For years, economic contrarians have been predicting financial disaster for the U.S. economy. And for years, famous mainstream economists and CNBC analysts have been assuring everyone that Federal Reserve was managing the new economy effectively, and that this new and astonishingly productive economy meant that economic laws of the past were outdated. Paul Krugman, the New York Times columnist who was recently awarded the Nobel Prize for economics, was one of the few honorable exceptions among the big names in the field, as his 1999 book, "The Return of Depression Economics," was more prescient than most in noting "depression economics – the kinds of problems that characterized much of the world economy in the 1930s, but have not been seen since – has staged a stunning comeback."
However, in his Nov. 10 column entitled "Franklin Delano Obama," Krugman offers two historical lessons to the incoming Obama administration. The first, the political lesson, is entirely correct. Economic missteps can absolutely undermine an electoral mandate, and they will do so very rapidly indeed. The problem, however, is that Krugman's second lesson, the economic one, advocates precisely such a misstep, a failure of such proportions that it can only be described as epic. He writes:
My advice to the Obama people is to figure out how much help they think the economy needs, then add 50 percent. It's much better, in a depressed economy, to err on the side of too much stimulus than on the side of too little.
Krugman's incredible notion is that the failure of the New Deal to lift America out of the Great Depression was due to FDR's overly conservative approach to government spending. He admits that federal spending increased dramatically, but argues that this was overshadowed by the previous administration's tax hikes and a reduction in state and local spending. He quotes the conclusion of an M.I.T. study that he considers definitive, in which E. Cary Brown states that the Keynesian-prescribed fiscal stimulus failed "not because it does not work, but because it was not tried." And he draws the wrong conclusion from economic growth of the 1950s when he concludes that it was the "enormous public works project known as World War II" that "saved the economy."
Incredibly, the Austrian economist Murray Rothbard managed to accurately foretell Krugman's column 45 years ago in the introduction to the 1963 edition of his book "America's Great Depresson":
Suppose a theory asserts that a certain policy will cure a depression. The government, obedient to the theory, puts the policy into effect. The depression is not cured. The critics and advocates of the theory now leap to the fore with interpretations. The critics say that failure proves the theory incorrect. The advocates say that the government erred in not pursuing the theory boldly enough, and that what is needed is stronger measures in the same direction."
Krugman's argument is intriguing in light of the way in which Obama and the Democrats have been critical of the Bush administration's tax cuts in the past. It is improbable that a Democrat-controlled Washington, D.C., will resist the urge to follow the same tack as Herbert Hoover; they don't tend to be slavish Keynesians but rather follow Keynesian theory only when it permits them to do what they wish, which in the case of falling federal revenues will almost surely be raising taxes. His argument is also based on inaccurate information, as this chart of federal government spending compared to state and local spending should suffice to show that there was no great decline in state and local government spending, a 38 percent increase in state and local spending from $8.1 billion to $11.2 billion could hardly offset the simultaneous 98 percent increase in federal spending, which rose from $5.1 billion to $10.1 billion during FDR's first two terms.
In fact, if the president-elect is to take Krugman's advice seriously, by the end of his first term he will have to spend more than the $5.605 trillion annually that would be the equivalent of FDR's spending. Even if state and local government spending remained flat, at $2.951 trillion, this would mean that government spending would account for 62 percent of the U.S. economy in 2007 without any economic contraction. If, however, the U.S. were to enter into a depression of similar proportions, an FDR-style spending increase would account for 115 percent of the entire economy!
Now it's obvious that Krugman's idea is that a massive spending shock would avert the greater part of the contraction; that's the whole idea of attempting to smooth out the business cycle in the first place. But the Nobel Prize winner is failing to account for two extremely important facts. The first is that in 1929, combined federal, state and local spending only accounted for 11.3 percent of GDP. In 2007, it accounted for 39.3 percent. Therefore, the massive spending shock has already been applied and even an increase to the historic 1945 level of 53.3 percent would be much smaller, in percentage terms, than the 98 percent increase that Krugman tells us was too small.
The reality is that Krugman's advice is incorrect because his Neo-Keynesian economic model is hopelessly flawed. Americans are witnessing, in real time, an unnecessary empirical test of John Maynard Keynes's failed theory. It is a real tragedy that Messrs, Bernanke and Krugman have studied the failures of the past only to reach precisely the wrong conclusions about the consequences of government attempts to manage the economy. For, if the Austrians are correct and these fiscal interventions only serve to exacerbate and prolong the depression, the famous students of economic history will not prevent a Great Depression, they will cause an even greater one.
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