Paul Krugman's Bad Economics

By: Gerard Jackson | Sun, Mar 14, 2010
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Paul Krugman, the New York City left's favourite economist, has been spouting his usual Keynesian nonsense. Nevertheless, statists continually appeal to his alleged authority in economics to support their own interventionist ideas. But does Krugman's record make him an economist who is really worthy of their adulation? Some years ago Charles Goodhart addressed a conference at the London School of Economics at which he claimed that Japan provided evidence for the existence of the liquidity trap, a situation in which interest rates fall so low that demand does not react. If one adopts this view then one is only a short step from proposing that the solution to such a situation is the printing press. And that is exactly what Goodhart did.

And right behind Goodhart there was Paul Krugman who urged Japan's central bank to fuel inflationary expectations and reduce savings by flooding the economy with money. Now this is the kind of monetary policy that got Japan into its present state in the first place. Not 'excess' savings, as our own John Stone smugly asserted, and certainly not the mythical liquidity trap, to which I shall now turn.

According to this fallacy when people come to believe that interest rates will rise and thus bond prices will fall liquidity preference (the demand for cash balances) becomes so intense the rate of interest cannot fall low enough to stimulate investment. Therefore, trying to stimulate the economy with low interest rates is like "pushing on a string". The only problem with this so-called analysis is that it is utterly and dangerously wrong.

The first thing about the Keynesian liquidity trap that should strike anyone conversant with Keynesian thinking is that it completely reverses the Keynesian explanation of what determines the interest rate. Keynes argued that it was determined by liquidity preference and the supply of money.

But the liquidity trap clearly assumes that the demand to hold money is determined by the rate of interest, meaning that this demand should vary inversely with changes in the rate of interest. If this is so, what then determines the rate of interest? Sir Dennis Robertson, a far shrewder economist than either Goodhart or Krugman can ever hope to be, was keenly aware of this contradiction causing him to cleverly write:

Thus the [Keynesian] rate of interest is what it is because it is expected to become other than it is; if it is not expected to become other than it is, there is nothing left to tell us why it is what it is. The organ which secretes it has become amputated. And yet it somehow still exists a grin without a cat.

Moreover, the Keynesian explanation of interest should actually see interest rates peak during a depression and bottom out during a boom. Hence Japanese interest rates should have been very high. The truth is that the monetary explanation for interest is one of the oldest fallacies in economics.

Twenty-four years before Keynes The General Theory of Employment, Interest and Money was published Professor von Mises called the monetary theory of interest one of "unsurpassable naivité" (The Theory of Money and Credit). Professor Frank Knight wrote that "no monetary change has any direct and permanent effect on the rate [of interest]" (On the History and Method of Economics, 1956). There is really no theoretical or historical support for Keynes, monetary explanation.

As we have seen, the liquidity trap concept unconsciously abandons Keynes' interest theory in favour of an indeterminate and unknown force. Our conclusion, therefore, is that the liquidity trap is a Keynesian fiction. No wonder the likes of Allan Meltzer, professor of economics at Carnegie Mellon University argue that "No country has ever been in a liquidity trap".

But even from a purely monetary angle the liquidity trap does not really make sense because governments can print as much money as they like. A fact that Charles Goodhart pointed out. This reality was behind his proposal that the Bank of Japan should "buy everything in sight", including bonds, property, etc.

Unfortunately, if it's a choice between facts and reason and bashing George Bush, Krugman will always sacrifice the former to engage in the latter. He now figured that he could use the liquidity trap to savage Bush with impunity and frighten the public with baseless threats of deflation, which he defines as a falling price level. (In fact, deflation is a contraction in the absolute quantity of money. A very different thing from a falling price level).

In support of his thesis he drew on the IMF for support, no doubt hoping that readers have forgotten the insults he has hurled at that organisation for its incompetence. All of sudden, though, the very organisation he treated with contempt became a reputable authority on deflation.

Not only did he backtrack on the IMF this brilliant economist also argues that once "an economy is caught in such a trap, it's likely to slide into deflation" and that " ... the most important reason to fear deflation is that it can push an economy into a liquidity trap". This is not a dowdified statement. It is a genuine Krugman contradiction.

That the fictitious liquidity trap had to be conjured up as an alternative explanation because Keynesian pump priming failed is the kind of heretical thinking that this Keynesian cultist evidently cannot tolerate. This is probably why he ignores the contradiction that exists between liquidity-trap thinking and the ability of the central bank to flood the economy with money.

Actually, Krugman's statement that "additional cash pumped into the economy -- added liquidity -- sits idle, because there's no point in lending money out if you don't receive any reward" demolished the liquidity preference theory. Let us go back to the 1930 to see why. Despite what Keynesians argue the 1930s are a tragic example of what happens when wage rates are maintained above their market clearing rates. When depression struck the U.S. the quantity of money contracted by about 35 per cent from June 1929 to June 1933 and consumer prices fell by 25 per cent.

However, the Hoover Administration fought against any cuts to money wages in the belief that maintaining them would restore prices and lift the economy out of depression. Statistics from the United States Bureau of Economic Analysis painted a stark picture of what this policy did to profits.

In 1929 the two-way division between employees and corporations was 81.6 per cent and 18.4 per cent respectively. In 1933 employees share had rocketed to 99.4 per cent, payrolls fell from $32.3 billion to $16.7 billion and unemployment rose to a horrific 25 per cent.

The tragedy of overpricing labour was compounded by heavy taxation and the introduction of labour legislation that was guaranteed to savage the ability of business to invest and hire. No wonder the depression was so deep and lasting. But when it comes to the Great Depression Krugman is not the man to ask anymore than Bernanke is. I would even go so far as to suggest that Krugman has absolutely nothing of value to say on the subject.

I have never doubted America's ability to rapidly recover from recessions without the need for Keynesian snake oil. What I do fear is the capacity of politicians like the leftwing Obama and those who influence them to sabotage that ability. In the meantime, Krugman and his ilk will continue to do all they can to poison the economic waters.

 


 

Author: Gerard Jackson

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

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