In my previous post when discussing Federal Reserve Chairman Bernanke’s fatuous speech at Jackson Hole I lumped him together with Paul Krugman as an American in denial about the US’s debt problems. As I know that both Bernanke and Krugman (Krugman especially) would bitterly disagree with any argument that lumps the two together I feel some explanation is in order.
Krugman’s writings show him to be a classic Keynesian and his views concerning the current crisis depend heavily on the thinking of Keynes. In Krugman’s view the problems the US faces are caused by something he calls a “liquidity trap”. This is a situation where expectations about the future are so bad that nothing governments can do by way of increasing the supply of money can persuade banks to lend or businesses to invest. The solution according to Krugman is a massive fiscal stimulus, one far bigger than the one the US has so far attempted, whereby the government spends enormous amounts of money on an ambitious programme of public works. Supposedly the increase in economic activity caused by such a stimulus will transform expectations, end the liquidity trap and by stimulating demand and investment put the economy back onto the road to full employment and growth. The increase in the amount of government debt caused by such a stimulus is according to Krugman not a serious problem since once growth has been restored the debt will rapidly diminish as a proportion of the economy as the economy grows whilst the increase in tax revenue that will result from the economy’s growth will make repayment of the debt and of the interest on it relatively easy. As for financing such borrowing, Krugman reasonably points out that this presents no difficulty since in a situation where expectations are as poor as they are today private investors have no realistic option but to lend to the government if they want to see a return on their money. In support of this Krugman points to the very low interest currently being asked for by buyers of US Treasury bonds.
I disagree with this view. I say this in the full knowledge that Krugman is a winner of the Nobel Prize for economics and I obviously am not. However it seems to me that Krugman is making the mistake of confusing the situation that exists today with the one that existed in the 1930s when Keynes was writing and when the idea of the “liquidity trap” was born.
The problem faced by the US economy in the 1930s was a problem of massive industrial overcapacity caused by a runaway boom in industrial investment in the US which had begun around 1900 and which got completely out of hand over the course of the 1920s. In conditions where US employers had managed to hold down wages this left the US at the end of the 1920s in a situation where its industries were producing far more goods than it could possibly absorb (a so called “overproduction crisis”). The result was that investment collapsed in 1929 (“the Wall Street Crash”), causing a collapse in production, which began in earnest the following year. Eventually this fed into the banking system, which had funded the investment boom, and which soon found itself facing concerns about its solvency. Over the course of the winter of 1932 the banking system in turn collapsed bringing the economy to crisis and the Depression to its lowest point.
In a less extreme form something similar happened to Japan in the 1990s. Japan is the economy upon whose experience Krugman mainly draws when discussing the “liquidity trap”. Japan also found itself lumbered at the end of the 1980s with enormous industrial overcapacity brought about as a result of an uncontrolled investment boom. This too collapsed causing industrial output to plummet and and leaving massive problems in the banking system in its wake. The economy has never recovered and has stagnated ever since.
It is easy to see how confronted with such a problem of massive overcapacity businesses in the US in the 1930s and in Japan in the 1990s were unwilling to invest and banks were unwilling to lend. It obviously made no sense in those conditions for businesses to invest and for banks to lend if the only effect was to add to an overcapacity that was already excessive. It is in the context of this problem of overcapacity that Keynes invented the concept of the “liquidity trap” and argued that the way to solve this problem was by a massive programme of government spending to absorb the excess capacity.
There was a strange paradox in Keynes’s work. At the time observers such as the British historian A.J.P. Taylor noticed that Keynes seemed to be writing prescriptions which applied to economies suffering from industrial overcapacity. In the 1930s this was true of the US and Germany. It was not however true of Britain. As A.J.P. Taylor said this meant that Keynes was coming up with ideas suitable for application in countries other than his own, which was Britain. This acute comment of A.J.P. Taylor’s should be borne in mind when assessing Keynes’s work. Since it was made by a historian and not an economist it never is. This is unfortunate because essentially the same point can be made when trying to use Keynes to deal with the problems of today.
Whatever caused the crisis that hit the US in the summer of 2007 it was not industrial overcapacity. The US did not face in 2007 an overproduction crisis. Nor does it face one now. That this is so is shown by the fact that the US today is the world’s biggest importer of manufactured goods. By contrast in the 1930s (and indeed until the 1970s) the US was the world’s biggest exporter of manufactured goods. The fact that the US has to import manufactured goods to satisfy its needs shows that it cannot suffer from a problem of industrial overcapacity or overproduction.
The reason businesses in the US today are unwilling to invest and banks are unwilling to lend cannot therefore be because as was the case in the 1930s they see no point in adding to already excessive capacity. The problem rather is that businesses are not willing to invest and banks are not willing to lend because they doubt the solvency of their customers. The reason they doubt the solvency of their customers is because many and perhaps most of their customers in fact actually are insolvent.
Starting in the 1970s but accelerating through the 1980s, the 1990s and the 2000s the growth of private debt came to substitute in the US (and in Britain) for the growth of real wages. By most calculations real wages have stagnated in the US since the 1970s and by some calculations they have actually fallen. The point has now been reached when the capacity of private debtors to take on more debt has reached its limit and their ability to repay the debt they already owe is now in doubt. The result is a collapse in demand and concern about the solvency of the banking system, which had already become dangerously overextended during the credit boom because of its speculations in bizarre debt based financial instruments such as derivatives. Together the trade in these instruments and the debts owed to the banks by those who have borrowed from the banks to supplement their incomes (usually on the security of their homes) make up the bulk of banks’ assets. Since there is now concern about the soundness of both the banks have found themselves in a situation where they doubt the value of their assets and are unsure of their own solvency.
In other words whereas the crisis in the US in the 1930s and in Japan in the 1990s was a crisis of overcapacity the crisis in the US and in the western economies today is better understood as a crisis of solvency. It is this fact that both Bernanke and Krugman each in their different ways struggle to accept.
Given that this is so it is very far from obvious at least to me what a massive debt fuelled government spending programme of the sort that Krugman proposes would achieve other than to add more government debt onto the massive already existing debt. Doubtless there would be some more growth but I suspect that most of the stimulus would disappear into debt repayment. Given the size of the debt (many times the amount of US GDP) it is difficult to believe that any stimulus would be big enough to do what Krugman wants it to do.
Whilst it is probably true that low borrowing costs at the moment make a big government spending programme possible those interest rates at present are only as low as they are because central banks have been keeping interest rates as low as possible and have even been indulging in experiments in printing money. One wonders to what extent they would feel able to continue to do this if they were to see government borrowing in the US soar in the way that Krugman wants. At some point interest rates will anyway have to go up if only to meet the needs of savers who are currently being hammered. Encouraging saving in the long run is essential if the financial system is to be restored to health since without saving there can be no long term capital accumulation as there needs to be. This obviously cannot happen whilst interest rates remain so low.
Needless to say the moment interest rates start to rise the cost of government borrowing will soar. If Krugman’s gigantic fiscal stimulus has not by that time achieved its purpose and made the economy grow in the way he expects it to (and I do not see how it can) then it seems to me that the US would then face a sovereign debt crisis the like of which the world has never seen and compared to which the sovereign debt crises we have seen this summer in places like Portugal and Greece would be like a picnic at the Vicarage.
Krugman and his supporters are familiar with this argument. They reject it and say that there is in fact no general debt crisis. They deny that the US has a general problem of solvency. Their major point is that because of their unwillingness to invest US corporations have accumulated vast cash hoards amounting to some $2 trillion. They argue that this means that not only is there no general problem of solvency in the US but on the contrary that there is an abundance of money in existence and available that only has to be put to use to make the economy grow.
This fails to understand the way cash hoards can co exist with high levels of personal debt though there are many examples of this in history extending back to the last years of the Roman Republic. In fact the existence of cash hoards together with growing concentration of wealth in an ever smaller ring of persons is a classic symptom of a debt crisis. Because trade has become so international the biggest of these dollar hoards are now held outsiide the US by the US’s international creditors, China, Russia, Japan and Taiwan. The simple fact is that where demand depends on debt the flow of money will always go back to producers who have to lend money to create demand for their goods. If this money cannot be spent or invested it will simply grow, which is what has happened.
Cash hoards are not therefore a sign of economic strength. Rather they are a symptom of crisis. They are of no use to the relatively small number of US companies and individuals that hold them if their customers or potential customers are all insolvent. On the contrary in such conditions the instinct of such companies will be not to invest their money but to hold on to it as insurance against another collapse in demand and freeze in bank lending such as the one that happened in the autumn of 2008. This logic will continue to apply for as long as the level of private debt remains as high as it currently is regardless of anything the US government does by way of higher spending in the meantime.
This brings me to my main point. There is no reason to invent a complicated concept like a “liquidity trap” to explain the problems in the US economy today. The reason demand is so low and economic activity is so depressed is because US consumers and US banks are saddled with massive debts they have no realistic hope of payiing off in any reasonable period of time. These debts, unlike the US’s government’s debt about which so much has been written, are many times greater than GDP. In fact the reason government debt in Europe and the US has grown so much since 2008 is that governments have tried to relieve some of the pressures on private lenders and borrowers by transferring a proportion of these debts onto ther own balance sheets. Whilst this relieved the immediate crisis of 2008 the extent of private debt is so vast that the effect has been limited whilst one unhappy consequence has been that the taking on of so much bad debt by governments has cast doubt upon their own solvency.
All in all it seems to me that what Krugman and his neo Keynesian allies (Stiglitz, Reich, Roubini, James Galbraith and the rest) are proposing is a massive gamble with the economic future of the US based on a premise that is actually false. Not for the first time it seems to me that economists have led themselves down a blind alley because of the way they insist on divorcing their subject from history. The result is that Krugman and the others as disciples of Keynes treat the master’s words not as Keynes’s creative response to the contemporary problems of his own day but as eternal truths that can be used to guide actions now.
In making these points I do however want to finish with one final but important point. Though I think Krugman is wrong I think he is less wrong (indeed far less wrong) than the assorted free market “classical” economists with their elaborate mathematical models and “rational expectations” theories who criticise him. Anyone who reads Krugman’s blog (which I do) can have no doubt that he is a serious and intelligent person who worries about conditions as they exist in the real world and who is struggling to come up with answers to the real problems that exist today. His answers may not always be the right ones but he always has something interesting and important to say. The same by the way cannot be said for some of the more strident and populist of his followers who write for such journals as Znet and Counterpunch and whose language and thinking is always a great deal cruder than Krugman’s ever is.
If Krugman is a serious and informed writer on economic affairs the same emphatically cannot be said of the tiresome claque of far right free market fanatics and fantasists who dominate most of what passes today for economic commentary and who inhabit the mainstream newspapers, television and academia. These people’s grasp of reality is about as strong as was that of ancient alchemists, astrologers and practitioners of ancient mystery religions. Where Krugman at least tries to find a path back towards some form of reality these people offer a path to nowhere at all.