Monday, May 21, 2012

Refuting Krugman

Without exaggeration, we can say that Paul Krugman has become the modern Apostle of Keynesianism, philosophically enabling those who seek to indefinitely put off difficult austerity measures. At once, Krugman downplays the very threat of our growing national debt, while actually encouraging politicians to expand their profligate government spending. In spite of his impressive resume, his argument that the United States can grow and inflate its way out of debt, without undertaking significant budget cuts, is riddled with problems so obvious that even a first year economics student would catch them. In his writings, Krugman expresses a nostalgia for the "good old days" of the 1950's, usually seen in some less dynamic conservatives. He presents them as a model for how we should address our fiscal ills. In response to the question "how did (post war) America pay down its debt?" Krugman's responds:

"Actually, it didn't: federal debt rose from $219 billion in 1950 to $237 billion in 1960. But the economy grew, so the ratio of debt to GDP fell, and everything worked out fiscally."

Krugman's overlooks the fact that the diminishing ratio of debt to GDP occurred in the context of an unparalleled economic boom. Between 1947 - 1948, we enjoyed a growth rate of 4.8%, between 1950 - 1953, it surged to 7.5% and for the rest of the decade it hovered between the respectable rates of 3.7% and 3.9%. Even the most optimistic economists do not forecast economic growth anywhere near the aforementioned levels. Among the most obvious differences between the post war economic climate and our own are: 

-With Europe and Japan in ruins, and much of the world living under colonial rule and / or a
state of underdevelopment, the United States was the sole remaining economic power. Whereas we now face stiff global competition from the resurgent  nations of: China, India, Taiwan, South Korea and Brasil. Rising production and consumption in the said nations have pushed up the cost of energy and other commodities, which places a further constraint on the American Economy.

-American industries were largely national and immobile in nature, whereas now, most corporations are willing and able to shift production overseas, which has further eroded our near monopoly on industry.

-The post war economy greatly benefited from: the pent up consumer demand of returning
servicemen, the baby boom, urbanization, sub-urbanization and significant increases in
productivity. None of these conditions currently exist. 

Even if Krugman were correct that the Keynesian stimulus measures of the 1950's were instrumental in promoting economic prosperity and a net reduction in debt, for a myriad of economic reasons, they are no longer effective:

-The booming economy and low base line of debt of the early 1950s allowed the American
Government to pursue continued fiscal stimulus such as the Marshall Plan, increased military
spending, massive infrastructure projects, such as the expansion of the interstate highway system and tax cuts (for all but the highest income brackets). But, given our historically high spending to GDP ratio,  low rate of federal taxation, the Federal Reserve's near zero interest rate policy, stimulus measures undertaken by the administrations of George W Bush Barack Obama have prove to be unsuccessful. Think of it like this: a cup of coffee is a great stimulant for someone who rarely drinks it, but ineffective for the addict who has become accustomed to drinking a dozen cups a day. That individual needs high levels of caffeine to even function and will face headaches and lethargy if they limit their intake through "coffee austerity". 

Nor are massive stimulus measures even sustainable:

-Even Keynes recognized that spending spikes must occur in the context of a low baseline of
spending and debt. This is all the more pertinent, when we factor in the trillions of dollars in unfunded social security, medicare and pension liabilities that awaits us.

-Primarily due to the astronomical growth of entitlements, 'from 1962 to 2010, discretionary
spending as a share of the federal budget declined from 67.5% to 37.8% of total outlays. This has greatly limited our capacity to engage in targeted spending and infrastructure projects and made it all the more difficult to get our fiscal house in order.

-And if we continue our attempts to decrease our debt through inflation, sooner or later or domestic and foreign creditors will increase the cost of borrowing (interest rate) and even their willingness to finance our debt.  

While Krugman is correct that economic growth was an essential component in the reduction of the debt to GDP ratio, he fails to note other equally important aspects of the equation, that are completely inapplicable to our current situation:

-Deficits were reduced not only as a percentage of GDP, but also in absolute terms. Between 1945 to 1948 $45.553 billion dollar deficit was  transformed into a  $11.796 billion dollar surplusFor the remainder of the decade, the budget vacillated between surpluses and deficits, ending with a $0.301 billion dollar surplus. As a percentage of the GDP, the surplus rose as high as 4.6%, dipping into the negative range during an economic downturn and ending the decade with a surplus of 0.1% .  Fast forward to 2012 and the deficit has risen to a whopping 8.5% of the total GDP.

-In sharp contrast to the rapid increases in debt that occurred during the presidencies of GW Bush and Obama, during the post war period, the debt, in absolute terms, was held relatively constant. In 1946 it was $268.932 billion, by 1948 it had been reduced to $250.381 billion and by 1960, under the pressure of the cold war, it had modestly increased by 13.44% to $283.827 billion. In contrast, we now face $16.334 Trillion in debt! In other words, if we were (as Krugman suggests) to take the 1950's as a model, we would not simply "focus on growth", but also take the necessary steps to eliminate deficits and halt the growth of the national debt. 

-Krugman preaches the need to address economic downturns with Keynesian stimulus measures, with no consideration to how much they have increased the deficit and debt. Coupled with that, he offers outright inflation as a means to reduce the debt. But, interestingly, when we analyze economic records, we find that the leaders of the "golden age" did not hold similar views. For example, of the 4 recessions that occurred between1945 - 1958, the federal government only increased spending twice, while actually cutting it the other two times. And knowing that it would lead to an economic downturn, the Federal Reserve imposed a restrictive monetary policy as a means to avoid inflation. So, it would appear that even when faced with politically damaging recessions, they exercised relative fiscal and monetary restraint. 

-He overemphasizes the role of revenue in the post war fiscal health , while ignoring the importance of reduced spending. Between 1945 - 1949, tax revenues dropped from 20.4% to 14.5% (of the GDP), while outlays dropped much further, from 41.9% to 14.3% (of the GDP). By 1960 receipts and outlays had modestly risen to 17.8% (of the GDP). By 2012 revenues had declined to 15.8%, while outlays had risen to 24.3%. So, in order to return to the fiscal equilibrium of 1960, receipts would have to increase by 12.65% and spending would need to be cut by 26.75%. In other words, in order to restore fiscal health, spending cuts would have to exceed revenue increases by a ratio of more than 2-to-1. Nowhere in Krugman's writings is this perspective expressed. 

In summary, we were able to pay down our post war debt (as a percentage of GDP) with economic growth, but only in the context of  fiscal and monetary restrain that Krugman derisively refers to as "austerity".  And continuing our current levels of spending, based on assumptions that they will lead to economic growth is unthinkably irresponsible. First, the economic, political and demographic climate of the 1950's no longer exist. And any any businessperson can tell you that while a net return on costly investments is never guaranteed, the future payment of the principle and interest used to finance them are. No sane owner of a heavily indebted firm would undertake major investments, without first cutting costs, as a first step to get their fiscal house in order.  This is all the more true for government projects in which costs always exceed estimates and returns rarely, if ever match promises offered by politicians. In other words, we will in all likelihood face serious fiscal costs without any real economic benefits. 

I wracked my brain trying to determine how a man of Krugman's intellectual caliber could present such a poor analysis of the economic history of the 1950s. And even more I wondered how he could use this analysis to draw such obviously irresponsible policy prescriptions for our current economic and fiscal ills. The essential question is not if we as a nation will have to pay down our debt through austerity measures, bur rather who will pay for it? Our generation or the next? The only feasible explanation is that his political mission and party loyalty have superseded his commitment to truth, reason and intellectual honesty. For even great men will ignore knowledge that contradicts their religious like faith, for such faith not only  provides them hope, but also the adoration of their followers. 

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