. And despite his partisan
Democratic Party politicking, he warned from the outset in 2009 that
President Obama’s modest counter-cyclical spending program was not
sufficiently bold to spur recovery.
These are the themes of his new book,
End This Depression Now.
In old-fashioned Keynesian style he believes that the solution to
insufficient market demand is for the government to run larger budget
deficits. It should start by giving revenue-sharing grants of $300
billion annually to states and localities whose budgets are being
squeezed by the decline in property taxes and the general economic
slowdown.
All this is a good idea as far as it goes. But Mr. Krugman stops there – as if that is
all
that is needed today. So what he has done is basically get into a fight
with intellectual pygmies. Thus dumbs down his argument, and actually
distracts attention from what is needed to avoid the financial and
fiscal depression he is warning about.
Here’s the problem: To focus the argument against “Austerian”
advocates of fiscal balance, Mr. Krugman hopes that economists will stop
distracting attention by talking about what he deems
not necessary. It seems
not
necessary to write down debts, for example. All that is needed is to
reduce interest rates on existing debts, enabling them to be carried.
Mr. Krugman also does not advocate shifting taxes off labor onto
property. The implication is that California can afford its Proposition
#13 – the tax freeze on commercial property and homes at long-ago
levels, which has fiscally strangled the state and led to an explosion
of debt-leveraged housing prices by leaving the site value untaxed and
hence free to be pledged to banks for larger and larger mortgage loans
instead of being paid to the public authorities. There is no hint in Mr.
Krugman’s journalism of a need to reverse the tax shift off real estate
and finance (onto income and sales taxes), except to restore a bit more
progressive taxation.
The effect of Mr. Krugman’s suggestions is for the government to
subsidize the existing financial and tax structures, leaving the debts
intact and ignoring the largely regressive, unfair and inefficient
system of taxation. It is unfair because the profits of the rich – and
even worse, their asset-price (“capital”) gains are taxed at lower rates
and riddled with tax loopholes and giveaways. The wealthy benefit from
the windfall gains delivered by the public infrastructure investment
advocated by Mr. Krugman, but there is not a word about the public
recouping this investment. Governments are indeed able to create their
own money as an alternative to taxing, but some taxes – above all, on
windfall gains, like site value resulting from public investment in
roads or other public transportation – are justified simply on grounds
of economic fairness.
So it is important to note what Mr. Krugman does not address these
issues that once played so important a role in Democratic Party
politics, before the Wall Street faction gained control via the campaign
financing process – even before the Citizens United case. For over a
century, economists have recognized the need for financial and fiscal
reform to go together. Failure to proceed with a joint reform has led
the banking and financial sector – along with its major client base, the
real estate sector – to scale back property taxes and “free” the
economy with taxes so that the revenue can be pledged to the banks as
interest to carry larger loans. The effect is to load the economy at
large down with private and public debt.
In Mr. Krugman’s reading, private debts need not be written down or
the tax system made more efficient. It is to be better subsidized –
mainly with easier bank credit and more government spending. So I am
afraid that his book might as well have been subtitled “How the Economy
can Borrow its Way Out of Debt.” That is what budget deficits do: they
add to the debt overhead. In Europe, which has no central bank permitted
to monetize the deficit spending, this pays interest to transfers to
the bondholders (and their descendants). In the United States the
Federal Reserve can monetize this indebtedness – but the effect is to
subsidize domestic debt service.
Mr. Krugman has become censorial regarding the debt issue over the last month or so. In last Friday’s
New York Times
column he wrote: “Every time some self-important politician or pundit
starts going on about how deficits are a burden on the next generation,
remember that the biggest problem facing young Americans today isn’t the
future burden of debt.”
[1]
Unfortunately, Mr. Krugman’s failure to see today’s economic problem as
one of debt deflation reflects his failure (suffered by most
economists, to be sure) to recognize the need for debt writedowns, for
restructuring the banking and financial system, and for shifting taxes
off labor back onto property, economic rent and asset-price (“capital”)
gains. The effect of his narrow set of recommendations is to defend the
status quo – and for my money, despite his reputation as a liberal, that
makes Mr. Krugman a conservative. I see little in his logic that would
oppose Rubinomics, which has remained the Democratic Party’s program
under the Obama administration.
Many of Mr. Krugman’s readers find him the leading hope of opposing
even worse Republican politics. But what can be worse than the
Rubinomics that Larry Summers, Tim Geithner, Rahm Emanuel and other Wall
Street holdovers from the Democratic Leadership Committee have
embraced?
Perhaps I can prod Mr. Krugman into taking a stronger position on
this issue. But what worries me is that he has moved sharply to the
“Rubinomics” wing of his party. He insists that debt doesn’t matter.
Bank fraud, junk mortgages and casino capitalism are not the problem, or
at least not so serious that more deficit spending cannot cure it.
Criticizing Republicans for emphasizing structural unemployment, he
writes: “authoritative-sounding figures insist that our problems are
‘structural,’ that they can’t be fixed quickly. … What does it mean to
say that we have a structural unemployment problem? The usual version
involves the claim that American workers are stuck in the wrong
industries or with the wrong skills.”
[2]
Using neoclassical sleight-of-hand to bait and switch, he narrows the
meaning of “structural reform” to refer to Chicago School economists
who blame today’s unemployment as being “structural,” in the sense of
workers trained for the wrong jobs. This diverts the reader’s attention
away from the pressing problems that are
genuinely structural.
The word “structural” refers to the systemic imbalances that
neoclassical economists dismiss as “institutional”: the debt overhead,
the legal system – especially unfair and dysfunctional bankruptcy and
foreclosure laws, regulations against financial fraud, and wealth
distribution in general. In 1979, for example, I juxtaposed economic
structuralism to Chicago School monetarism in my monograph on
Canada in the New Monetary Order. I have elaborated that discussion my textbook on
Trade, Development and Foreign Debt
(new ed. 2010). The tradition is grounded in the Progressive Era’s
reform program. Correcting such structural and institutional defects,
parasitism and privilege seeking “free lunches” is what classical
political economy was all about – and what the neoclassical reaction
sought to exclude from the economic curriculum. But from the perspective
of neoclassical writers through Rubinomics deregulators, the problem of
massive, unpayably high debt expanding inexorably by compound interest
(and penalty fees) simply disappears
So the great problem today is whether to stop the siphoning off of
income and wealth to financial institutions at the top of the economic
pyramid, or reverse the polarization that has taken place over the past
thirty years between creditors and debtors, financial institutions and
the rest of the economy. I realize that it is more difficult to
criticize someone for an error of omission than for an error of
commission.
But the distinction was erased a month ago when Mr. Krugman got lost in
the black hole of banking, finance and international trade theory that
has engulfed so many neoclassical and old-style Keynesian economists.
But last month Mr. Krugman insisted that banks do not create credit,
except by borrowing reserves that (in his view) merely shifts lending
savings from wealthy people to those with a higher propensity to
consume. Criticizing Steve Keen (who has just published a second edition
of his excellent
Debunking Economics to explain the dynamics of endogenous money creation), he wrote:
Keen then goes on to assert that lending is, by definition (at least
as I understand it), an addition to aggregate demand. I guess I don’t
get that at all. If I decide to cut back on my spending and stash the
funds in a bank, which lends them out to someone else, this doesn’t have
to represent a net increase in demand. Yes, in some (many) cases
lending is associated with higher demand, because resources are being
transferred to people with a higher propensity to spend; but Keen seems
to be saying something else, and I’m not sure what. I think it has
something to do with the notion that creating money = creating demand,
but again that isn’t right in any model I understand.
Keen says that it’s because once you include banks, lending increases
the money supply. OK, but why does that matter? He seems to assume that
aggregate demand can’t increase unless the money supply rises, but
that’s only true if the velocity of money is fixed;
[3]
But “velocity” is just a dummy variable to “balance” any given
equation – a tautology, not an analytic tool. As a neoclassical
economist, Mr. Krugman is unwilling to acknowledge that banks not only
create credit;
in doing so, they create debt. That is
the essence of balance sheet accounting. But writing like a tyro, Mr.
Krugman offers the mythology of banks that can only lend out money taken
in from depositors (as though these banks were good old-fashioned
savings banks or S&Ls, not what Mr. Keen calls “endogenous money
creators”). Banks create deposits electronically in the process of
making loans.
Mr. Krugman then doubled down on his assertion that bank debt
creation doesn’t matter. People decide how much income they want to
save, or decide how much to borrow to buy goods that their stagnant wage
levels no longer enable them to afford. Everything is a matter of
choice, not a
necessity (“price-inelastic” is the neoclassical euphemism):
First of all, any individual bank does, in fact, have to lend out the
money it receives in deposits. Bank loan officers can’t just issue
checks out of thin air; like employees of any financial intermediary,
they must buy assets with funds they have on hand.
So how much currency does the public choose to hold, as opposed to
stashing funds in bank deposits? Well, that’s an economic decision,
which responds to things like income, prices, interest rates, etc.. In
other words, we’re firmly back in the domain of ordinary economics, in
which decisions get made at the margin and all that. Banks are
important, but they don’t take us into an alternative economic universe.
As I read various stuff on banking — comments here, but also various
writings here and there — I often see the view that banks can create
credit out of thin air. There are vehement denials of the proposition
that banks’ lending is limited by their deposits, or that the monetary
base plays any important role; banks, we’re told, hold hardly any
reserves (which is true), so the Fed’s creation or destruction of
reserves has no effect.
[4]
Not only do banks create new credit – debt, from the vantage point of
their customers – but in the absence of government spending and
regulation along more progressive lines, this new debt creation is the
only way that the economy has avoided a sharp shrinking of consumption
as real wages have remained stagnant since the late 1970s. The banks
offer is one most people can’t refuse: “Take out a mortgage or go
without a home,” or “Take out a student loan or go without an education
and try to get a job at McDonald’s.” In other words, “Your money or your
life.” It is what banks have been saying through the ages. The
difference is that they can now create credit freely – and as Alan
Greenspan has pointed out to Senate committees, workers are so
debt-burdened (“one check away from homelessness”) that they are afraid
that if they complain about working conditions, ask for higher salaries
(to say nothing of trying to unionize), they will be fired. If they miss
a paycheck their credit-card rates will soar to about 29%. And if they
miss a mortgage payment, they may face foreclosure and lose their home.
So the banking system has cowed the population with its credit- and
debt-creating power.
Mr. Krugman’s blind spot with regard to the debt overhead derails
trade theory as well. If Greece leaves the Eurozone and devalues its
currency (the drachma), for example, debts denominated in euros or other
hard currency will rise proportionally. So Greece cannot leave without
repudiating its debts in today’s litigious global economy. Yet Mr.
Krugman believes in the old neoclassical nonsense that all that is
needed is “devaluation” to lower the cost of domestic labor. It is as if
he is indifferent to the suffering that such austerity imposes – as
Latin American countries suffered at the hands of IMF austerity plans
from the 1970s onward. Costs can “be brought in line by adjusting
exchange rates.”
[5]
The problem thus is simply one of exchange rates (which translates into
labor costs in short order). Currency depreciation will (in Mr.
Krugman’s trade theory) reduce labor’s cost and other domestic costs to
the point where governments can export enough not only to cover their
imports, but to pay their foreign-currency debts (which will soar in
depreciated local-currency terms).
If this were the case, Germany could have paid its reparations debt
by depreciating the mark in 1921. But it did so by a billion-fold, even
this did not suffice to pay. Neither neoclassical trade theorists nor
Chicago School monetarists get the fact that when public or private
debts are denominated in a foreign (hard) currency, devaluation
devastates the economy. The past half-century has shown this again and
again (most recently in Iceland). Domestic assets are transferred into
foreign hands – including those of domestic oligarchies operating out of
their offshore dollar or Swiss-franc accounts.
Blindness to the debt issue results in especial nonsense when applied
to analysis of why the U.S. economy has lost its export
competitiveness. How on earth can American industry be expected to
compete when employees must pay about 40 percent of their wages on
debt-leveraged housing, about 10 percent more on student loans, credit
cards and other bank debt, 15 percent on FICA, and about 10 to 15
percent more in income and sales taxes? Between 75 and 80 percent of the
wage payment is absorbed by the Finance, Insurance and Real Estate
(FIRE) sector even before employees can start buying goods and services!
No wonder the economy is shrinking, sales are falling off, and new
investment and hiring have followed suit.
How will the government running a larger deficit cope with today’s
dimension of the debt problem – except by taking Mr. Krugman’s
suggestion to enable states and localities to spend marginally more
revenue and avoid further layoffs, while the military industrial complex
steps up its “Pentagon capitalism”? So far, the great increase in
recent government debt has been to bail out the banking sector, not to
help the “real” economy recover.
Increasing the debt burden of European nations has the same dire
consequences. Germany balks at bailing out Greece unless Greece moves to
streamline its bloated government and inefficient bureaucracy, stop tax
evasion by the wealthy, clean up corruption and, in a word, be more
Germanic. The U.S. “Austerian” budget cutters whom Mr. Krugman
criticizes likewise can point to wasteful government spending, failing
to distinguish positive infrastructure investment from pork-barrel
“roads to nowhere” and tax loopholes promoted by Congressional
politicians whose campaigns are sponsored by special financial
interests, real estate and monopolies.
But I fear that Mr. Krugman is being drawn into the gravitational
pull of Rubinomics, the Democratic Party’s black hole from which the
light of clarity dealing with the debt issue and bad financial and legal
structures simply cannot escape. The only variables he admits are
structure-free: The federal government can indeed spend more and reduce
interest rates (especially on mortgages) so that the higher mortgage
debt, student debt, personal debt and corporate debt overhead can be
afforded more easily. No need to write any of these debts down. That
seemingly obvious and sensible structural solution lies outside the
scope of Mr. Krugman’s neoclassical economics. He fails to recognize
that debts that can’t be paid, won’t be. This is the immediate problem
facing the U.S. and European economies today – and the way in which it
is resolved will shape the coming generation.
The problem with Mr. Krugman’s analysis is that bank debt creation
plays no analytic role in Mr. Krugman’s proposals to rescue the economy.
It is as if the economy operates without wealth or debt, simply on the
basis of spending power flowing into the economy from the government,
and being spent on consumer goods, investment goods and taxes – not on
debt service, pension fund set-asides or asset price inflation. If the
government will spend enough – run up a large enough deficit to pump
money into the spending stream, Keynesian-style – the economy can revive
by enough to “earn its way out of debt.” The assumption is that the
government will revive the economy on a broad enough scale to enable the
individuals who owe the mortgages, student loans and other debts – and
presumably even the states and localities that have fallen behind in
their pension plan funding – to “catch up.”
Without recognizing the role of debt and taking into account the
magnitude of negative equity and earnings shortfalls, one cannot see
that what is preventing American industry from exporting more is the
heavy debt overhead that diverts income to pay Finance, Insurance and
Real Estate (FIRE) expenditures. How can U.S. labor compete with foreign
labor when employees and their employers are obliged to pay such high
mortgage debt for its housing, such high student debt for its education,
such high medical insurance and Social Security (FICA withholding),
such high credit-card debt – all this even before spending on goods and
services?
In fact, how can wage earners even afford to buy what they produce?
The problem interfering with the circular flow between producers and
consumers (“Say’s Law”) is not “saving” as such. It is debt payment. And
unless debts are written down, the U.S. economy will shrink just as
will the economies of Greece, Spain, Portugal, Italy, Ireland, Iceland
and other countries subjected to the Washington Consensus of neoliberal
austerity.
Michael Hudson’s new book summarizing his economic theories, “The
Bubble and Beyond,” will be available in a few weeks on Amazon.
[1] Paul Krugman, “Easy Useless Economics,”
The New York Times, May 11, 2012.
[3] Paul Krugman, “Conscience of a Liberal” blog, March 27, 2012,
Minsky and Methodology (Wonkish).
[4] Banking Mysticism, Continued, “The Conscience of a Liberal,” March 30, 2012.
http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/?emc=eta1
[5] Paul Krugman, “The Euro Trap,”
The New York Times, April 30, 2010.
