The New Neo

Tim Cavanaugh writes that Paul Krugman has become a laughingstock both here and abroad for his devotion to Keynesian spending in the face of overwhelming deficits and the burgeoning threat of bankruptcy in many countries of the western world. The reason, as Cavanaugh puts it, is that [emphasis mine], “As Margaret Thatcher predicted would happen, we have all run out of other people’s money.”

That’s what both the formerly ultra-liberal states of Massachusetts and New Jersey have recently learned, resulting in the elections of Scott Brown and Chris Christie. But Krugman’s having none of it, writing that we face a third depression if we don’t follow his advice:

…[G]overnments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

But I don’t think Krugman should be called a laughingstock, exactly; he does have somewhat of a point, although he overstates it and understates the flip side of the issue. There’s no question that either deflation or inflation are possibilities, depending on how the current crisis is handled. There’s also no question that we (and economists such as Krugman, as well as his opponents) simply don’t know what will happen. But Krugman is ignoring the fact that this “depression” is different from others in the incredible size and scope of the government spending and deficits that have already piled up, and the crisis of confidence around the world that has resulted.

Confidence is a huge part of economic growth and prosperity, although it’s not everything. But people must feel that governments are not tottering on the brink of bankruptcy if they are going to get that old prosperity spark going again. Nearly everyone knows that this crisis was preceded, and in part caused, by too much and too easy credit, especially in the housing market, and then risky trading of that credit in order to make gobs more money. Many also know that banks were too highly leveraged. And nearly everyone knows that governments around the world are in debt up to their ears right now, with no end in sight. Throwing good money after bad (or more bad money after bad?), and increasing Europe’s and America’s debt, (or printing more money) is not going to reassure anyone—except, perhaps, Paul Krugman.

I’m with Robert Samuelson on this one:

We may be reaching the limits of economics. As Keynes noted, political leaders are hostage to the ideas of economists — living and dead — and economists increasingly disagree about what to do. Granted, the initial response to the crisis (sharp cuts in interest rates, bank bailouts, stimulus spending) probably averted a depression. But the crisis has also battered the logic of all major economic theories: Keynesianism, monetarism and “rational expectations.” The resulting intellectual chaos provides context for today’s policy disputes at home and abroad…

[T]he benefits of higher deficits can be lost in many ways: through higher interest rates if greater debt frightens investors; through declines in private spending if consumers and businesses lose confidence in governments’ ability to control budgets; and through a banking crisis if bank capital — which consists heavily of government bonds — declines in value. There’s a tug of war between the stimulus of bigger deficits and the fears inspired by bigger deficits.