How to Deal with Economic History

In a recent article at the NYT entitled 'Incredible Credibility', Paul Krugman once again takes aim at those who believe it may not be a good idea to let the government's debt rise without limit. In order to understand the backdrop to this, Krugman is a Keynesian who thinks that recessions should be fought by increasing the government deficit spending and printing gobs of money. Moreover, he is a past master at presenting whatever evidence appears to support his case, while ignoring or disparaging evidence that seems to contradict his beliefs.

Among the evidence he ignores we find e.g. the 'stagflation' of the 1970's, or the inability of Japan to revive its economy in spite of having embarked on the biggest government deficit spending spree ever in a modern industrialized economy. Evidence he likes to frequently disparage is the evident success of austerity policies in the Baltic nations (evident to all but Krugman, one might say).


As readers of this blog know, we are generally of the opinion that it is in any case impossible to decide or prove points of economic theory with the help of economic history – the method Krugman seems to regularly employ. This is why we listed the evidence he ignores or disparages: the fact that there exists both plenty of evidence that contradicts his views and a much smaller body of evidence that seems to support them at an unreflected first glance, already shows that the positivist approach to economic theory must be flawed.

An economist must in fact approach things exactly the other way around, but then again it is a well-known flaw of Keynesian thinking in general that it tends to put the cart before the horse (examples for this would be the idea that one can consume oneself to economic wealth instead of saving and investing toward that goal, or that employment creates growth; it is exactly the other way around in both cases).

So how must one approach the 'evidence' of economic history? As we have shown on numerous occasions, an especially dumb method is to look at prices in financial markets and then conclude that these markets 'know' something about the future. The proper method is to have a tenable, causal-realist economic theory first, and then employ that in interpreting the facts of economic history. Most historians, even so-called economic historians, have failed in this task. The reason why one must use this approach is that economics is not like physics: there are no repeatable experiments one could conceivably conduct to 'test' a hypothesis.  Human beings are not rocks, they have minds and volition, they pursue goals and must employ scarce economic means to attain them.  One therefore requires a theory of human action before embarking on the task of interpreting economic history.  Every incidence of economic history is unique, and subject to a myriad of disparate factors that are interlocking and producing the outcomes observed. It is not even possible to isolate all these factors with precision. And yet, underlying each episode are undoubtedly the laws of praxeology and economics – they constrain both our interpretations of the past as well as our forecasts of the future.


What Do Financial Markets Know?

As noted above, financial markets really don't 'know' anything. It is certainly true that their prices convey signals to actors in the economy, but given the fact that money is centrally planned by a bureaucracy, these signals are more often than not grossly distorted and misleading.

In his article Krugman discusses the fact that both the UK and the US currently  have very low government bond interest rates – and complains that some observers ascribe the UK's low level of interest rates to 'austerity'. If that's the case, so Krugman asks, then why are they also low in the 'non-austere' US? Of course the whole point of the exercise is to disparage fiscal restraint. Krugman already  makes a major misstep by taking it as a given that there is actually 'austerity' in the UK. In reality, there is only talk about austerity; the thing as such doesn't yet exist. Here is for instance a recent Bloomberg report entitled: “UK Deficit Unexpectedly Swells on Spending Gain”. We read there:


Worse-than-expected public sector borrowing in October has put the pressure back on the chancellor,” Robert Wood, an economist at Berenberg Bank in London who was advising Bank of England policy makers until earlier this year, said in an e- mailed note. “Stalling growth means the deficit is likely to overshoot official forecasts this year, while the growth forecasts in the last budget are likely to be scaled back.”


(emphasis added)

Does this strike anyone as an example of 'austerity'? In the UK is has never been more than a hollow phrase, a political slogan. The reality has so far failed to live up to it.

Krugman also cavalierly omits the not insignificant fact that the Bank of England has bought some £375 billion of outstanding UK gilts, almost 30% of the long term government debt in issue. Could it be that this might have had an effect on their interest rates? Similarly, in 2011, the Fed bought some 60% of the treasury debt issued that year in the course of 'QE2'. With 'Operation Twist' it has continued to remove long term debt from the market.

However, Krugman does of course mention that possession of the printing press is an advantage in these matters. Let us look at what he writes:


“There’s an interesting mix of contrast and similarity between the policy debates in Britain and the United States right now. In both countries — as in every country that retains its own currency and has debts denominated in that national currency — interest rates are near record lows.

However, Very Serious People tell very different stories in the two nations. In the United States, we supposedly have low borrowing costs despite our budget deficit — and if we don’t implement Bowles-Simpson immediately, the bond vigilantes will attack. Really! This time we mean it!

Meanwhile, in the UK, the official line is that the low rates are a reward for all that fiscal austerity — and VSPs get upset and abusive if someone well-informed points out that a much better explanation is that investors expect the economy to remain weak, and hence for short-term rates to remain very low, for a long time.

Let’s unpack this a bit. It’s very hard to come up with any reason why either the US or the UK might default, since they can simply print money if they need cash. And given the absence of real default risk, long-term interest rates should be more or less equal to an average of expected future short-term rates (not exactly, because of maturity risk, but that’s a fairly minor detail).

So if you expect the US and UK economies to be depressed for a long time, with the central bank keeping rates low, long rates will be low too — end of story.

But won’t that money printing cause inflation? Not as long as the economy remains depressed. Budget deficits could lead people to expect higher inflation down the road, once the slump finally ends — but that would be a good thing for the economy in the short run, discouraging people from sitting on cash and weakening the exchange rate, thereby making exports more competitive.

The point, then, is that the whole “credibility” argument is incoherent.”


Let's for the moment leave aside  the absurd contention made at the end of his post that 'inflation' (here meaning rising prices of goods and services) and a depreciating currency are somehow 'good'.

First, here are a few things we agree with:

Krugman is correct that expectations regarding the economy's future performance play a role in keeping interest rates low. It would be more precise to state that the associated 'inflation expectations' (i.e., the market's estimate of the future rate of change of CPI) are affecting long term interest rates. Moreover, there is the fact that a large group of investors has been scared of investing in assets deemed risky since the 2008 crisis. This can be seen by looking at yields on highly rated government bonds everywhere. Since 2008 there has also been a growing shortage of highly rated debt, which plays an important role as collateral in repo markets. This is yet another reason why such debt is being bid up. Some countries even enjoy negative nominal interest rates on the short end of the maturity curve. So rates are kept low  not only due to the fact that central banks are shrinking the supply of debt with quantitative easing.  Krugman is also correct that 'austerity' isn't what keeps UK interest rates low, not least because there simply is no 'austerity' in the UK.

However, he then commits a grave error: for one thing, he concludes that the markets 'know' something, and that therefore one shouldn't worry about how big the public debt mountain becomes, especially not if the country concerned has its own money printing press at its disposal.

To this we would counter: 5 year credit default swaps on Greek government debt sold for 35 basis points in 2007. Four years later, Greece defaulted and the same CDS had soared to more than 26,800 basis points. What did the market 'know' in 2007? It 'knew' that no sovereign debtor in the developed world would ever default. What did it know four years later? That Greece would default with absolute certainty.

It is the same story with the ultra-low interest rates on the government debt of countries that is currently rated AA or AAA. Today, the markets 'know' that this debt is 'safe' . This fact per se tells us precisely nothing about future states of knowledge. A few years hence, the markets may 'know' decidedly otherwise.


Defaults and the Printing Press

However, so Krugman would counter, taking a leaf from the chartalist 'State Theory of Money' (today called 'MMT'), Greece didn't have control over the printing press! Surely it would never have defaulted if it did!

We would say that depends on one's definition of 'default'. In all likelihood, given the size of Greece's debt and the intractable corruption and inefficiency of its administration, it would have inflated its currency into oblivion. That would effectively have been a default as well, even if not a 'formal' one. The bonds would still have been repaid; only with money worth perhaps one tenth of what it was worth when the debt was contracted. For bond holders it makes no practical difference if they get 10 lepta on the drachma after a 'formal' default or after the value of the drachma has been destroyed.

Krugman then compounds his error by asserting that there is an 'absence of default risk' in the rest of the developed world (ex the European periphery, one presumes). That is a big leap of the imagination; in fact, if nothing is changed about the 'mandatory' portion of government spending on future entitlements, default – one way or the other – seems all but certain.

Not content with making such sweeping pronouncements about an unknown future, Krugman then asserts that “But won’t that money printing cause inflation? Not as long as the economy remains depressed”.

As Kyle Bass noted in a recent letter to investors in Hayman Capital, this entire train of thought – that governments who have their own printing press won't default and that there can be no inflation in a depressed economy – may be one of the most dangerous misconceptions of our time.

Leaving aside that every single housewife in America and Europe would gape at Krugman's statement about inflation in recessionary times with incredulity (after all, just because the effects of inflation on prices don't show up in government's 'CPI' statistics does not mean that such effects are not noticeable), Krugman seems to have completely forgotten that Keynesians said the same thing in the 1950s and the 1960s, and then found themselves completely unable to explain the 'stagflation' of the 1970s. In fact, this episode almost buried the Keynesian dogma for good. It is no coincidence that people like Milton Friedman and Friedrich Hayek rose to prominence during the decade. Krugman has conveniently forgotten it ever happened.

However, if one thinks things through properly, one should realize that a weak economy is by no means a 'guarantee' for tame 'price inflation', given that central banks indeed print a lot of money whenever the economy weakens. Assume for instance that the credit boom preceding the bust has weakened the economy's pool of real funding to such an extent that it is no longer possible to divert resources toward various bubble activities. The production structure will have to be shortened then, no matter how much additional money is thrown into the economy, as the real resources necessary to keep the existing length of the structure intact simply won't be there. As Ludwig von Mises reminds us (in Human Action, ch. XX, 6 ):


“However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media.”


By necessity this will over time lower the economy's output. Then, at some future point, there will arise a situation when fewer goods are chased by a massively grown wall of money. In short, recessions actually have an inbuilt long term tendency to negatively influence the purchasing power of money both from the monetary policy side as well as from the goods-induced side.

Moreover, one thing that Krugman always completely ignores are the highly variable and often very large lag times involved (another reason why today's low interest rates tell us absolutely nothing about the future).

After all, we know for a fact that the true broad US money supply stood at $5,3 trillion on January 1 2008, and stands at nearly $9 trillion today. There has already been massive inflation.

As Ludwig von Mises writes about the manner in which inflation and its effects on the purchasing power of money proceed (in Human Action, ch. XVII, 8):


The course of a progressing inflation is this: At the beginning the inflow of additional money makes the prices of some commodities and services rise; other prices rise later. The price rise affects the various commodities and services, as has been shown, at different dates and to a different extent.

This first stage of the inflationary process may last for many years. While it lasts, the prices of many goods and services are not yet adjusted to the altered money relation.

There are still people in the country who have not yet become aw-are of the fact that they are confronted with a price revolution which will finally result in a considerable rise of all prices, although the extent of this rise will not be the same in the various commodities and services. These people still believe that prices one day will drop. Waiting for this day, they restrict their purchases and concomitantly increase their cash holdings. As long as such ideas are still held by public opinion, it is not yet too late for the government to abandon its inflationary policy.

But then finally the masses wake up. They become suddenly aware  of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The  crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them.”


(emphasis added)

Clearly, we are at the point in time where only the prices of 'some commodities and services have risen', the 'first stage that may last for many years'. The demand for cash balances still remains high, and there is therefore in theory still time for the monetary authority to abandon the inflationary policy before things get out of hand. It should be obvious though that the rate at which government debt increases will influence the decision making of the monetary authority, regardless of its nominal 'independence'. Once public opinion about the inflationary policy changes – i.e. the point in time when the Fed's vaunted 'credibility' goes up in smoke because the 'masses wake up' – it will be too late.

Krugman is certainly correct that the government will then not necessarily formally default on its previously contracted debt; but the holders of the debt will get paid in 'scrap paper'.


Paul Krugman – coming to wrong conclusions about the future on the basis of cherry-picked slices of the recent past …

(Photo via



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