Krugman right about depression, wrong about debt

Posted on 04 July 2010 with 1 comment from readers

Professor Paul Krugman wrote a prescient book called ‘The Return of Depression Economics’ in 1999 after the Asian Financial Crisis. Then he was against the economic orthodoxy of the IMF and a champion of budget deficits and devaluation to counter the downturn.

He has not changed his tune in a decade. In an article in the New York Times last week he lambasted the European countries for their ’stunning resurgence of hard-money and balanced-budget orthodoxy’.

His argument is pure Keynesian economics: ‘Slashing spending in the midst of a depression which deepens that depression and paves the way for deflation, is actually self-defeating’.

Debt junkie nations

Yes but is adding more debt to debt mountains not pouring more petrol on the fire, or giving another drug dose to a junkie? After all if economies could really spend their way to prosperity we would not be in the mess we are today but living in an economic success story.

Professor Krugman sees a double-dip recession turning into a true depression, only the third in modern times, after the Long Depression following the Panic of 1873 and The Great Depression of the 1930s. That is probably correct but his analysis is flawed on the reason why this is happening.

‘This third depression will be primarily a failure of policy,’ he contends. ‘Governments are obsessing about inflation when the real threat is deflation, preaching the need for belt tightening when the real problem is inadequate spending.’

Indequate spending? What utter poppycock. The problem is too much spending by governments and far too much borrowing for that purpose. The world has been living beyond its means for at least a decade or more, and the chickens are coming home to roost. Debt is growth borrowed from the future.

Would more of the same tide us all over until a sunny day? Does it work like that? Say you are deep in debt and somebody loans you the money to pay the interest. Does that not make your debt bigger and your situation worse, unless some happy miracle improves your income situation?

And from the national perspective, is it not true that the tough orthodox medicine from the IMF actually saved the Asian countries from their financial crisis, and that is precisely why they are much better positioned to deal with the current crisis. China learned its lesson and saved and did not spend like the profligate Western nations and Japan.

No gain without pain

Surely the correct view is therefore that orthodox economics do work but not without pain. As Krugman says that means higher levels of unemployment and sovereign debt defaults.

But he is totally wrong to conclude that this will not ultimately bring about a new era of prosperity. Just look at how Asia blossomed again in the 2000s. This is also not the 1930s. Then the US did not have massive budget deficits. It does now. The US needs lower debt levels, not higher levels.

If you tried to push these deficits even higher there is a systemic risk to the whole global financial system. Is that not what almost crucified us in late 2008? And it was dealt with by massive government borrowing. But yes there will be a painful deflationary downcycle. The fallacy is to think that an alternative exists or might work better. More debt will not work.

This is not the 1930s and whether Keynesian policies would have worked then is also debatable because it was never tried and proven. And this is also not the 1930s because we have become far wealthier and cutbacks will not be nearly as desparately painful as in that era, although the suffering for some will be bad indeed.