Sunday, 1 June 2014

Paul Krugman and the New Keynesians

I just had read Paul Krugman’s book – End the Depression Now - for the second time. Everyone regardless of political philosophy should read this book. Even though Paul Krugman has become the top spokesman for Keynesian economics, he writes clearly, succinctly, and intelligently for an economist. Perhaps, Paul Krugman should rewrite Keynes’s book. Unfortunately, the world’s two most famous economists, Maynard Keynes and Karl Marx, are incredibly long-winded writers as every sentence overflows with superfluous words, and sentences stretch across pages.

Paul Krugman is correct in many ways but errs in other ways. The world continues to struggle from the Great Recession that struck the world in 2007. Something seriously happened to the U.S. economy, and many people do not get it. Paul and I get it, and I understand why most people do not get it. Everyone grew up during the prosperous times when the U.S. economy plowed ahead and created millions of jobs while the U.S. military and U.S. businesses dominated the world. If someone wanted to work, the person would simply fill out several job applications and wait for the phone call. Then this person had a job. Then this person could apply for other jobs while working, and gradually transition themselves into better positions.

Nevertheless, something had changed. After the 2007 Great Recession, the U.S. economy has become stuck like a truck spinning its tires in the mud. Jobs had become scarce while the unemployment rate gradually falls towards the 5% rate, which we consider normal. However, many smart people know something had broken in the U.S. economy.

Many politicians and leaders view the falling unemployment rate as a barometer on the economy’s health. However, a falling unemployment rate masks two problems. First, the U.S. government does not count discouraged workers as unemployed. Discouraged workers want to work, but they stopped searching for employment because they believe they can’t find a job in the economy. Second, some people found part-time jobs after being laid off during the 2007 Great Recession. However, some of these people want to work full time and not part time.

What had happened? Something struck the economy like the Ebola virus coursing through a healthy person’s body. Of course, I argue the transition from a manufacturing economy to a service-oriented one had replaced many good-paying, full-time jobs with low-paying, part-time jobs. Then we add an overbearing, all-controlling government that further damaged our economy. Now, we arrive at the first rule - just like the socialists and communists, Keynesians accurately describe the poor’s plight and misfortune.

Rule 1: The Keynesians, Socialists, and Communists can accurately describe the plight of the poor and misfortune in our society.

Paul Krugman correctly assessed Europe’s plight. European leaders have fallen into the austerity trap - governments must increase taxes and reduce government programs. If people picked up an elementary economics textbook, they would discover austerity would be a disastrous policy. During recessions, government should increase government spending and/or reduce taxes because the government injects money into the economy, raising consumers' incomes and spending. Similarly, the government could reduce taxes, allowing taxpayers to keep more income, so they can increase their spending and help expand the economy.

Paul Krugman, however, has missed the point. The European countries never used Keynesian economics correctly, which becomes Rule 2. Governments should use austerity during economic expansions that would slow the economy. Austerity helps create budget surpluses to reduce the government’s debt and strengthens a government’s finances. Then during a crisis or recession, government can boost its spending and lower taxes to expand the economy. Unfortunately, European governments reduced taxes and boosted government spending during the economic expansion, weakening their financial resources. As European governments tried to increase government spending during the 2008 Financial Crisis, investors became leery, pessimistic, and fearful. They stopped investing in Greek, Spanish, and Irish bonds. Investors believed these governments had issued too much debt, and the governments would experience troubles repaying the bonds with interest. We know this became true. Remember the Greek haircut? Euphemism for forcing the bondholders to take a 50% loss on their Greek bonds.

Rule 2: For pure Keynesian economics, government reduces spending or raises taxes during economic booms and boost spending or reduces taxes during recessions. Thus, government strengthens its finances to handle downturns in the economy.

Keynesians are biased towards government spending, which becomes Rule 3. Don’t get me wrong. I understand the concept well. Every economy has four broadly defined sectors: Consumers, businesses, governments, and exports-imports. During a recession, consumers and businesses become fearful and pessimistic about the future. Consumers reduce their spending, buy fewer imports, and boost their savings. As businesses sell fewer products or services, companies lay off some of their labor and reduce their investments. Meanwhile, if the recession had spread to a foreign country, then foreigners buy fewer exports from us. Consequently, our economy takes a huge hit from lack of spending. Consequently, government becomes the only entity that can defy the recession and can boost its spending to overcome society's lower spending.

Rule 3: Keynesians have a bias towards government spending. Nevertheless, government can reduce taxes to expand the economy and raise taxes to slow the economy down.

Many Keynesians discourage businesses, government, and consumers from saving, leading to Rule 4. They must spend all their incomes in the economy to buy goods and services, and keep the economic machine turning. Since everyone becomes fearful and saves more during recessions, people remove money from the economy. Thus, Keynesians are correct if people hide their savings under their mattresses while business and government store their money in vaults. On the other hand, if companies and people deposit their funds into banks, then banks can lend out their funds. Consumers borrow to buy houses, cars, and appliances while companies borrow to invest in buildings, machines, computers, and equipment. This explains why the Asian tigers - Hong Kong, Singapore, Taiwan, and South Korea - grew phenomenally. Asians are phenomenal savers who deposit their savings into banks. Then banks could grant loans to businesses that invest in their economies that fuel their extraordinary economic growth rates.

Rule 4: Keynesians are against businesses, government, and consumers from saving. They must continually spend to prop up the economy.

Here is where Paul and I begin to diverge. Keynesians pick certain periods to show Keynesian economics works, which becomes Rule 5. They always point to a particular time such as the U.S. government preparing the U.S. economy for World War II. The U.S. federal government ramped up spending to build ships, trucks, weapons, and supplies for soldiers. U.S. manufacturing went into overdrive and stomp on the economy’s accelerator. Many young men joined the armed forces while many factories hired women to work in the factories. No question, Keynesian economics had worked.

Rule 5: Keynesians choose their times well to show Keynesian economics works. Then they neglect other times when Keynesian economics had failed.

Everyone forgets Franklin Roosevelt, who started his presidency in 1932. The president boosted government spending during the 1930s by creating numerous alphabet soup agencies and sponsored massive public works projects. Did the U.S. economy recover? No - the U.S. economy had entered a recession in 1937. Of course, the U.S. government also raised taxes, which the government should never do during a recession, and the U.S. government encouraged companies to keep paying high wages to the workers. The high wages ensured the workers retained their purchasing power. Unfortunately, people increase their savings during uncertain times and reduce their spending.

Let’s say the Great Depression was an anomaly. I can find another significant failure of Keynesian economics. Japan entered its two-decade malaise starting in the early 1990s. Japan also used Keynesian economics since the 1990s as the Japanese government amassed a public debt to GDP ratio of 200%. Consequently, the Japanese economic engine continues sputtering and struggling along since the 1990s. What makes Japan unique is the Japanese government bonds are held within Japan, and thus, Japan has little risk of foreigners triggering a financial crisis, which I explain later in this blog.

Returning to our side of the world, the U.S. federal government has dumped trillions of dollars into the economy since the start of the 2008 Financial Crisis, and we have witnessed the weakest recovery ever. Of course, Paul Krugman said, if Keynesian economics does not work, then government must scale up its spending, which becomes Rule 6. Using Paul’s analogy from his book, the broken economy represents a car with a defective battery. The government must only replace the battery to get the car running again. Well, the government has spent $700 billion to bail out the financial institutions and another $831 billion for the American Recovery and Reinvestment Act of 2009. Then the Federal Reserve, our central bank, lent about $2 trillion to bail out the banks. Replacing the battery has become expensive while that damn car still won’t start. The U.S. economy measures about $16 trillion, so if government continues boosting its spending, it will dominate and control our society, similarly to the Soviet Union, where the bureaucrats controlled the entire economy.

Rule 6: Communists and Keynesians only differ in their scale of the government's planning.

I do agree with Paul Krugman – government should never decrease government spending or boost taxes during a recession. Nevertheless, I must add one caveat - government must have strong finances to weather the downturn. In his book, Krugman cites Minsky, an unknown economist. Minsky expounded a simple idea. A company with low debt can expand quickly by taking out bank loans, which we call leveraging. The company continues doing well and keeps expanding while banks keep granting the company more loans. Then a crisis happens, and banks start examining their loans. If banks believe the company has too many loans, the bank cuts the company off, which imposes hardship onto the company. The company begins deleveraging by cutting back on spending and repaying its loans. If a financial crisis strikes the company, then the company may nosedive while the bankers, stockholders, and bondholders panic. Subsequently, the company accelerates towards bankruptcy.

For example, Lehman Brothers bankrupted in October 2008. It began with a leverage ratio of 26 to 1 in 2003 that surged to 39 to 1 in 2006. Consequently, Lehman Brothers borrowed $39 for every $1 it had in equity. Equity measures a company’s financial strength by taking its assets and subtracting its liabilities. Investors want a low leverage ratio because they want to recoup their investments if the company bankrupts. Unfortunately, Lehman Brothers borrowed to buy expensive real estate at the height of the housing bubble.

Did you catch the irony? The U.S. federal government has a leverage ratio too. We know the U.S. government has accumulated $17 trillion dollar debt, but we do not know the government’s equity. Although the U.S. government spends about $3.5 trillion per year, this does not represent equity. We must add all the government’s assets, such as military bases, equipment, government buildings, and other assets and subtract its liabilities. I bet the government's current leverage ratio tilts towards the high side. If a government debt becomes too high, investors will stop buying the government bonds, triggering a financial crisis. Then government must deleverage by paying down its debt and selling off its assets. Unfortunately, the U.S. government holds many assets that it cannot sell, such as military bases, weapons, and so on.

Paul Krugman argues the U.S. government could ramp up its spending that would push the U.S. debt to new records. Although a high debt could trigger a financial crisis, a government does not have to deleverage if it experiences financial trouble. A government could force its central bank to buy government bonds. Thus, the central bank prints money to cover a government budget shortfall. However, printing money leads to inflation and weakens a currency. (The Greek, Irish, Italian, and Spanish governments have no control over the central bank. They only have the power to tax, spend, and borrow. Since investors do not want to buy these government bonds, these governments cannot expand government spending or reduce taxes during a recession.)

Here is where Paul Krugman stumbles in his book, which becomes Rule 7. The U.S. federal government cannot weaken the U.S. dollar by forcing the Federal Reserve to buy U.S. bonds because people around the world hold U.S. dollars to save their purchasing power. If the U.S. government weakens and depreciates the U.S. dollar, people will stop holding U.S. dollars. Then many countries will stop investing in U.S. government securities. For example, China holds roughly $1 trillion in U.S. securities. If the Chinese believes the U.S. government will depreciate the U.S. dollars, then those U.S. government bonds and U.S. dollars plummet in value. Thus, China will dump those dollars and bonds that would trigger a financial crisis. Then the world rushes to unload the U.S. dollars and U.S. government securities, and we Americans will truly experience hard times.

Rule 7: Government cannot debase its currency if the world uses the country’s currency as the world’s transaction currency. Thus, the Eurozone and United States cannot devalue their currencies to jump start exports.

I am not anti-Keynesian, and I do not object if a government builds and expands roads, hospitals, schools, and infrastructure during a recession to create jobs. Nevertheless, the government must possess good finances, which becomes the most important rule – Rule 8.

Rule 8: The politicians have butchered Keynesian economics. Most governments did not raises taxes or reduce government spending during good times, so they could reduce their debts and strengthen their finances. Then governments would have the resources to combat the downturns in the economy.

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