DRI-186 for week of 1-5-14: The Secular Stagnation of Macroeconomic Thought

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The Secular Stagnation of Macroeconomic Thought

The topic du jour in economic-policy circles is “secular stagnation,” thanks to two recent speeches on that topic by high-powered macroeconomist Lawrence Summers. The term originated just after World War II when Keynesian economists, particularly Alvin Hansen, used it to justify their forecast of the high unemployment and low growth that ostensibly awaited the U.S. after the war.

Now, nearly 70 years later, it is back. In a recent Wall Street Journal op-ed, monetary economist John Taylor likened its re-emergence to a vampire arising from his crypt. There is indeed something ghoulish about the propensity of Keynesian economists to ransack outdated textbooks in search of conceptual support for their latest brainstorm.

The backstory behind secular stagnation is only half the story, though. The other half is the insight it offers into the mindset of its patrons.

The Birth of the Secular Stagnation Hypothesis

As World War II drew to a close, economists gradually turned their attention to a problem that had intermittently occupied them since the late 1930s. The Great Depression had soured the profession on the workings of free markets. The publication of John Maynard Keynes’ General Theory of Employment Interest and Money had suggested a new framework for economic analysis that placed emphasis on unemployment and its elimination. While war mobilization had made this issue moot, the return of servicemen and readjustment to a peacetime economy brought it back to prominence.

Many Keynesians foresaw a return to mass unemployment and Depression. The leading American exponent, Alvin Hansen, developed a specific hypothesis along those lines. Keynes had posited a simple theory of aggregate consumption: consumption was a stable, linear function of income. These properties implied that, over time, it might become progressively more difficult to maintain full employment.

A numerical example using the simple Keynesian macroeconomic model will clarify this point. Y = real income or output, which is the sum of C (Consumption), I (Investment) and G (net Government spending). Further, C is a linear function of Y; that is, C = a + bY, where the “a” term reflects the influence on Consumption of factors other than real income and “b” (the slope of the Consumption function depicted diagrammatically) is the marginal propensity to consume from additional income acquired. Assume, purely for expository purposes, that a = 50, b = .75, I = 100 and G = 100. If Y = 1000, then C = 50 + .75 (1000) = 800. The influence of technology, which improves from year to year, will cause productivity to increase and output to increase over time, all other things equal. Assume, again purely for illustrative purposes, that this increase is 5%. In that case, the full employment level of income will increase from 1000 to 1050. But C does not increase by 5% to 840; it increases only to 837.50. In order to preserve full employment (according to Keynesian logic), the sum of I and G will have to increase by 212.50, an increase of 6.25% over its previous value of 200 – which is more than 5%. Over time, this putative annual shortfall in Consumption would get larger and larger, requiring successively larger doses of I and G to keep us at full employment.

Already we can see the germ of logic behind Hansen’s secular stagnation hypothesis, which is that Consumption over time will fall farther and farther behind the level necessary to preserve full employment. (The word “secular” does not reflect its customary meaning of “non-religious or worldly” but rather its technical economic meaning of “a long time series of indefinite duration.”) Underconsumption is a theme dear to the hearts of Keynesian economists. In this case, it depends as a first approximation on the algebraic structure of the simple Keynesian model, in which Consumption is a simple linear function of income (Y).

There was much more to the analysis than this. In principle, Consumption might increase for reasons unrelated to income. But Hansen predicted just the opposite. He believed the primary source of autonomous increases in Consumption was population growth, and he foresaw a sharp in U.S. population growth after the war. He was equally pessimistic about increases in autonomous Investment because he thought the highest-returning investments had already been tapped. Thus, by default, government deficit spending was the only possible remedy for progressively worsening unemployment and stagnating economic growth – hence the term “secular stagnation.”

The Gruesome Death of the Secular Stagnation Hypothesis

Alvin Hansen was known as the “American Keynes.” Presumably this was because of the apostolic fervor with which he preached Keynesian gospel. In this case, he shared something else with Keynes: the thoroughness with which history repudiated his ideas.

Hansen predicted population decline. Instead, the U.S. experienced the biggest baby boom in history. Among other effects, this produced an explosion of household investment in consumer durables such as homes, automobiles and appliances. The shortages and government-imposed rationing of World War II had generated a pent-up demand that burst its boundaries in the postwar climate.

Rather than unemployment and depression, the U.S. enjoyed one of its biggest expansions ever in 1946. This eventually created problems when, during the Korean War, the Truman administration preferred to fund the war via money creation rather than employing the borrowing that had financed most defense expenditures during World War II. The result was inflation, which the Administration countered with wage and price controls.

The U.S. had borrowed to the max in its conquest over the Axis powers, with debt climbing to its highest level as a percentage of national output. In his recent book, David Stockman pointed out the important role played by the Eisenhower Administration in paying down this debt and returning a semblance of sanity to federal-government spending.

This combination of private-sector buoyancy and government fiscal retrenchment left no need or room for the Keynesian remedy proposed by Hansen. As the 1950s unfolded, economic theoreticians on all sides of the spectrum delivered the coup de grace to the secular stagnation hypothesis.

In 1957, Milton Friedman presented his “permanent income” hypothesis of consumption spending, which fleshed out the individual utility-maximizing theory of consumer behavior with the picture of a consumer whose spending is governed by an estimation of lifetime or “permanent” income. He or she will tend to dissave by borrowing when young and by drawing down accumulated assets when old, meanwhile accumulating assets via saving in prime earning years. It is not actual or realized income so much as this individualized conception of expected normal income that influences consumption spending.

Keynesian Franco Modigliani developed his own theory of “life cycle” consumption, rather broadly similar to Friedman’s, within the same time frame. Left-wing economist James Duesenberry developed a “relative income” hypothesis stating that consumption was influenced by the consumer’s income relative to that of others. While there were important theoretical and practical differences between the three theories, they all rejected the simple Keynesian linear dependence of consumption on income. And this drove a stake through the heart of the secularly widening gap between consumption and income. The slats had been kicked out from under the secular-stagnation platform.

The secular stagnation hypothesis had already been proved to be a resounding flop in practice. Now it was shown to be wrong in theory as well. Before Keynesian economics had even been adopted on a wholesale basis, it had suffered its first crushing defeat.

The Rise of the Undead: Secular Stagnation Rises from the Crypt

Broadway impresarios sometimes revive past productions, but they invariably choose to revive hit plays rather than flops. Based on its first run, secular stagnation would not seem to be a prime candidate for revival. Nevertheless, Lawrence Summers mounted a new version of the concept and took it out of town for a tryout in two recent speeches, supplemented by comments on subsequent blog posts.

In his first speech, made to the International Monetary Fund Research Council, Summers grappled with the theoretical issues involved in resurrecting Hansen’s ancient bogeyman. Paraphrasing Clemenceau on war and generals, Summers mused that “finance is too important to be left to financiers.” The U.S. quickly recovered from the financial panic of 2008-09, but the ensuing four years brought astonishingly little progress when measured in standard macroeconomic metrics like employment and output growth. Although the term “secular stagnation” has long been neglected by his profession, Summers now finds it “not…without relevance” in understanding our current situation.

If the U.S. suffered a mass power blackout, output would fall precipitously. It would be idiotic for economists to object that electricity constitutes “only 4%” of total output – obviously, its importance is not indicated by its fraction of total output. Similarly, finance should be viewed in the same light – as the intermediating, lubricating force that enables the bulk of our goods and services. If a power blackout did occur, we would naturally expect restoration of service to be followed by a catch-up period of increased output, rather than the sort of prolonged stagnation we have actually experienced after the financial crisis. So why hasn’t it happened?

Summers’ explanation to the IMF audience was technical – that the “natural rate of interest” is negative; e.g., below zero. “We may need to think about we manage an economy in which the zero nominal interest rate is a chronic and systemic inhibitor of economic activity, holding our economies back, below their potential.” Summers means that the practical inability to charge negative rates of interest – e.g., subsidize loans rather than charge money for them – is what is chaining the U.S. economy down.

In his second speech and follow-up blog  comments, Summers elaborated on the policy implications of his musings. “Our economy is constrained by lack of demand rather than lack of supply. Increasing our capacity to produce will not translate into increased output unless there is more demand for goods and services.” Of course, this is the old-time Keynesian religion of underconsumption, set to the background music of Cole Porter’s “Everything Old is New Again.” Secular stagnation has been brought down from the attic, fumigated with a dusting of demographics (the declining U.S. birth rate) to remove the stench of disgrace left by Hansen.

We need to “end the disastrous trends toward less and less government spending and employment each year.” In other words, the problem is not that we overspent and created too much sovereign debt in 2008-09; the problem is that we spent too little – and then cut spending after that. We should replace coal-first power plants – that will necessitate a huge program of capital spending to keep the power on. Following Keynes, Summers stresses the importance of supporting domestic demand by improving the trade balance.

Just as this program begins to sound suspiciously like a hair of the dog that bit us – or maybe the entire hair coat – Summers removes all doubt. It is “a chimera to rely on regulation” to pop asset bubbles in the face of the monetary excess necessary to underpin his program.

At the close of his first speech, Summers provided the only saving grace with the caveat: “This may all be madness and I may not have this right at all.”

Krugman’s Endorsement of Summers: For This We Need Economists?

Summers’ revival of the secular stagnation hypothesis was the talk of policymaking circles. Half of the talk was probably devoted to wondering what Summers was saying; the other half to wondering why he was saying it. Perhaps trying to be helpful, Summers’ partner in Keynesian crime Paul Krugman weighed in with his own interpretation of Summers’ remarks.

Inevitably, Krugman’s own views crept in to his discussion. The result was a blog post that could scarcely be believed even when read. (Readers with broad minds and strong stomachs are referred to “Secular Stagnation, Coalmines, Bubbles, and Larry Summers,” 11/16/2013, on the Krugman archive.)

Krugman begins with an uncharacteristic (and unrepeated) touch of humility. Noting the similarity between his own previous published diagnosis of our economic ills and Summers’ current one, he admits that Summers’ is “much clearer…more forceful, and altogether better.”

According to Krugman, he and Summers both view the U.S. economy as stuck in a “liquidity trap.” This is another Keynesian illustration of market pathology. As Keynes originally described the concept, a liquidity trap existed during an economic depression so intense that monetary policy was rendered impotent. Governments use banks as their tool for creating money; securities sold to the public are snapped up by banks, which in turn use them as the basis for making loans to businesses. But banks cannot force businesses to take out loans. If businesses decide that conditions are so bad that investing is too risky no matter how low the borrowing rate of interest, then monetary policymakers are helpless. In contrast, fiscal policy labors under no such constraint, since the government can always spend money for stimulative purposes. In a liquidity trap, though, monetary policy is likened to “pushing on a string” – a fruitless effort.

Krugman carries this notion further by identifying it with Summers’ evocation of a negative equilibrium interest rate. Investment demand is so weak and the desire to save so strong that the two are equilibrated only when “the” interest rate is below zero. In this climate, Krugman maintains, “the normal rules of economic policy don’t apply…virtue becomes vice and prudence becomes folly. Saving hurts the economy – it even hurts investment thanks to the paradox of thrift.” Krugman hereby drags in Keynesian anachronism #3. The so-called “paradox of thrift” states that the attempt to save more results in less saving because ex ante increases in saving will reduce income and employment, thus preventing the saving that consumers are trying to do, while reducing consumption as well. The only problem with this is that we have actually realized increases in saving and income at the same time, which is diametrically opposite to the effects predicted by the concept.

But these are trifles compared to the powerhouse contentions Krugman has coming up. Summers outlined a general program of public spending to increase demand and frankly admitted the futility of suppressing bubbles caused by the money creation necessary to finance the spending. Is Krugman troubled by this? Not merely “no,” but “Hell, no.”

“While productive spending is best, unproductive spending is still better than nothing…this isn’t just true of public spending. Private spending that is wholly or partially wasteful is also a good thing, unless it somehow stores up trouble for the future.” And how could that possibly happen? (See “Europe, Sovereign Debt of; Europe, Financial Crises of; Europe, Bailouts Multiply Across; Europe, Political Protests Blanket.”)

Krugman continues with an example of wasteful spending by U.S. corporations that produced virtually no payoff after three years. “Nevertheless, the resulting investment boom would have given us several years of much higher employment, with no real waste, since the resources employed would have otherwise been idle.[emphasis added] F.A. Hayek characterized Keynesian economics as the negation of the market, a description well befitting this rationalization. In Krugman’s world, the labor market and relative prices might as well not exist, for all the effect they have. Microeconomics either does not exist or operates on a different plane of existence than the macroeconomic plane on which the statistical construct of aggregate demand wields its decisive influence. For this we need economists?

Krugman now arrives at “the radical part of Larry’s presentation” – as if the foregoing weren’t radical enough! He straightforwardly, even proudly admits what Summers guardedly suggests – that asset bubbles are a good thing. In fact, according to Krugman, U.S. prosperity has been built on bubbles for quite a while. “We now know that the economy of 2003-2007 was built on a bubble.” Krugman is being coy here since he made a celebrated statement in 2002 calling for the Federal Reserve to create a bubble in the housing market. Oddly enough, this attracted almost no attention at the time and has brought him no adverse reaction since then. “You can say the same about the latter part of the 90s expansion; and… about the later years…of the Reagan expansion, which was driven …by runaway thrift institutions and a large bubble in commercial real estate.”

Krugman’s recall of history is curiously defective, especially considering that he was employed in the Reagan Administration at the time, albeit in a minor position. The 1986 tax reform law was, and still is, pinpointed for tax-law changes that helped pop a real-estate bubble largely built on tax-deductibility. The political Left is fond of criticizing Reagan for claiming to have lowered taxes in the early 80s while actually raising them later on. The Left is even fonder of excoriating Reagan and Paul Volcker for ending inflation on the backs of the poor by killing off inflation by stopping monetary expansion too abruptly. Now Krugman is criticizing Reagan for doing just the opposite!

Krugman’s piece de resistance is his riposte to future critics who will object to the runaway inflation that the Summers/Krugman project will promote. Krugman unblinkingly admits that inflation “expropriates the gains of savers,” but replies that “in a liquidity trap, saving may be a personal virtue but it’s a social vice.” And in an economy facing secular stagnation, the liquidity trap is “the norm. Assuring people they can get a positive rate of interest on safe assets means promising them something the market doesn’t want to deliver.”

Krugman implicitly and explicitly assumes that markets are as dysfunctional as life-support patients with no respirator. But when he needs a justification for deep-sixing the life savings of hundreds of millions of people, he suddenly pulls out “the market” and gives its ostensible verdict a personal blessing of moral authority. Yet in this very same blog post, he cavalierly dismisses his critics as “a lot of people [opponents of Krugman] want economics to be a morality play and they don’t care how many people suffer in the process” [!!] For the benefit of readers unfamiliar with the long-running debate between Krugman and his critics, those critics are free-market economists who want bubbles to end with unsustainable businesses being liquidated rather than bailed out, and the business cycle to be cut short rather than prolonged indefinitely with each iteration worse than the previous one.

Intellectual Stagnation, Not Economic

At this point, it is all too clear that secular stagnation has taken place. But the stagnation is intellectual, not economic. Keynesian economists are framing policy arguments using terms like “secular stagnation,” “liquidity trap” and “paradox of thrift.” These recondite terms went out of fashion over thirty years ago, along with the paleo-Keynesian economic theory that spawned them. They survive in the 20th-century textbooks and graduate-school memories of economists now approaching retirement.

The shocking character of the Summers/Krugman hypothesis doesn’t derive from its vintage, though. Its anti-economic character – relative prices are irrelevant, waste is a good thing, markets are worthless except when economic managers need a pretext for arbitrary action – is professionally repellent. Even more frightening is the hubris on display. Summers is a disgusting sight, standing up in front of an audience at the International Monetary Fund, pontificating with grandiose gravity about “managing an economy” – as if he were the CEO of a U.S. economy of some 315 million people and tens of thousands of businesses.

There are quite a few people who consider a large public corporation too unwieldy to manage effectively. The difficulty of one economist managing an entire economy must increase not merely linearly but exponentially, considering the interaction and feedback effects involved. At least Summers had the minimal presence of mind to recognize that he might be mistaken. Krugman, in contrast, displays the same mindset as his intellectual antecedent, John Maynard Keynes. Several biographers and friends – including F.A. Hayek, with whom his relations were cordial despite their opposing views – remarked that Keynes was obsessed with his own preeminence as a public intellectual rather than with mastery of economic theory as such. Hayek remarked that Keynes may have been the most brilliant man he ever encountered but was a bad economist. Summers and Krugman show no signs of possessing the intellectual diversity and flexibility of Keynes – only his arrogance and deep-seated need for personal attention.

There is another shocking aspect to this latest policy flap. Summers/Krugman are in the anomalous position of criticizing the results of their own policies. That is, even they cannot credibly maintain that we have lived under a regime of laissez-faire or tight fiscal or monetary discipline for the last five years. They can only insist that not enough was done. Of course, this is the standard big-government lament; when big-government fails, try bigger government. But in this case, they are telling us that the results they formerly called bad were really good and we should expect no more from them in the future. The friendliest left-winger would have to acknowledge that Summers/Krugman are confessing failure and telling us that this is the best we can do. Notice, for example, that neither man stressed the very short-term nature of their policy prescription or promised that once their strategy of fiscal inebriation reached its apogee, we could let the market take over. No, theirs was a counsel of despair reminiscent of late 1970s malaise.

You can’t get any more stagnant than that.

DRI-326 for week of 5-12-13: Paul Krugman Can’t Stand the Truth About Austerity

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Paul Krugman Can’t Stand the Truth About Austerity

The digital age has produced many unfortunate byproducts. One of these is the rise of shorthand communication. In journalism, this has produced an overreliance on buzzwords. The buzzword substitutes for definition, delineation, distinction and careful analysis. Its advantage is that it purports to say so much within the confines of one word – which is truly a magnificent economy of expression, as long as the word is telling the truth. Alas, all too often, the buzzword buzzsaws its way through its subject matter like a chain saw, leaving truth mutilated and amputated in its wake.

The leading government budgetary buzzword of the day is “austerity.” For several years, members of the European Union have either undergone austerity or been threatened with it – depending on whose version of events you accept. Now the word has crossed the Atlantic and awaits a visa for admission to this country. It has met a chilly reception.

In a recent (05/11/2013) column, economist Paul Krugman declares that “at this point, the economic case for austerity…has collapsed.” In order to appreciate the irony of the column, we must probe the history of the policy called “austerity.” Tracing that history back to the 1970s, we find that it was originated by Keynesian economists – ideological and theoretical soul mates of Paul Krugman. This revelation allows us to offer a theory about otherwise inexplicable comments by Krugman in his column.

The Origin of “Austerity”

The word “austerity” derives from the root word “austere,” which is used to denote something that is harsh, cold, severe, stern, somber or grave. When applied to a government policy, it must imply an intention to inflict pain and hardship. That is, the severity must be inherent in the policy chosen – it cannot be an invisible or unwitting byproduct of the policy. There may or may not be a compensating or overriding justification for the austerity, but it is the result of deliberation.

The word was first mated to policy during the debt crisis. No, this wasn’t our current federal government debt crisis or even the housing debt and foreclosure crisis that began in 2007. The original debt crisis was the 1970s struggle to deal with non-performing development loans made by Western banks to sovereign nations. At first, most of the debtor countries were low-income, less-developed countries in Africa and Latin America. Eventually, the contagion of bad loans and debt spread to middle-income countries like Mexico and Argentina. This episode was a rehearsal for the subprime-mortgage-loan defaults to follow decades later.

The original debt crisis was motivated by the same sort of “can’t miss” thinking that produced the housing mess. Sovereign nations were the perfect borrower, reasoned the big Wall Street banks of the 1970s, because a country can’t go broke the way a business can. After all, it has the power to tax its citizens, doesn’t it? Since it can’t go broke, it won’t default on its loan payments.

This line of reasoning – no, let’s call it “thinking” – found willing sets of ears on the heads of Keynesian economists, who had long been berating the West for its stinginess in funding development among less-developed countries. Agencies like the International Monetary Fund and the World Bank perked up their ears, too. The IMF was created at the end of World War II to administer a worldwide regime of fixed exchange rates. When this regime, named for the venue (Bretton Woods, New Hampshire) at which it was formally established, collapsed in 1971, the IMF was a great big international bureaucracy without a mandate. It was charmed to switch its attention to economic development. By brokering development loans to poor countries in Africa, Central and South America, it could collect administrative fees coming and going – coming, by carving off a chunk of the original loan in the form of an origination fee and going, by either rolling over the original loan or reformulating the development plan completely when the loan went bust.

The reformulation was where the austerity came in. Standard operating procedure called for the loan to be repaid either with revenues from the development project(s) funded by the loan(s) or by tax revenues reaped from taxing the profits of the project(s). Of course, the problem was that development loans made by big bureaucratic banks to big bureaucratic governments in Third World nations were usually subverted to benefit leaders in the target countries or their cronies. This meant that there were usually no business revenues or tax revenues left from which to repay the loans.

Ordinarily, that would leave the originating banks high and dry, along with the developers of the failed investment projects. “Ordinarily” means “in the context of a free market, where lenders and borrowers must suffer the consequences of their own actions.” But the last thing Wall Street banks wanted was to get their just desserts. They influenced their colleagues at the IMF and the World Bank to act as their collection agents. The agencies took off their “economic development loan broker” hats and put on one of their other hats; namely, their “international economics expert advisor” hat. They advised the debtor country how to extricate itself from the mess that the non-performing loan – the same one that they had collected fees for arranging in the first place – had got it into. Does this sound like a conflict of interest? Remember that these agencies were making money coming and going, so they had a powerful incentive to maintain the process by keeping the banks happy – or at least solvent.

Clearly, the Third World debtor country would have to scare up additional revenue with which to pay the loan. One possible way would be to divert revenue from other spending. But the agency economists were Keynesians to the marrow of their bones. They believed that government spending was stimulative to the economy and increased real income and employment via the fabled “multiplier effect,” in which unused resources were employed by the projects on which the government funds were spent. So, the last thing they were willing to advise was a diversion of spending away from the government and into repayment of debt. On the other hand, they were willing to advise Third World countries to acquire money to spend through taxation. If government were to raise $X in taxes and spend those $X, the net effect would not be a wash – it would be to increase real income by X. Why? Because taxation acquires money that private citizens would otherwise spend, but also money that they would otherwise save. When the entire amount of tax revenue is then spent by government, the net effect is to increase total spending – or so went the Keynesian thinking. One of Keynes’ most famous students, Nicholas Kaldor, later to become Lord Kaldor in Great Britain, complained in a famous 1950s’ article: “When will underdeveloped nations learn to tax?”

Thus, the development agencies kept a clear conscience when they advised their Third World clients to raise taxes in order to repay the debt incurred to Western banks. Not surprisingly, this policy advice was not popular with the populations of those countries. That policy acquired the descriptive title of “austerity.” Viewing it from a microeconomic or individual perspective, it is not hard to see why. By definition, a tax is an involuntary exaction that reduces the current or future consumption of the vict-…, er, the taxpayer. The taxpayer gains from it if, and only if, the proceeds are spent so as to more-than-compensate for the loss of that consumption and/or saving. Well, in this case, Third World taxpayers were being asked to repay loans for projects that failed to produce valuable output in the first place and did not produce the advertised gains in employment either. A double whammy – no wonder they called it “austerity!”

How austere were these development-agency recommendations? In Wealth and Poverty (1981), George Gilder offers one contemporary snapshot. “The once-solid economy of Turkey, for example, by 1980 was struggling under a 55 percent [tax] rate applying at incomes of $1,600 and a 68 percent rate incurred at just under $14,000, while the International Monetary Fund (IMF) urged new ‘austerity’ programs of devaluation and taxes as a condition for further loans.” Note Gilder’s wording; the word “austerity” was deliberately chosen by the development- agency economists themselves.

“This problem is also widespread in Latin America,” noted Gilder. Indeed, as the 1970s stretched into the 80s and 90s, the problem worsened. “[Economic] growth in Africa, Latin America, Eastern Europe, the Middle East and North Africa went into reverse in the 1980s and 1990s,” onetime IMF economist William Easterly recounted sadly in The Elusive Quest for Growth (2001). “The 1983 World Development Report of the World Bank projected a ‘central case’ annual percent per-capital growth in the developing countries from 1982 to 1995″ but “the actual per-capita growth would turn out to be close to zero.”

Perhaps the best explanation of the effect of taxes on economic growth was provided by journalist Jude Wanniski in The Way the World Works (1978). A lengthy chapter is devoted to the Third World debt crisis and the austerity policies pushed by the development agencies.

Two key principles emerge from this historical example. First, today’s knee-jerk presumption that government spending is always good, always wealth enhancing, always productive of higher levels of employment depends critically on the validity of the multiplier principle. Second, the original definition of austerity was painful increases in taxation, not decreases in government spending. And it was left-wing Keynesians themselves who were its practitioners, and who ruled out government spending decreases in favor of tax increases.

Fast Forward

Fast forward to the present day. Since the 1970s, the worldwide experience with taxes has been so unfavorable – and the devotion to lower taxes has become so ingrained – that virtually nobody outside of Scandinavia will swallow a regime of higher taxes nowadays.

Keynesian economics, thoroughly discredited not only by its disastrous economic development policy failures but also by the runaway inflation it started but could not stop in the 1970s, has emerged from under the earth like a protagonist in a George Romero movie. Its devotees still preach the gospel of stimulative government spending and high taxes. But they stress the former and downplay the latter. And, instead of embracing their former program of austerity as the means of overcoming debt, they now accuse their political opponents of practicing it. They have effected this turnabout by redefining the concept of austerity. They now define it as “slashing government spending.”

The full quotation from the Paul Krugman column quoted earlier was: “At this point, the economic case for austerity – for slashing government spending even in the face of a weak economy – has collapsed.” Notice that Krugman says nothing about taxes even though that was a defining characteristic of austerity as pioneered by development-agency Keynesians of his youth. (Krugman does not neglect devaluation, the other linchpin, since he advocates printing many more trillions of dollars than even Ben Bernanke has done so far.)

When Krugman’s Keynesian colleagues originated the policy of austerity, they did it with malice aforethought – using the term themselves while fully recognizing that the high-tax policies would inflict pain on recipients. Now Krugman projects this same attitude on his political opponents by claiming that not only does reduced government spending have harmful effects on real income and employment, but that Republicans will it so. The Republicans, then, are both evil and stupid. Republicans are evil because they “have long followed a strategy of ‘starving the beast,’ slashing taxes so as to deprive the government of the revenue it needs to pay for popular programs. They are stupid because their reluctance “to run deficits in times of economic crisis” is based on the premise that “politicians won’t do the right thing and pay down the debt in good times.” And, wouldn’t you know, the politicians who refuse to pay down the debt are the Republicans themselves. The Republicans are “a fiscal version of the classic definition of chutzpah…killing your parents, then demanding sympathy because you’re an orphan.”

But the real analytical point is that Krugman, and Democrats in general, are exhibiting the chutzpah. They have taken a policy term originated and openly embraced not merely by Democrats, but by Keynesian Democrats exactly like Krugman himself. They have imputed that policy to Republicans, who would never adopt this Democrat policy tool because its central tenet is excruciatingly high taxes. They have correctly accused Republicans of wanting to reduce government spending but wrongly associated that action with austerity in spite of the fact that their Keynesian Democrat forebears did not include it in the original austerity doctrine.

Why have they done this? For no better reason than that they oppose the Republicans politically. Psychology recognizes a behavior called “projection,” the imputing of a detested personal trait or characteristic to others. Having first developed the policy of austerity in the late 1970s and seen its disastrous consequences, Democrats now project its advocacy on their hated Republican opponents. In Krugman’s case, there are compelling reasons to suspect a psychological root cause for his behavior. His ancillary comments reveal an alarming propensity to ignore reality.

Paul Krugman’s Flight from Reality

In the quoted column alone, Krugman makes numerous factual claims that are so clearly and demonstrably untrue as to suggest a basis in abnormal psychology. Pending a full psychiatric review, we can only compare his statements with the factual record.

“In the United States, government spending programs designed to boost the economy are in fact rare – FDR’s New Deal and President Barack Obama’s much smaller recovery act are the only big examples.” Robert Samuelson’s recent book The Great Inflation and Its Aftermath (2008)covers in detail the growth and history of Keynesian economics in the U.S. During the Kennedy administration, Time Magazine featured Keynes on its cover to promote a story conjecturing that Keynesian economics had ended the business cycle. Samuelson followed Keynesian economics and such luminaries as Council of Economic Advisors Chairman Walter Heller, Nobel Laureates Paul Samuelson and James Tobin through the Kennedy, Johnson, Carter and Reagan administrations. One of his major theses was precisely that Keynesian economists produced the stagflation of the 1970s by refusing to stop deficit spending and excessive money creation – a view that helped to discredit Keynesianism in the 1980s. There can be no doubt that U.S. economic policy was dominated by Keynesian policies “designed to boost the economy” throughout the 1960s and 1970s.

Moreover, every macroeconomics textbook from the 1950s forward taught the concept of “automatic stabilizers” – government programs in which spending was designed to automatically increase when the level of economic activity declined. These certainly qualify as “big” in terms of their omnipresence, although since Krugman is an inflationist in every way he might deny their bigness in some quantitative sense. But they are certainly government spending programs, they are certainly designed to boost the economy and they are certainly continually operative – which makes Krugman’s statement still more bizarre.

“So the whole notion of perma-stimulus is a fantasy… Still, even if you don’t believe that stimulus is forever, Keynesian economics says not just that you should run deficits in bad times, but that you should pay down debt in good times.” The U.S. government has had one true budget surplus since 1961, bequeathed by the Johnson administration to President Nixon in 1969. (The accounting surpluses during the Clinton administration years of 1998-2001 are suspect due to borrowing from numerous off-budget government agencies like Social Security.) This amply supports the contention that politicians will not balance the budget cyclically, let alone annually. European economies are on the verge of collapse due to sovereign debt held by their banking systems and to the inexorable downward drift of productivity caused by their welfare-state spending. Krugman’s tone and tenor implies that “Keynesian economics” should be given the same weight as a doctor prescribing an antibiotic – a proven therapy backed by solid research and years of favorable results. Yet the history of Keynesian economics is that of a discredited theory whose repeated practical application has failed to live up to its billing. Now Krugman is in a positive snit because we don’t blindly take it on faith that the theory will work as advertised for the first time and that politicians will behave as advertised for the first time. If nothing else, one would expect a rational economist to display humility when arguing the Keynesian case – as Keynesians did when repenting their sins in favor of a greatly revised “New Keynesian Economics” during the mid-1980s.

“Unemployment benefits have fluctuated up and down with the business cycle and as a percentage of GDP they are barely half what they were at their recent peak.” Unemployment benefits have “fluctuated” up to 99 weeks during the Great Recession because Congress kept extending them. The rational Krugman knows that his fellow economists have debated whether these extensions have caused people to stop looking for work and instead rely on unemployment benefits. Robert Barro says they have, and finds that the extensions have added about two percentage points to the unemployment rate. Keynesian economists demur, claiming instead that the addition is more like 0.4%. In other words, the profession is not arguing about whether the extensions increase unemployment, only about how much. Meanwhile, Krugman is in his own world, pacing the pavement and mumbling “up and down, up and down – they’re only half what they were at their highest point when you measure them as a percentage of GDP!”

“Food stamp use is still rising thanks to a still-terrible labor market, but historical experience suggests that it too will fall sharply if and when the economy really recovers.” Food stamp (SNAP) use has steadily risen to nearly 48 million Americans. Even during the pre-recession years 2000-2008, food-stamp use rose by about 60%. Thus, the growth of the program has far outpaced growth in the rate of poverty. The Obama administration has bent over backward to liberalize criteria for qualification, allowing even high-wealth, low-income households into the program. This does not depict a temporary program whose enrollment fluctuates up and down with economic change, but rather a tightening vise of dependency.

Krugman’s picture of a “still-terrible labor market” cannot be reconciled with his claim that government spending is an effective counter-cyclical tool. If Krugman’s reaction to the anemic response to the Obama administration economic stimulus is a demand for much higher spending, he will presumably pull out that get-home-free card no matter what the effects of a spending program are. Why would much higher spending work when the actual amount failed? Krugman makes no theoretical case and cites no historical examples to support his claim – presumably because there are none. Governments need no urging to spend money – European governments are collapsing like dominos from doing exactly that. European unemployment has lingered in double digits for years despite heavy government spending, recent complaints about “austerity” to the contrary notwithstanding.

“The disastrous turn toward austerity has destroyed many jobs and ruined many lives. And its time for a U-turn.” Keep in mind that Krugman’s notion of “austerity” is reduced government spending but not higher taxes. This means that he is claiming that taxes have not gone up – when they have. And he is claiming that government spending has gone down, presumably by a lot since it has “destroyed many jobs and ruined many lives.” But government spending has not gone down; only a trivial reduction in the rate of growth of government spending has occurred during the first four and one-half months of 2013.

“Yet calls for a reversal of the destructive turn toward austerity are still having a hard time getting through.” Krugman’s rhetoric implies that Keynesian economics is a sound, sane voice that cannot be heard above the impenetrable din created by right-wing Republican voices. As a rational Krugman well knows, the mainstream news media has long been completely dominated by the Left wing. (It is the Right wing that should be complaining because the public is unfamiliar with the course of economic research over the last 40 years and the mainstream news media has done nothing to educate them on the subject.) Its day-to-day vocabulary is permeated with Keynesian jargon like “multiplier” and “automatic stabilizers.” The rhetorical advantage lies with Democrats and Keynesians. It is practical reality that has let them down. The economics profession conducted an unprecedented forty-five year research program on Keynesian economics. Its obsession with macroeconomics led to a serious neglect of microeconomics in university research throughout the 40s, 50s and 60s. By approximately 1980, the verdict was in. Keynesian economics was theoretically discredited, although its theoretical superstructure was retained in government and academia. Even textbooks were eventually revised to debunk the Keynesian debunking of Classical economics. Macroeconomic policy tools were retained not because free markets were inherently flawed but because policy was ostensibly a faster way to return to “full employment” than by relying on the slower adjustment processes of the market. The reaction to recent “stimulus” programs has demonstrated that even that modest macroeconomic aim is too ambitious.

Keynesian economics has had no trouble getting a hearing. It has had the longest, fairest hearing in the history of the social sciences. The verdict is in. And Krugman stands in the jury box, screaming that he has been framed by conservative Republicans as the bailiffs try to remove him from the courtroom.

Memory records no comparable flight from reality by a prominent economist.