All Commentary
Wednesday, July 22, 2009

Have Government Deficits “Saved the World”?

A Second Stimulus Would Be Disastrous

Paul Krugman's Chart Explaining How Deficits

Paul Krugman’s Chart Explaining How Deficits “Saved the World”

Last week, I wrote about the crudeness of so-called Keynesian economic theory in which one assumes that all assets and capital “investment” are “homogeneous” in character, which means that their only contribution to the economy is from the money that is spent in their creation and continued operation. This view contrasts with the Austrian paradigm, which emphasizes the structure of production within an economy and the unsustainability of capital that is malinvested during a boom.

Unfortunately, too many people in high places are prone to believe what on its face is unbelievable: running huge federal deficits somehow is a good thing for the economy. The latest outburst comes from Paul Krugman, who recently claimed that deficits “have saved the world.”

Krugman reports a quote from a Goldman Sachs analyst who pointed out that at the present time, private savings is greater than private investment. In his July 15, 2009, New York Times blog, the 2008 Nobel Prize winner writes:

That’s an interesting way to think about what has happened — and it also suggests a startling conclusion: namely, government deficits, mainly the result of automatic stabilizers rather than discretionary policy, are the only thing that has saved us from a second Great Depression.

He concludes by stating,

… absent the absorbing role of budget deficits, we would have had a full Great Depression experience. What we’re actually having is awful, but not that awful—and it’s all because of the rise in deficits. Deficits, in other words, saved the world.

Unfortunately, Krugman has confused cause with effect. The supposed imbalance between savings and planned investment is not causing an economic downturn; it is the result of the downturn. Likewise, the reluctance of people to spend as they did before is not causing a recession, but rather is occurring because of the recession.

In the Keynesian world, it is all so simple. People spend and the economy does well. However, if people don’t spend money like before, then the economy is in the doldrums and needs to be bailed out by government spending.

Once upon a time, people would have seen through this nonsense, but since Keynesian theory dominates the academic world and, unfortunately, the investment world, too many people are beguiled by such beliefs. However, for all of its supposed simplicity, the Keynesian theory is loaded with fallacies and just plain bad ideas.

First, and most important, deficits have not “saved the world.” They only have extended the unsustainable “boom” (or, more appropriately, what is left of the boom) and are postponing the day of reckoning. Second, they are guaranteeing that future generations are going to be faced with the devil’s bargain of either having to tax themselves mightily to pay off the debt or to repudiate it with inflation. Neither is a satisfactory outcome.

Keynesians seem to believe that a boom can be sustained forever, providing that governments fill in with extra spending. However, that is extremely unsound thinking. As Ludwig von Mises and the Austrians long ago noted, the very nature of the crisis at the end of a boom is built upon the fact that a boom cannot be sustained because the longer the boom goes on, the greater the malinvestments.

Indeed, the only way out of the crisis is for the malinvestments to be liquidated or diverted to other, more sustainable, uses. Once the fundamentals of an economy are put back into balance, a recovery can begin.

Unfortunately, because of the action taken by presidents Bush and Obama, as well as the Federal Reserve System, the excesses of the original boom still have not been fully shaken from our economy. That means that the recession still has a way to go before it hits bottom, which means bad news for a lot of Americans.

One wishes that the nation’s policymakers would realize that their actions to sustain the boom not only are ineffective, but downright harmful. Likewise, the “second stimulus” only would keep the malinvestments from liquidating and put off that awful day of fiscal reckoning in the future. And it will arrive, and Washington cannot do anything about it.

  • Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Economics from Auburn University. He is a member of the FEE Faculty Network.