Even When Krugman’s Right, He’s Wrong

In other words, Krugman’s enemies–Eugene Fama and John Cochrane–use invalid arguments but reach a true conclusion, namely that big government deficits don’t help an economy in recession.

So here’s Krugman’s opening paragraph:

Brad DeLong is upset about the stuff coming out of Chicago these days — and understandably so. First Eugene Fama, now John Cochrane, have made the claim that debt-financed government spending necessarily crowds out an equal amount of private spending, even if the economy is depressed — and they claim this not as an empirical result, not as the prediction of some model, but as the ineluctable implication of an accounting identity.

Then Krugman goes on to quote from each. Just so Mises.org readers know the full context, I’ll reproduce them here as well. So first Fama:

The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another.

And now Cochrane:

First, if money is not going to be printed, it has to come from somewhere. If the government borrows a dollar from you, that is a dollar that you do not spend, or that you do not lend to a company to spend on new investment. Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both.1 This is just accounting, and does not need a complex argument about “crowding out.”

Second, investment is “spending” every bit as much as consumption. Fiscal stimulus advocates want money spent on consumption, not saved. They evaluate past stimulus programs by whether people who got stimulus money spent it on consumption goods rather save it. But the economy overall does not care if you buy a car, or if you lend money to a company that buys a forklift.

And then Krugman goes on to rip the above views as sooo 1935. (I.e. the year before Keynes came out with his General Theory.)

But at the risk of giving Prashanth a stroke, let me say: Krugman is totally right. (!!) Fama and Cochrane are wrong in spinning out what appear to be tautologies above. And I say this, knowing full well that plenty of free marketeers–myself included–critique deficit-spending using the exact same arguments when writing an op ed or getting interviewed on the radio.

To a first approximation, and especially if you’re dealing with somebody who doesn’t know the first thing about scarcity, then yes I think it’s fine to say, “Every dollar the government spends just means one fewer dollar spent in the private sector.” But that’s actually not correct, at least not in the way most people believe. And it’s also not literally true to say, “If the government creates a job in industry X with a subsidy, then there must be an offsetting job destroyed in industry Y because of higher taxes or interest rates.”

This is actually quite simple: Suppose the government imposes a one-shot head tax on Bill Gates of $1 million, and then uses the revenue to hire 50 people at $20,000 each to work for a year scrubbing graffiti off bridges. Do Austrians really want to say that it’s an accounting necessity that this causes Bill Gates to adjust his behavior such that precisely 50 other people lose their jobs, but only for a year? Of course not–it would be a miracle if exactly that happened because of the new tax on Bill Gates. In fact, no matter how many people are initially laid off because of changes in Gates’ spending and investing, if wages adjust quickly enough, then that excess unemployment can be whittled away.

So does my concession to Krugman mean that he is right to champion government deficits as a way to prop up aggregate demand, to get “money circulating,” to create jobs and start using idle resources?

Of course not. In contrast to the all-clearing-all-the-time view of markets held by Fama and other Chicago School believers in the “efficient markets hypothesis,” Austrians know that it takes time for the market to adjust after the bursting of an unsustainable boom. So yes, during a deep recession, it’s possible for the government to reduce the unemployment rate through various means, especially through printing money. But that doesn’t mean it’s a good thing. The idle period of spare capacity (in both capital and labor) serves a definite purpose in a market economy, and the government sabotages the cleansing process by forcing those resources back to work on any old project that’s “shovel ready.”

I elaborate on this point in some detail here, and Arnold Kling (with a nod to the Austrian School) comes to the same conclusion from a different angle here.

In conclusion, free marketeers shouldn’t focus their efforts on trying to prove that the government is incapable of boosting “total spending.” For one thing, that’s a false proposition, so it’s a bad move to try to prove it. But more important, it concedes that boosting “total spending” is a good thing. No, the important thing is for the economy to steer resources to their most efficient uses. If that process requires, say, prices in general to fall–and hence nominal aggregate expenditures–then who cares? You consume goods and services, not a flow of green pieces of paper.

This blog post orgiinally appeared on the Ludwig Von Mises Institute website.