Krugman's interventionist crusade

The high priest of interventionist economics

From his perch at the New York Times, Professor Krugman has been dispensing economic and political advice for many years. Unfortunately, he is to economics somewhat similar as Ben ('you have to buy financials here') Stein is to investments, in short, he is potentially capable of doing a lot damage.

For this reason alone, his views must be challenged from time to time, even though we poor bloggers do certainly not have his reach. My fellow blogger and friend Mish has recently done so , in a blog entitled 'Krugman still wrong after all these years'.

He certainly is, and i want to take the opportunity to add a few complementary thoughts to Mish's ruminations on the topic.

First of all, i would recommend this paper(pdf) by Daniel Klein and Harika Bartlett, in which Krugman's editorials have been analyzed statistically and then interpreted by the authors.

The verdict is clear: Krugman is propounding a social-democratic ethos , even though he curiously never admits it outright.
On the contrary, he presents himself as somehow being 'above ideology', while at the same time managing to be one of the most vocal and well known advocates for statism and interventionist policies in the economics profession today.

As the paper notes, if one thoroughly looks at e.g. his concern for the poor, it turns out that this concern is trumped by his support for statist intervention – this is to say, when the choice is between a policy of liberalization that clearly helps the poor and a continuation of a regime of regulation harmful to their interests, he will always favor regulation (by simply remaining silent on the topic).

His record of favoring markets apparently consists of a single assertion in one of his editorials which he purports 'not to be against the market' – a statement that is then thoroughly contradicted in almost every paragraph of the hundreds of articles he has written.
He has come out in favor of liberalization in exactly two cases in his writings for the NYT from 1997 to 2008, which comprised 645 editorials as of January 2008.

Krugman's political ethos is also marked by the 'social compact' chimera – he strongly supports democracy, because the act of voting in his mind legitimizes state coercion.
After all, you have a choice, so this theory goes. If you're not happy with the status quo, vote against it.
We all know however that this is not how it works in reality. You can not opt out, or vote against the status quo, because that choice is simply not presented in elections.
In the US specifically, the two party system is akin to a one party system with only slight shades of difference in emphasis regarding the types of statist policies that are supported.
In this context read Albert Jay Nock's very interesting and entertaining essay 'What the American votes for', in which he explains why he decided to abstain from voting, respectively only voted for people that were already dead.

Criticism without basis

Occasionally, Krugman will criticize the Austrians (whom he doesn't name – he calls them the 'liquidationists' instead – presumably short hand for everyone who thinks the state should not intervene to stem the bust), who in turn frequently criticize right back.

Curiously, Krugman does his utmost to ignore the Austrian school's arguments – it is as if he is aware he's being criticized, and given that the views of the Austrian school are lately gaining a certain degree of credence with the public, finds it necessary to publish an occasional criticism, but at the same time is studiously avoiding to actually read what they have written.

In his recent article on what he calls the 'Hangover Theory' , which can by implication only refer to Austrian Business Cycle Theory (ABCT), he once again roundly ignores arguments that have been sent his way quite some time ago already.

This can only mean one of three things:
A) he doesn't grasp the arguments (unlikely), B) he didn't read any of them, nor any of the classical works (possible i guess) , or C) he has read them, but now makes as if they didn't exist, thereby misrepresenting them by omission.

As Robert Murphy shows here by means of a little economic anecdote, Krugman simply ignores the role of capital (a failing of Keynesianism in general), and its intertemporal structure.
Now, he has either read Murphy's piece or he hasn't, but he sure does ignore it completely. Most importantly he ignores the point that during the boom, resources will be misallocated, which in turn leads to consumption of capital.

I urge everyone to read Murphy's article, as it lucidly explains why the view of the economy as an agglomeration of 'aggregates' is wrong – and how in an artificial boom, misallocation of capital along the production structure leads to capital being consumed and falling into disrepair.
As Murphy correctly remarks, it is vital to understand this part of the ABCT if one wants to sensibly contribute to the debate. It is the process of capital consumption – respectively consumption of the pool of real funding, or put in other words, previously accumulated wealth - that creates the illusion of the boom.

The master builder

Ludwig von Mises had numerous little common sense quotes and anecdotes in which he tried to paint an easy to understand picture illustrating such concepts.
With regards to capital consumption, he referred to consumption without preceding production (which is a side effect of the fiat money system's 'money out of thin air' creation) as akin to 'burning the furniture to heat one's home.'

One can do that for a while, and the house will be nice and warm for some time, depending on the amount of furniture available to burn. One day though, one will perforce run out of heating material, and voila – the home will grow cold (as a metaphor for the inevitable bust resulting from capital consumption).

Another von Mises anecdote that illustrates scarcity and the importance of correct – i.e., market-based - information in guiding entrepreneurial decision making, is the one about the master builder.

Imagine the Pharao charges you with building him a palace. At the outset, you are informed how many pieces of wood, hows many bricks, nails, glass panes, shingles and other building materials will be at your disposal.
In short, you seemingly have perfect information about the resources available to you.

However, someone made a mistake – there are in fact 20% fewer bricks available than you were led to believe. Some of the crew discover the mistake, but given that building the palace means a good time for everyone – they all have jobs, they're building a nice palace, everybody, including the builder seems happy – they decide to keep you in the dark about it.

You will of course succeed in erecting the foundation, and perhaps in building up to say, the first floor.
However, the building you have planned on the basis of this incorrect information will forever remain unfinished – at some point, the bricks will run out prematurely.

It follows that the earlier in the process you learn of the error, the better the outcome will be.
If you learn of it while still drawing up your plans, you can plan anew, and only some of everybody's time will be lost. If you learn of it after having built the foundations, there may still be time to change plans for a somewhat smaller, but still doable palace. If you learn of it one day before the bricks actually run out, it will simply be too late – a monument to malinvestment will have been erected – an unfinished palace.

The resources that have been used up in erecting this unfinished building have been used up, and while everybody had a 'good time' (the boom) while doing that, they are now faced with the fact of an unsalvageable and uneconomic project standing before them.

Relevance to the economy at large

The problem presented by an artificial credit boom to the whole economy is akin to this master builder problem. In this case, the artificially low interest rate is what creates a fata morgana – i.e. a crucial piece of misinformation – that leads businessmen astray, namely the illusion that more savings are available than there really are.

It is the conceptual difference between money and real resources that trips up Krugman. He thinks if only someone – preferably, in his view, the state – were to spend money in the teeth of the bust, everything would be alright again. This ignores what has happened in the boom – scarce resources were misallocated due to false information on the true state of savings, and thus capital ended up being malinvested and consumed.

If we look at the policies enacted since the bust began, we see that they are all geared to keeping the disinformation that the boom was based on alive.

Once again, interest rates are being suppressed to an artificially low level. The state meanwhile is set to spend more money than at any time before in such a brief time span in peace time, on the idea that more spending is going to cure what too much spending has wrought.
However, the state can not add one iota to the pool of scarce economic resources that need to be optimally allocated if the economy is to recover.
We must always come back the the fact that the state does not have any economic resources of its own – it does not produce any. Instead, it must take them from those who do produce them.

Listening to Krugman, you'd think Austrians were a bunch of sourpusses begrudging everyone the good times of the boom, and then making things worse by being especially dour party-poopers with regards to the remedies thought to be necessary 'fix' the bust.
However, it is just realism and rigorous a priori reasoning that leads to their conclusions. Once the economy's pool of real funding has been damaged on account of an artificial credit boom, the priority must be to allow the production structure to readjust to reality, and that process, while painful, is also necessary.

The efforts of a coercive redistribution agency (the government) can not change that, and the printing of more fiat money can not either.
What the introduction of these factors does is to upset the market process.
They are deliberately used to induce booms (booms are politically popular until they go bust), in the hope that someone else will have to deal with the consequences (as is indeed the case; Bernanke gets to deal with Greenspan's legacy, and Obama with Bush's), and when those consequences inevitably arrive, they are used again in a futile attempt to keep those consequences at bay.

As long as the pool of real funding hasn't been damaged too excessively during a boom, a dose of monetary pumping can be expected to revive the illusionary boom – as has indeed happened several times in the past, most recently after the technology bubble flamed out.
The problem is that this only stores up even bigger problems for the future. We can all clearly see now that Greenspan's attempt to prevent the previous correction/bust from doing its work has led to an even bigger, more intractable bust in the present, but the interventionist caste still insists that we have to do the same thing all over again, only in larger dosage!

Once a boom turns to to bust, there are a number of facts that need to be faced:

1. there were not as many savings as thought, so capital was misallocated;
2. what the economy needs is as little interference as possible, since otherwise the danger is that even more capital will be misallocated.
3. the process of realigning the capital structure to reality is not painless, since it requires far fewer workers than are are needed when everything is humming.
4. the less interference there is, the faster it will be over.
5. to interfere means de facto to burden an already weakened economy even more – therefore, the more intervention, the less desirable the likely outcome (and it's not as if we didn't have any examples for that).

The pretence of knowledge

Lastly, look at how Krugman argues in favor of state intervention and spending to 'mitigate the bust'. His argument in favor of increased fiscal spending in Europe is summed up as follows:

dY/dD = (1-m)/[1 - (1-t)(1-m)c - t(1-m)]

Read the linked article for an explanation of the formula.

This is what Hayek referred to as the 'Pretence of Knowledge'.
Modern day economists seem to think that if it can't be put into a formula, then it can't be science. Economics is however a social science, not a natural one. It is about human beings, and the interactions of millions, nay billions, of human beings can not be pressed into neat little formulas.

This is not to say that one must completely abandon a formulaic approach to certain economic concepts (a graphic representation of a supply-demand curve surely has its place for instance), only that the 'ceteris paribus' type equilibrium which these formulas assume to be in place is not present in the real world.
The science of economics must proceed from sound a priori reasoning, otherwise it can not present the proper conclusions and provide policy recommendations.

It is this latter point that should worry us all. Krugman and other supporters of interventionist dogma are self-styled advisers to the political class, which in turn likes to hear nothing better than advice that prods it to intervene.
The courtier economists are thereby apt to doing a lot of damage, as mentioned in the opening paragraph.

Naturally, few economists would be prepared to admit that they actually don't know what to do. In this, the Austrian school is quite different. It essentially says: 'The entity that knows best what is to be done is the free market. Let it work'.
In other words, they have no 'policy recommendation' except - 'do nothing'.
When Ludwig von Mises was once asked what his first action would be if he were to be appointed 'minister of economics' he answered: 'Resign'.

It's not the type of advice one can easily make a living from. The interventionist courtier economist of Krugman's type on the other hand is asked to draw up plans, has the ear of the powers-that-be, gets to feel important , and gets paid nicely for his efforts.

Furthermore, as has been shown over and over again, the fact that intervention does not work is never seen as a reason to abandon it, but rather to come up with new, additional interventions purportedly designed to fix the unintended consequences of the old ones.
In this manner, the power of the state grows and grows – which is to the advantage of both the political class as well as its 'advisors' and everyone feeding at the state's trough (including many corporations; contrary to what one would think, most corporate entities are not in favor of a free market either – rather, they seek protection from competition in the form of anti-competitive regulations, respectively seek a slice of the tax payer pie that is doled out by the political class in its favors and vote buying activities).

What is to the advantage of the political class and its advisors and hangers-on is however as a rule to the disadvantage of everyone else.
If we want a sound economic policy, we must oppose Krugman's call for more intervention.

A failure of capitalism?

The 'year of the financial flame-out' as Bob Prechter has christened 2008, so far proves to be somewhat depressing for supporters of the free market.
Not only do we read that sales of Karl Marx' tedious tome 'Das Kapital' are lately taking off, we have also been witness to the depressing spectacle of Krugonomics being found worthy of a Nobel Prize (as an aside, we have no problem with Krugman being a 'Bush critic').

The latest event is a huge government summit dedicated to combating the financial crisis - a get-together of statists of all stripes, who, as a German newscast averred, 'want to put the financial system in chains' (this was uttered in an approving tone). So what are the ideas of these worthies? They want to 'stimulate demand and increase regulation', and -surprise - they 'agree that the IMF should play a critical role' in resolving the crisis.
In other words, doomed-to-failure Keynesian policy prescriptions combined with charging a bureaucracy that many had hoped was finally dying of its own accord with overseeing the unfolding debacle are seen as the panacea that will save us. Oh well.

To be sure, there's a silver lining here and there. For instance, the sudden popularity of Marx may not get anywhere.

"There's a younger generation of academics tackling hard questions and looking to Marx for answers," Mr Schuetrumpf said.
But he doubted their perseverance: "I doubt they will read it all the way to the end, because it's really arduous."

Well, thank God Marx is boring as hell; it's still astonishing that anyone, let along an 'academic' would look to Marx for answers. It has been almost 20 years since the murderous communistic system failed, but surely people do remember that this was inter alia the biggest bankruptcy of all time?
Also, it seems that Krugman's Nobel prize 'can quiet some critics, but not all'. Phew.

Unfortunately this isn't sufficient grounds for optimism; the press all over the world has miscast the crisis and beginning economic bust as a 'failure of capitalism and free market ideology' , an idea eagerly embraced by politicians across the ideological spectrum (proving once and for all that support for the free market was never much more than lip service), who of course love nothing more than expanding the power of the state.

The battle cry of the day is 'we need more regulations'. Consider for a moment here that the EU bureaucracy had already produced almost 100,000 pages of regulations by the end of 2002 (i couldn't find an up-to-date count) , a body of law governing commerce so complicated and convoluted that both compliance and enforcement seem nigh impossible. Between 1997 and 2005 alone, 12,000 new laws were introduced. Businesses across the EU have seen an entire additional bureaucratic jungle added to the one they already battled with in their home countries. No wonder Europe isn't exactly known for vigorous economic growth - entrepreneurs are suffocating in red tape to an unprecedented extent (note that many of the regulations produce situations that can only be described as utter madness).

While the US can still point to a somewhat less regulated marketplace, make no mistake, economic freedom has been on the retreat for decades there as well. The most recent boom-bust cycle of course can be squarely attributed to government intervention in the markets, via a Federal Reserve that left interest rates too low for too long, and the government sponsored enterprises which with their access to cheap credit (on account of the formerly implicit, now explicit, government guarantee) were the major engines behind the housing bubble.
So the people who now charge that the crisis is a 'failure of the free market ideology' should perhaps first show where exactly that free market was allegedly operating.

The above mentioned pow-wow of various heads-of-state has studiously neglected to confront the real reason for the crisis: namely the boom that preceded it. How come there was such an unsustainable boom? Did it drop from the sky unbidden?
Not one of the things that should have been discussed have even been mentioned in passing - central banks and their credit and money inflation, too high and onerous taxation, enormous fiscal deficits, the disastrous over-regulation of commerce, trade barriers. Instead the talk centered on - more regulation.
No genuine reform can be expected from these dunderheads; instead they're - unwittingly - paving the way for a depression.

In his 1969 essay 'Economic depressions: their cause and cure' , Murray Rothbard recounts Ludwig von Mises' view on the subject:

"Mises, then, pinpoints the blame for the cycle on inflationary bank credit expansion propelled by the intervention of government and its central bank. What does Mises say should be done, say by government, once the depression arrives? What is the governmental role in the cure of depression? In the first place, government must cease inflating as soon as possible. It is true that this will, inevitably, bring the inflationary boom abruptly to an end, and commence the inevitable recession or depression. But the longer the government waits for this, the worse the necessary readjustments will have to be. The sooner the depression-readjustment is gotten over with, the better. This means, also, that the government must never try to prop up unsound business situations; it must never bail out or lend money to business firms in trouble. Doing this will simply prolong the agony and convert a sharp and quick depression phase into a lingering and chronic disease. The government must never try to prop up wage rates or prices of producers' goods; doing so will prolong and delay indefinitely the completion of the depression-adjustment process; it will cause indefinite and prolonged depression and mass unemployment in the vital capital goods industries. The government must not try to inflate again, in order to get out of the depression. For even if this reinflation succeeds, it will only sow greater trouble later on. The government must do nothing to encourage consumption, and it must not increase its own expenditures, for this will further increase the social consumption/investment ratio. In fact, cutting the government budget will improve the ratio. What the economy needs is not more consumption spending but more saving, in order to validate some of the excessive investments of the boom.

Thus, what the government should do, according to the Misesian analysis of the depression, is absolutely nothing. It should, from the point of view of economic health and ending the depression as quickly as possible, maintain a strict hands off, "laissez-faire" policy. Anything it does will delay and obstruct the adjustment process of the market; the less it does, the more rapidly will the market adjustment process do its work, and sound economic recovery ensue.

The Misesian prescription is thus the exact opposite of the Keynesian: It is for the government to keep absolute hands off the economy and to confine itself to stopping its own inflation and to cutting its own budget.

It has today been completely forgotten, even among economists, that the Misesian explanation and analysis of the depression gained great headway precisely during the Great Depression of the 1930s — the very depression that is always held up to advocates of the free market economy as the greatest single and catastrophic failure of laissez-faire capitalism. It was no such thing. 1929 was made inevitable by the vast bank credit expansion throughout the Western world during the 1920s: A policy deliberately adopted by the Western governments, and most importantly by the Federal Reserve System in the United States. It was made possible by the failure of the Western world to return to a genuine gold standard after World War I, and thus allowing more room for inflationary policies by government. Everyone now thinks of President Coolidge as a believer in laissez-faire and an unhampered market economy; he was not, and tragically, nowhere less so than in the field of money and credit. Unfortunately, the sins and errors of the Coolidge intervention were laid to the door of a non-existent free market economy.

If Coolidge made 1929 inevitable, it was President Hoover who prolonged and deepened the depression, transforming it from a typically sharp but swiftly-disappearing depression into a lingering and near-fatal malady, a malady "cured" only by the holocaust of World War II. Hoover, not Franklin Roosevelt, was the founder of the policy of the "New Deal": essentially the massive use of the State to do exactly what Misesian theory would most warn against — to prop up wage rates above their free-market levels, prop up prices, inflate credit, and lend money to shaky business positions. Roosevelt only advanced, to a greater degree, what Hoover had pioneered. The result for the first time in American history, was a nearly perpetual depression and nearly permanent mass unemployment. The Coolidge crisis had become the unprecedentedly prolonged Hoover-Roosevelt depression."

The parallels between what happened in the boom-bust cycle of the 1920s and 1930s and the events of today are eerie. Once again a huge credit inflation has turned inevitably into a giant bust, and once again governments are trying to avert the bust by inflating even more, by massively raising their deficits, by propping up failed enterprises, and suffocating an already over-regulated marketplace with even more regulations. Rest assured that as the bust progresses, their interventions will continue to grow in scope and extent, in a desparate attempt to keep a system alive that is doomed to failure a priori.

The biggest mistake made in post WW2 economic history was to cut all links of the currency system with the vestiges of the gold standard - this removed the only remaining check on the expansion of government debt and the associated expansion of money and credit more generally. It is also seldom discussed that the Federal Reserve removed another important brake of unchecked credit expansion in the mid 90's by allowing banks to use the 'sweep' method to lower their reserve requirements. Since term savings deposits have much lower reserve requirements than demand deposits, banks 'sweep' the unused funds in demand deposits into non-interest bearing CDs, temporarily transforming them into savings deposits. Ever since this became the norm, the banking system has been de facto insolvent (which is to say, it could not possibly survive a run on deposits).

Governments are now injecting huge amounts of money into the banking system, but are faced with the fact that the credit intermediation process has broken down. Neither are banks willing to lend, not are potential borrowers very eager to borrow. Instead, banks are hoarding this money, as they expect even more writedowns to hit what is left of their capital in coming months. This is of course a reasonable expectation, as the corporate default rate has only just begun to tick up, and consumer credit defaults , including mortgage defaults, are likely to continue to climb.

As Frank Shostak explains in his essay 'Good and Bad Credit' , it is really the state of the pool of real funding that determines if monetary pumping can seemingly 'work'.
Money created out of thin air merely dilutes the money already in circulation, it can not create one iota of wealth or real resources. As long as the pool of real funding (explanation of the term can be found here) is still expanding, monetary pumping will divert resources into economic activities that are not really self-funding and create no wealth - an illusory boom ensues (with the recent housing boom representing a pertinent example).

It is important to realize that the pool of real funding is put under pressure by such an artificial credit-induced boom. In other words, there comes a point in time when the pool of real funding is exhausted, and begins to stagnate or shrink - namely once one boom too many has diverted so many resources and led to capital consumption on such a great scale that the 'point of no return' has been reached.
While the subsistence fund is not directly measurable, we can guess when it has begun to stagnate or shrink by observing what happens when the central bank lowers rates and begins with monetary pumping. If there is no effect (most immediately the effect should be visible in financial markets, which tend to discount the future), i.e. the boom fails to be reignited, then we have reached this point.

In short, it will not matter how much money out of thin air is thrown at the banks when real resources are not available in an amount sufficient to allow for the resurrection of bubble-like activities. This brings us back to what Rothbard wrote: once one is in this situation, it is necessary for the structure of production to be realigned with the new reality, and consumed capital needs to be rebuilt.
A bust becomes inevitable - with the consolation being that the bust is the economy's method of achieving these objectives, i.e. it is the economy's way of healing itself, and laying the foundations for renewed growth.

Obviously, any government interference with this process can ipso facto only be harmful. If one thinks things through, it becomes clear that contrary to widespread misconceptions, government does not possess a tree on which resources and capital grow, and it has not bunkered any of these things in a warehouse somewhere either. It can only take resources from someone else and shift them around. It perforce must take them from those sectors of the economy that still produce wealth (the bankrupt entities it tries to bail out are obviously consumers of wealth), in other words, this centrally planned shifting around of resources will weaken those sectors of the economy that are still healthy.
It does not matter in this context whether government crowds out private sector borrowers by borrowing the money used in these wealth transfers or whether it acquires the money by taxation - the effect is the same.

There is of course a third option, which will no doubt play an increasingly important role going forward - government can, vía the central bank, simply print money up. This will be limited by the so-called 'bond vigilantes' putting in an appearance at some point, but in the meantime, is apt to do untold economic harm. The Federal Reserve has in recent weeks roughly doubled the size of its balance sheet, and the growth of high-powered 'base money' over this period stands at a roughly 130% annualized rate.

Students of economic history take note: from 1929 to 1932, the annualized growth of base money was 98% and free bank reserves were increased by over 400%.
This will come as a surprise to those that have heard the false claim (which for reasons unknown gets repeated over and over again) that the 'Fed failed to pump enough money into the economy in the early 1930s'.
The Fed did in fact do what it is doing now - it slashed interest rates to the bone, and pumped furiously. Only, it did not help, as the pool of real funding had suffered too much damage in the 1920's credit boom.

Today, we find ourselves at a very similar juncture - just as leftist propaganda held in the 1930s that 'the free market had failed' , prompting massive government intervention that turned a sharp recession into a depression, so we are today at a point where the same propaganda claim is being made, and governments once again respond by intervening in the market at an unprecedented scale.
To expect a different outcome, is to paraphrase Einstein, 'the very definition of insanity'.



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