Paul Krugman’s Economic Blinders — By Michael Hudson

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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 loca­tion­al 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 in 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. 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) said Krug­man:

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 through­out 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 and 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 thatwhat is pre­vent­ing Amer­i­can indus­try from export­ing more is the heavy debt over­head that diverts income to pay the Finance, Insur­ance and Real Estate (FIRE) sec­tor. 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.

The Bubble and Beyond

[1] Paul Krug­man, “Easy Use­less Eco­nom­ics,” The New York Times, May 11, 2012.

[2] Ibid.

[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.

[5] Paul Krug­man, “The Euro Trap,” The New York Times, April 30, 2010.

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About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.