For some reason, I found myself reading through Paul Krugman’s recent NY Times material. Perhaps it was a desire for a little mental vaunting, what with the direction the elections seem to be taking, and if so I should have come away quite satisfied as Mr. Krugman is in full Chicken Little mode. A GOP takeover of congress will be a disaster, and we should all be very afraid. Stupid people are allowing their emotions to run away with them and will destroy the world economy through getting all moralistic about debt. And of course, the reason why the entire world doesn’t see things Krugman’s way is because macroeconomics is too hard for them to understand.
Well, I’m certainly prepared to admit that Krugman’s expertise in macroeconomics is greater than my own — and I’ll even stretch and say that my understanding probably goes farther than that of the average bear. However, I can’t escape the feeling that Krugman is somewhere between singing:
The intelligent lot, the intuitive lot,
The infallible lot we are.
The marvellous mugs, miraculous mugs,
The mystical mugs we are.
But since he’s rather less exuberant than Chesterton he says it like this:
The greatness of Keynes is illustrated by the trouble people who consider themselves well informed have, to this day, in understanding the basic principles of how a depressed economy works.
It’s true that most people are not very good at understanding complex systems with many, interdependent moving parts. This is why most people are confused by macroeconomics, or come to that microeconomics at the theoretical level. But then, it’s also why even terribly clever people who think that they have a solid grasp of macroeconomic theory get themselves in trouble by believing that they understand all the factors in play and drawing up charts which demonstrate that unless we pass the President’s recovery plan, unemployment might go as high as 9%.
Don’t get me wrong, macroeconomics is indeed different from everyday business experience, as Krugman touches on:
Businesses are open systems; the world economy is a closed system, with feedback effects that are crucial but play no role in ordinary business experience. In particular, an individual businessman, no matter how brilliant, never has to worry about the fact that total income equals total spending, so that if some people spend less, either someone else must spend more, or aggregate income must fall.
But when the explanations become too mystical, I can’t help (perhaps because it’s just my simplistic, middle brow, self) cocking an eyebrow:
The years leading up to the 2008 crisis were indeed marked by unsustainable borrowing, going far beyond the subprime loans many people still believe, wrongly, were at the heart of the problem. Real estate speculation ran wild in Florida and Nevada, but also in Spain, Ireland and Latvia. And all of it was paid for with borrowed money.
This borrowing made the world as a whole neither richer nor poorer: one person’s debt is another person’s asset. But it made the world vulnerable. When lenders suddenly decided that they had lent too much, that debt levels were excessive, debtors were forced to slash spending. This pushed the world into the deepest recession since the 1930s. And recovery, such as it is, has been weak and uncertain — which is exactly what we should have expected, given the overhang of debt.
The key thing to bear in mind is that for the world as a whole, spending equals income. If one group of people — those with excessive debts — is forced to cut spending to pay down its debts, one of two things must happen: either someone else must spend more, or world income will fall.
Yet those parts of the private sector not burdened by high levels of debt see little reason to increase spending. Corporations are flush with cash — but why expand when so much of the capacity they already have is sitting idle? Consumers who didn’t overborrow can get loans at low rates — but that incentive to spend is more than outweighed by worries about a weak job market. Nobody in the private sector is willing to fill the hole created by the debt overhang.
Now, as a stand-alone economic model, this makes a great deal of mathematical sense — and that’s hardly a surprise as Krugman is a smart guy with an ability to understand complex mathematical models. Yet it’s a model, it’s not the real world. And as such, it’s only as useful as its resemblance to the real world.
Mathematically speaking, if demand is not coming from one source (businesses and individuals spending money which they have or which they have borrowed) then you can make up for that demand from another source (the government spending money it has borrowed) and the effect will be the same. The two main problems I see, however, have nothing to do with the mathematics of the model — they have to do with the relation of the model to reality.
First off, however much it clearly annoys Krugman that this is the case, voters simply do not like the idea of the government spending endless amounts of borrowed money on projects which might not otherwise be funded because it’s important to “prime the pump” of the economy. People can’t escape the idea that this is their money, as taxpayers, which is being spent, and that they’re going to have to pay it back. During a recession, people are particularly troubled by their own debts and bills — and since one of the bills that they see every so often is a tax bill, they don’t like thinking about the government racking up endless debts which they are going to have to pay back later. So while in theory government spending could make up for a private demand shortfall and keep the economy up, it seems to me that in practice it’s simply not sustainable in a situation where that public spending would have to be financed through massive borrowing, because since people would be thinking “that’s borrowed money” they would continue to be afflicted by economic anxiety and to sit tight on their savings. Knowing that the public money being used to “prime the pump” was “fake” demand would keep people from recovering their confidence and prolong the lack of private demand.
The second big issue that comes up, it seems to me, it the question of what the government should spend its money on in order to stimulate demand. This was comparatively easy during the New Deal programs of the Great Depression — a significant percentage of the country was employed in manual labor, and many major public works projects required large numbers of manual laborers, so it was easy to start up a big project, pay the workers, and expect that money to filter out into the economy. Today’s workforce is much more heavily focused on skilled/specialized labor, and so even if we assume that the government could use deficit spending to employ lots of people through public spending, this brings up the question of what the government should spend on which wouldn’t cause mal-investment in capital and labor training.
Say, for instance, the government were to announce a major project of putting up wind farms. Huge amounts of money are spent, lots of new wind turbine making factories are built and wind turbine makers and installers are trained. All this spending helps get the economy back on track, as those wind turbine installers head down to Wal-Mart and spend their paychecks. After two years the program is a success, and so the wind turbine program ends. Now what happens to those workers and the capital investments in those factories? How easily are they turned to other work, and how long are they unemployed in the interim? Do we simply end up with another economic slowdown as a result of massive unemployment in the windfarm industry?
The problem is, even a wonderfully complex economic model dreamed up by an intelligent lot, and intuitive lot, and infallible lot of marvelous, mystical mugs will end up being simpler than the actual world. And as a result, it’s not always as easy to get the real world to do what you want as it is to get a model to do so.