Are you tired of Krugman’s economic magic tricks? I know I am. Krugman recently again reiterated that an economy is not the same as a family and therefore doesn’t have to worry about spending or debt. Krugman says that comparing the economy’s finances to a family’s is a bad metaphore he heard while debating supporters of David Cameron. I think Krugman’s choice of debate opponent says a lot about the competence of his arguments. As any magic trick there is always some means of diverting the audience’s attention as not to reveal true essence of the trick. To achieve this Krugman uses an economic fallacy of the seen versus the unseen. To see how he applies this fallacy we have to read exactly what he said.
Krugman: “The answer is that an economy is not like an indebted family. Our debt is mostly money we owe to each other; even more important, our income mostly comes from selling things to each other. Your spending is my income, and my spending is your income. So what happens if everyone simultaneously slashes spending in an attempt to pay down debt? The answer is that everyone’s income falls — my income falls because you’re spending less, and your income falls because I’m spending less. And, as our incomes plunge, our debt problem gets worse, not better. ”
First of all notice how Krugman sets up a straw-man, “what happens if everyone simultaneously slashes spending?”
Yes, if everyone slashes spending, the economy will shrink, but as you will see, that is quite impossible, unless people who slash their spending take that money and stick it under their mattress, no aggregate spending decrease actually occurs. What Krugman shows you is the seen. He shows you a person who cuts their spending to pay off a debt, and as a result doesn’t buy a new iphone, thus decreasing the income of the iphone merchant. What he doesn’t show you , the unseen, is the fact that when you pay down your debt, you are paying some other person back, thus increasing his income.
Remember even according to Krugman, the debt of economy, is money that we owe to each other. Thus one person’s debt payment, is some other person’s receive of payment. If one person slashes his spending to pay off a debt, the lender of the debt will receive extra spendable funds. So as you see, since for every debt payment there is a receive, it is impossible for everyone to simultaneously slash their spending. Unless the person receiving the payment is putting it in a mattress, which they don’t, they put it in a bank, the aggregate spending decrease in an economy never occurs. One person’s spending decrease to pay of debt, or as Krumgan likes to call austerity, is another’s spending increase, prosperity.
This concept is easily applied to government spending. Since government either taxes or borrows money from its citizens, if the government spends less, that means either less taxation or less borrowing. The smaller government expenditure means less spendable funds for the people who receive government spending. However, the smaller government tax or borrowing means extra spendable funds for either tax payers or government debt purchasers. The cut in government spending thus does not result a net decline of total spending in the economy.
Something Bastiat, a french political economist explained in the 19th century. That government cannot increase the overall spending in the economy, what it does is merely changes the composition of the spending. This concept of transfer of spending is highly supported by the Austrian school of economics, big names like Hayek,and Mises.
Once you come to this realization, whether higher government spending is good or bad for the economy becomes just a question of which composition of spending is more productive. You see, even though increase or decrease in government spending is just a transfer of spending, and does not effect total current spending in the economy, just its composition, the composition can still affect total future spending. The more productive the current composition of spending is, the higher the productivity of future labor force. A more productive future labor force produces more goods and services, and thus spends more. The question is then, if you want to increase spending in the future, which composition of spending do you have now? One with government making spending decisions or the private sector? If you guessed private sector, then you right. Historically the government does not even come close to the productivity of the private sector.
The graph below shows that countries with large debt to GDP ratio’s. Or what can be described as a spending composition in which large share of current spending is transferred to government’s hands, have lower growth levels. So countries with large government spending, have lower total spending in the future.
Krugman off course ignores this, and picks the left’s favorite poster child for big government spending, Sweden, as an example. Ironically Sweden has actually been going in the opposite direction then Krugman advocates for. Since 2006 Sweden has cut taxes, decreased welfare spending, and deregulated the economy under the leadership of prime minister Fredrik Reinfeldt.