Monday, December 1, 2008

Paul Krugman Is Wrong

Nobel Prize, several books, PhD, leading economic thinker on the Left, but he's still way off.

From his column today:

The claim that budget deficits make the economy poorer in the long run is based on the belief that government borrowing “crowds out” private investment — that the government, by issuing lots of debt, drives up interest rates, which makes businesses unwilling to spend on new plant and equipment, and that this in turn reduces the economy’s long-run rate of growth. Under normal circumstances there’s a lot to this argument.
This is what I have been arguing.

But circumstances right now are anything but normal.
Kind of like last Tuesday when the pull of gravity fell by 10% for a few hours.

What about longer-term rates? These rates, which are already at a half-century low, mainly reflect expected future short-term rates. Fiscal austerity could push them even lower — but only by creating expectations that the economy would remain deeply depressed for a long time, which would reduce, not increase, private investment.
A half-century low? Really? Moody's AAA Corporate bond rates are not at half century lows. They were lower earlier this year and have averaged below or the same for several years now. They were also lower in the 1960s.

Of course, what he is really talking about are Treasury rates. Corporations don't borrow at the lower treasury rates, they borrow at corporate rates. Private investment has to do with private interest rates not government interest rates.

One might think that I'm being overly technical, and I would respond not technical enough. You see, he is also referring to nominal interest rates, which also mean very little. The real interest rate is the true borrowing costs for corporations. Earlier this year when corporate bonds were yielding 5.25%, the TIPS-5yrTreasury measurement of inflation was running at 2%. This implies that real AAA rates were running at 3.25%. Now, these corporate bonds are yielding 5.75%, and the TIPS inflation is running at -0.7%, implying that AAA corporate bonds are really yielding 6.45%. Crowding out causing higher private interest rates? Seemingly.

He goes on:

The idea that tight fiscal policy when the economy is depressed actually reduces private investment isn’t just a hypothetical argument: it’s exactly what happened in two important episodes in history.

The first took place in 1937, when Franklin Roosevelt mistakenly heeded the advice of his own era’s deficit worriers. He sharply reduced government spending, among other things cutting the Works Progress Administration in half, and also raised taxes. The result was a severe recession, and a steep fall in private investment.

This is all accurate, it just doesn't prove that we should start a fiscal stimulus plan.

Allow me an analogy to show why this happened. Let's say I'm the king of a small Caribbean island where all economic activity is fishing and growing sugar. The country is in a recession. I decide, let's borrow money from America to build cute little castles on our island because I'm a crazy loon. My citizens start building castles, which provides many jobs. Several new businesses open on the island that provide cut stone and gargoyles. Output shifts and employment shifts to building castles. After a few years I decide that I am too far in debt and that we now have enough castles. Not only do the government employees lose their jobs, the cut stone and gargoyle manufacturers also go out of business. A dramatic shock to the economy takes a while to sort out. A man who has spent years laying stone can't just become an expert fisherman in a day.

As I quoted him here from his blog on what happens after you come off of fiscal stimulus:
But eventually the economy will have to come off life support. What will
take the place of the stimulus? I don’t really know the answer..."
Forgive me one more analogy. Imagine your son has built a plane out of legos. I walk in and smash it and tell him to build a house. It takes him a while, but he builds a house. Then I come back in and smash it again and tell him to build the plane again. It takes a while, but he does.

The answer, Mr. Krugman, is that the "fiscal stimulus" will cause a recession when you start. Then when the economy gets used to the reorganization the fiscal money will run out. Coming off the stimulus will cause yet another recession.

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