Prof. Krugman Is = Wrong, Again

Posted by Steve H. Hanke

Prof. Paul Krugman asserts in his New York = Times=20 column of May 31st that =E2=80=9CBoth textbook economics and = experience say that=20 slashing spending when you=E2=80=99re still suffering from high = unemployment is a really=20 bad idea =E2=80=94 not only does it deepen the slump, but it does little = to improve the=20 budget outlook, because much of what governments save by spending less = they lose=20 as a weaker economy depresses tax receipts.=E2=80=9D

While Prof. Krugman and most other fiscalists believe this to be=20 self-evident, it is not. Indeed, this fiscalist dogma fails to = withstand=20 the indignity of empirical verification. Prof. Paul = Krugman=E2=80=99s formulation=20 fails to mention the state of confidence. This is an important=20 oversight. As Keynes himself put it: =E2=80=9CThe state of = confidence, as they=20 term it, is a matter to which practical men pay the closest and most = anxious=20 attention.=E2=80=9D

By ignoring the confidence factor, economic theory can lead to wildly = incorrect conclusions and misguided policies. Just consider naive=20 Keynesian fiscal theory =E2=80=94 the type presented (as Prof. Krugman = notes) in=20 textbooks and embraced by most policymakers and the general = public. =20 According to Keynesian theory, an expansionary fiscal policy (an = increase in=20 government spending and/or a decrease in taxes) stimulates the economy, = at least=20 for a year or two after the fiscal stimulus. To put the brakes on = the=20 economy, Keynesians counsel a fiscal contraction.

A positive fiscal multiplier is the keystone for Keynesian fiscal = theory=20 because it is through the multiplier that changes in the budget balance = are=20 transmitted to the economy. With a positive multiplier, there is a = positive relationship between changes in the fiscal deficit and economic = growth:=20 larger deficits stimulate growth and smaller ones slow things down.

So much for theory. What about the real world? Suppose a = country=20 has a very large budget deficit. As a result, market participants = might be=20 worried that a further loosening of fiscal conditions would result in = more=20 inflation, higher risk premiums and much higher interest rates. In = such a=20 situation, the fiscal multipliers may be negative. Fiscal = expansion would=20 then dampen economic activity and a fiscal contraction would increase = economic=20 activity. These results would be just the opposite of those = predicted by=20 naive Keynesian fiscal theory.

The possibility of a negative fiscal = multiplier=20 rests on the central role played by confidence and expectations about = the course=20 of future policy. If, for example, a country with a very large = budget=20 deficit and high level of debt (estimated U.S. deficit and debt levels = as a=20 percentage of GDP for 2010 are 10.3% and 63.2%, respectively) makes a = credible=20 commitment to significantly reduce the deficit, a confidence shock will = ensue=20 and the economy will boom, as inflation expectations, risk premiums and=20 long-term interest rates decline.

There have been many cases in which negative fiscal multipliers have = been=20 observed. The Danish fiscal squeeze of 1983-86 and the Irish = stabilization=20 of 1987-89 are notable. The fiscal deficits that preceded the = Danish and=20 Irish fiscal squeezes were clearly unsustainable, and risk premiums and = interest=20 rates were extremely high. Confidence shocks accompanied the = fiscal=20 squeezes, and with negative multipliers in play, the Danish and Irish = economies=20 took off. (Evidence from the U.S. is presented in an article by Professors Jason E. Taylor and Richard = K. Vedder=20 which appears in the current May/June 2010 issue of the Cato Policy=20 Report.)

Margaret Thatcher also made a dash for confidence and growth via a = fiscal=20 squeeze. To restart the economy in 1981, Thatcher instituted a = fierce=20 attack on the British deficit, coupled with an expansionary monetary=20 policy. Her moves were immediately condemned by 364 distinguished=20 economists. In a letter to the Times of London, they = wrote a=20 knee-jerk Keynesian (Prof. Krugman-type) response: =E2=80=9CPresent = policies will deepen=20 the depression, erode the industrial base of our economy and threaten = its social=20 and political stability.=E2=80=9D Thatcher was quickly = vindicated. No sooner=20 had the 364 affixed their signatures than the economy boomed. = People had=20 confidence in Britain again, and Thatcher was able to introduce a long = series of=20 deep free-market reforms.

While Prof. Krugman=E2=80=99s authority is weighty, his arguments and = evidence are=20 slender.

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