Paul Krugman, a Nobel Prize winning economist who writes for the New York Times, recently caused a stir when he wrote about “the third depression.” The premise of Krugman’s theory is the fiscal belt tightening taking place in many European economies, along with calls for budgetary restraint in the U.S., will push the world into its third depression. The first one transpired in 1873 while the second happened in the 1930s. According to Krugman, the world’s governments should be increasing its expenditures, not balancing its budget.
Is Dr. Krugman right? Will fiscal prudence send the world headlong into another depression? I say no.
I will acknowledge that we could experience some short term pain if government expenditures decreased, but I believe this is the best cure for the world over the longer term. Let me explain.
Krugman is a disciple of the Keynesian economic theory. John Maynard Keynes was a popular economist during the Great Depression, and his theory permeates the governmental and academic establishment today. Essentially, Keynes argued that the government should step in during economic downturns to maintain or increase aggregate demand. What is aggregate demand? It is the level of economic activity in the economy. Looking at today, our Gross Domestic Product (GDP), the barometer of the economy, is around $14 Trillion. Using Keynes logic, the government needs to keep aggregate demand around $14 Trillion. Keynes had an equation to exemplify aggregate demand (AG).
AG= C+I+G+(X-M)
I am not trying to bring back nightmares from your college Calculus class, but to put context to the theory. In this equation, C represents consumer spending, I is investment, G signifies government spending, and (X-M) is exports minus imports. Add these up, and you have the economy or aggregate demand. In theory, it seems to make sense. If C or I decrease, then increasing G will keep the economy from receding – maybe Krugman is right. The problem arises in the execution of this process. Keynes argues that keeping AD at its current level or higher is the key. It should be done at all costs even if that means going into debt to do so. As long as aggregate demand stays steady, everything is copacetic.
This runs contrary to another economic school of thought called the Austrian School, which suits my logic. The basic premise is true wealth is derived from savings and investment (at individual or economy level). Increased economic activity through the use of debt is a sham or house of cards. Why?
As an example, imagine two businesses that are purchasing equipment to increase revenues. The first company uses profits from the business while the second borrows to buy the equipment. Borrowing may not be a bad decision, especially if the cost to borrow is below the cost of the debt. However, Austrians argue that economies tend to become too reliant on debt. Companies and individuals continue to access debt to buy assets or consumer goods. This can continue for an extended period of time until the debt repayment infringes on the company’s or individual’s cash flow. At this point, spending must decrease to cover the debt or assets must be sold. A third option is default.
A reduction in spending will obviously hurt the economy in the near term as aggregate demand drops. Asset sales can hurt as well in this scenario. If several parties attempt to sell assets at the same time, the price of the assets drop, oftentimes below the debt owed on the asset. Once asset prices deflate, the third option, default, comes into play. This is why economic activity based on debt is a sham say the Austrians. If you purchased assets or goods with savings, you don’t face this situation. You aren’t forced to cut expenses or sell assets to pay debt.
The Austrian economists would argue that the U.S. and many other Westernized nations face a debt burden that will stunt growth for years to come. As the chart below shows, the U.S. has 3.7 times as much debt as economic activity. This includes individual, corporate and government debt. At the peak of the Great Depression, this number failed to reach 3 to 1 despite a 25% drop in GDP. The average ratio is 1.75 to 1. To reach the average, we would have to shed about $28 Trillion in debt through repayment, assets sales or default. Regardless of the method, it will take sacrifice or pain (depending on how you look at it) to get there.
The Keynesians will scream that I just proved that the government must step up and fill any void created by a debt repaying consumer or corporation. Otherwise, the economy could free fall if that much debt is liquidated or spending drops to pay back debt. Again, I disagree. We have historical precedence to show that the Keynesians are wrong. It is called Japan. Much like the U.S., Japan built a debt bubble back in the late 1980s.
Japan Debt
In 1989, the Japanese stock market tanked – much like ours did in 2008. At that time, Japan’s debt to GDP was 2.7 to 1. Consumer and corporate debt comprised the vast majority of the debt load at 219% while the government had a healthy ratio of only 52% debt to GDP. The debt levels peaked in 1996, but you will notice that the consumer and corporation reduced its debt load over the past two decades. However, the Japanese government increased its debt levels fearing that the economy would crater as the individual and corporation lowered its debt levels. The government debt to GDP went from the healthy 52% to almost 200% today.
What has been the result of this government intervention and stimulus? The Japanese stock market is still 3/4 below its peak of 1989; its real estate is selling for what it did in the 1970s; and its debt level relative to GDP has not improved at all. Since 1989, the Japanese markets have gone nowhere, and if you believe the Austrians theory on debt, Japan is no closer to a solution than it was two decades ago.
I fear we will suffer the same fate if we follow Krugman’s advice and become Japanese.
I also contend that the C+I+G+(X-M) fails to adequately address the inefficiency of the government. Based on this equation, a dollar of government spending is the same as a dollar of corporate or individual spending. This assumes the government is just as efficient at utilizing capital as companies or consumers. Keynesians argue that this is true. In fact, they believe a multiplier effect exists with government spending. The Obama administration has discussed how every dollar spent by the government creates 1.5 dollars of economic activity. Other studies show that the government doesn’t create a multiplier effect; it creates a divider effect, meaning every dollar spent by the government creates less than a dollar of economic activity. The International Monetary Fund (IMF) conducted a study and found the divisor is 0.7% and drops rapidly. The European Central Bank estimated a 0.3% divisor. This means every dollar spent by the government adds between 30 and 70 cents to the GDP. I lean towards the divisor argument having served at a Washington DC agency previously and having stood in line at the DMV.
There are also studies out there that argue that a dollar of debt by any party does not result in a dollar of economic activity. This probably doesn’t surprise an Austrian economist, but what is surprising is a dollar of debt might only produce about 30 cents of growth.
This chart from Chris Puplava shows that as our debt has grown, its effectiveness as an economy booster has not. This means that having the government borrow more to spur the economy has a muted impact. It also means that the costs for the little economic boost are huge. We pay back a dollar plus interest to get 30 cents of growth today. Would you take 30 cents today if you had to pay $1.10 over the coming decade? I wouldn’t.
This is why I disagree with Krugman. Short term, he has a point, but we end up paying a greater price down the road. We won’t get through this economic mess. In fact, it could intensify if we kick the can down the road.
Finally, I would point to the mini-Depression of 1920-21 as proof that government debt and spending is not the answer. In 1920, the US experienced a painful economic environment where the GDP shrank 16.5% and the markets dropped by 50%. The government’s response was to cut taxes in half as well as government spending. Eighteen months after President Harding took these steps, the US economy was booming. Of course, we can’t say this period lines up exactly with today since the US was coming out of WWI where tax rates were already high to pay for the war. Also, the government controlled a large part of the economy as well. However, it is a clear example of putting more money in the hands of private capital during a crisis as opposed to increasing or maintaining government spending.
Our choice is to continue on our path of Japanese stimulus and debt, which has clearly failed, or put more money in the hands of private parties, which succeeded in 1920.