Paul Krugman and the Consumption Myth

[_Droopy]

https://mises.org/daily/4193



Paul Krugman and the Consumption Myth


In "China's Water Pistol," Paul Krugman turned commentary on China into a general attack on those who remain wary of the United States' large public debt. In it, he sums up the Keynesian views on saving, consumption, and government spending. Whatever his intentions, all Krugman does is underscore his own lack of understanding of economic theory.

Yet, it is his misguided view of economics that is most prevalent amongst those pseudo economists who shape national policy. For the sake of the hundreds of millions of individuals who have their livelihoods at stake, it must be made clear that it is capital accumulation — not consumption — that drives wealth-creation.

Krugman makes the following three assertions:

Given the "paradox of thrift," all types of savings are bad for the economy.

Government must make up for a loss in private investment.

The United States' economy would grow if China were to sell its US treasury bills.

Unsurprisingly, Krugman is wrong on all three points. What his argument boils down to, after wading through the myriad of contradictions that make up the majority of his writing, is the belief that our economic woes can be solved through inflation. His final assertion is the most telling, as it illustrates his faith in the principle that more money — a return of US dollars from China — would bring about more prosperity.

What Krugman offers us is a path, not to prosperity, but to poverty. Without savings there can be no investment, and as a result no job or wealth creation. The irony is that without savings government spending cannot be financed, and so the Keynesian bias against "thrift" is absolutely self-defeating. What Paul Krugman fails to wrap his head around is the fact that money is not synonymous with wealth or capital. When the Federal Reserve prints a million dollars it does not also produce steel, nails, or any other type of capital good. The conflation of money and capital is one of the crippling weaknesses of mainstream economic thought.

Thankfully, the world can still fall back on the sound economics espoused by the scholars of the Austrian School: Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, Friedrich Hayek, et cetera. Within the context of Paul Krugman's commentary, the most important part of Austrian theory that should be incorporated into the mainstream is capital theory. A basic understanding of the relationship between capital accumulation, investment, and wealth creation is of the utmost importance, given that this alone is sufficient to undermine the Keynesian fallacies of underconsumption and inflation.

Our purpose here is to offer an introduction to Austrian theory by refuting Paul Krugman's underlying mistake. Savings are absolutely necessary for economic growth.
Paradox of Thrift

One of John Maynard Keynes's biggest contributions to economic theory was his "paradox of thrift." Although the fallacy did not originate with Keynes, it was the publication of The General Theory of Employment, Interest and Money that popularized it in mainstream intellectual thought.

Keynes wrote,

The reconciliation of the identity between saving and investment with the apparent "free-will" of the individual to save what he chooses irrespective of what he or others may be investing, essentially depends on saving being, like spending, a two-sided affair. For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others make it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.[1]

Keynes's argument is that by saving part of an income, a saver necessarily takes away from the income of another. Keynes assumes that a person's income depends on the consumption of the product being sold, and by extension believes that by not consuming, one is denying a wage earner a wage. Accordingly, saving is self-defeating, as a loss in income will disallow individuals to save over the long-run.

But Keynes's mistakes are easy to spot. His principle limitation was his obvious lack of understanding of capital theory, which is interesting given that he made frequent references to Austrian theory and Friedrich Hayek. It goes to show that John Maynard Keynes really had no idea what he was reading. This allowed him to overlook Hayek's point entirely.

To this effect, Keynes finished the above-quoted paragraph with,

It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment.[2]

This passage is a direct reference to the Austrian theory of the business cycle. Earlier in the chapter, Keynes asserted,

The notion that the creation of credit by the banking system allows investment to take place to which "no genuine saving" corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment.[3]

Here, John Keynes criticized Mises's and Hayek's theory that an extension of bank credit will lead to malinvestment. His reasoning was that the inflation brought about by the creation of money necessarily leads to a rise in wages, allowing the ratio between nominal investment and nominal savings to return to one. His downfall was his reliance on the mechanical quantity theory of money, which had already been refuted by the likes of Benjamin Anderson and Ludwig von Mises.[4] While the quantity theory of money suggests that inflation affects all sectors of the market simultaneously and proportionally, it ignores the microeconomic effects of inflation on the relative prices of capital goods versus consumer goods.[5] Paul Krugman keeps John Keynes's fallacious bias against savings, although Krugman perhaps does it out of blind faith, while Keynes simply misunderstood basic economic theory.

Savings, or capital accumulation, is the most important direct factor in wealth creation. The volume of capital directly influences the cost to borrow said capital, otherwise known as the rate of interest. Naturally, the greater the supply of capital, the lower the cost to borrow, providing an incentive for entrepreneurs to borrow and invest.

Investment in lines of production, whether it is the creation of a new factory or an investment in a new method of production, is what leads to rises in productivity. A rise in productivity leads to an increase in the quantity supplied of any given good, allowing for a reduction in price. It is this increase in the quantity supplied that leads to an increase in real wages, and an increase in the general wealth of society.

It is thus nonsensical to oppose savings on the grounds that an increase in savings will necessarily lead to a decrease in wages. Real wages rely directly on investment; without increases in productivity, wages are bound to stagnate at best. Furthermore, it has to be considered that the purchase of capital-goods for investment necessitates the payment of wages to workers in the relevant industries. For example, when a contractor purchases steel to use in the construction of a building, he necessarily pays the wages of the workers involved in the production of that steel, and so in that sense investment fulfils the same function as consumption.
"In an economy, what matters is the exchange and investment of goods, not money. Money is a standard by which economic agents decipher the exchange value of goods, and so it only becomes relevant at the moment of an exchange."

The Keynesian fallacy of the paradox of thrift relies on their confusion between real wealth and nominal wealth. This fallacy builds from Keynesians' misunderstanding of the role and purpose of money in an economy. As opposed to being a source of capital, money is a common and widely-accepted good that represents the flow of capital in a common standard. Money is but a means to accommodate barter within a complex society with an extensive division of labor, in which the direct exchange of heterogeneous goods is nearly impossible. So, when Ben Bernanke orders the production of one million dollars he does not simultaneously make possible the production of one million dollars worth of steel. The production of steel can only be made possible through the exchange of goods, represented by dollars, and through the investment of capital goods.

Keynesians fail to understand this complex system of trade, and so do not realize that what is really paying for a worker's wages is one's capital, not one's money. By consuming capital, an individual necessarily reduces the total volume of capital available, and so over the long-run this is self-defeating in nature. Who will pay for wages when all the capital has been consumed? Keynes would have solved the problem by printing money, but he did not realize that what allowed for capital formation was investment made possible through capital accumulation. What use is a million dollars if there is no steel for you to purchase for the construction of your factory?

Finally, the Keynesian myth of hoarding must be dispelled. On the surface, Keynes's belief that an individual necessarily contributes to inefficiency by stashing money under his mattress makes sense. But this is just another product of the conflation of money and capital.

In an economy, what matters is the exchange and investment of goods, not money. Money is a standard by which economic agents decipher the exchange value of goods, and so it only becomes relevant at the moment of an exchange. Holding or using money will either increase or decrease the purchasing power of an individual unit of the money standard, but will not influence the flow of capital beyond that. In fact, the purchasing power of the money in circulation necessarily rises as a result of hoarding.[6]
Government Spending, China, and Money

Paul Krugman's thesis centers on the idea that if the private sector is unwilling to risk investment, then the government's role is to step in and invest. His prejudice against savings is ironic, given that without savings the government has no pool of capital from which to extract the resources necessary to make the investments Krugman wants it to make. He alludes to this himself:

As a nation, our dependence on foreign loans is way down; the surging deficit is, in effect, being domestically financed.

When an individual finances public debt through the purchase of treasury bills, the individual's time preference will change in favor of future goods. This is because the individual has allotted a certain percentage of his wage towards a long-term bond in an effort to collect on interest, or increase his wealth. The individual, in effect, is financing the provision of capital for the government to invest in whatever it fancies. So, Paul Krugman jumps from blasting savings as a bane to economic prosperity to then suggesting that savings is the only reason why our dependence on Chinese financiers is no longer as relevant.

Whether Krugman believes that government should consume or invest is for anybody to guess. It remains to be seen whether Krugman even differentiates between the two — both seem to fall under the more common term of "spending." The topic of government expenditure has been covered elsewhere,[7] nevertheless the belief that government can better predict the market than entrepreneurs is befuddling; it is what Hayek referred to as the "fatal conceit."[8]

Whilst discussing the topic of government spending and debt, Krugman makes the same mistake Keynes made when writing on the "paradox of thrift." Krugman writes,

The bottom line in all this is that we don't need the Chinese to keep interest rates down. If they decide to pull back, what they're basically doing is selling dollars and buying other currencies — and that's actually an expansionary policy for the United States, just as selling shekels and buying other currencies was an expansionary policy for Israel (it doesn't matter who does it!).

Krugman makes two mistakes. First, he assumes that by selling securities, China returns dollars to the United States. In fact, it is quite the opposite. When buying securities, the Chinese are using dollars earned in trade to buy US debt, and so the dollars used are now spent by the US government. What the Chinese buy is the promise of a greater amount of future dollars. When the Chinese sell securities, they receive a greater amount of dollars than they actually gave. All considered, that does not mean that the sale of securities will cause China to "hoard" dollars. The Chinese have absolutely no interest in hoarding dollars, because the dollar is only useful to exchange for American goods or to exchange with other individuals who find the dollar valuable.

Krugman's second mistake is the belief that a greater quantity of dollars leads to greater wealth. This is the same assumption Keynes erroneously made when expounding his beliefs on the paradox of thrift. To clarify, what matters is not the amount of dollars in circulation but the amount of capital.

As a final comment, it is important to recognize that it does not matter who holds American debt. Whether it is a Chinese saver or an American saver does not matter, as what the debt problem comes down to is the fact that the US government cannot permanently finance growing expenditure.[9] The US debt pyramid is bound to collapse when its financers are no longer willing to risk their capital on insecure government bonds. The trigger point will occur when the distortion caused by government spending is completely unveiled.
The Paradox of Keynesianism

The Keynesian argument against saving cannot stand on its own two feet. Keynes's "paradox of thrift" is nothing but the result of a bad economist making poor assumptions based on a weak understanding of economic theory. Ultimately, the Keynesian's deficiency comes down to their lack of capital theory, which eventually leads them to believe in a very disjointed monetary theory.

$19 $18

Given his education in the Keynesian framework, Paul Krugman's economics are nothing more than an extension of Keynes. His poor training has led Krugman to apply Keynesian theory to current events, and the unfortunate byproduct has been his influence — and the influence of those who think like him — on central macroeconomic policy; this includes the belief that there should be central planning at all.

Individuals should choose their time preferences based on their own subjective concerns. If this means that the individual prefers saving over present consumption, then that is all for the better, as saving is what leads to economic growth. Given the current global economic situation, the individual should not be blamed for a partiality in favor of "hoarding." The truth is that individuals should be keener on "hoarding" given that the alternative seems to consist of government-sponsored destruction of wealth.

[_Kevin Graham]

There is no response from Krugman to this sophomoric piece, pretending to be refuting one of the world's most respect economists.

I wonder why that is...

Jonathan M. Finegold Catalán writes from San Diego and studies political science and economics

Oh, nevermind. Another droopy styled "auto-didact", taking on the world with his "think tanks."

[_Kevin Graham]

Fine Austrian Whines

Andrew Leonard:

There’s a lockdown on the Wikipedia page for Austrian economics and wouldn’t you know it, one or way or another, it all seems to be Paul Krugman’s fault.
…

For more detail, you can go, of course, to the Wikipedia page for Austrian economics. But until at least Feb. 28, if you do so, you will find that the page “is currently protected from editing.” An “edit war” has been raging behind the scenes. Two factions were repeatedly deleting and replacing a section of text that had to do with a description of a critique of Austrian economics made by economist Paul Krugman.

Substance aside — not that substance isn’t important — Austrian economics very much has the psychology of a cult. Its devotees believe that they have access to a truth that generations of mainstream economists have somehow failed to discern; they go wild at any suggestion that maybe they’re the ones who have an intellectual blind spot. And as with all cults, the failure of prophecy — in this case, the prophecy of soaring inflation from deficits and monetary expansion — only strengthens the determination of the faithful to uphold the faith.

It would be sort of funny if it weren’t for the fact that this cult has large influence within the GOP.

[_Droopy]

There is no response from Krugman to this sophomoric piece, pretending to be refuting one of the world's most respect economists.

I wonder why that is...

Jonathan M. Finegold Catalán writes from San Diego and studies political science and economics

Oh, nevermind. Another droopy styled "auto-didact", taking on the world with his "think tanks."

Yet another classic Kevin Fitzgraham ad hominem fail, right out of the same little black bag of logical fallacies he's been plucking his white flags from for years.

[_Kevin Graham]

Well, at least Daniel Kuehn doesn't think he is worth listening to:

The Austrian Problem

Yes, another post on the Austrian School. The catalyst is an initial post on what's wrong with Austrian economics by Martin Wolf, with responses by Brad DeLong and Paul Krugman.

Martin Wolf essentially solicits reactions to the Austrian School - it looks like there's been a lively exchange in the comment section, but I haven't reviewed it yet. DeLong gives eight alleged tenets of the Austrian School, and ends up giving the thumbs up to one of them but a thumbs down to all the others. I think he could probably qualify a few of his thumbs downs, but he's largely on target. Krugman, as usual, has some very prescient insights.

The first is the fundamental asymmetry of the Austrian argument about the business cycle:

"In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps."

His point is that if Austrians had a more consistent position on human action, they'd recognize that the very processes that they abhor in an artificial, sub-optimal boom can also cause an artificial, sub-optimal depression. Simply recognizing that would bring the Austrians considerably closer to reality. So why don't they recognize it? Krugman suggests:

"And the key to all this, I believe, is that the Austrian abhorrence of explicit models, even for the purposes of clarifying thought, leaves them unaware of the holes in their account."

Austrians actually take pride in their methodological dogmatism and backwardness, but it prevents them from really scrutinizing their own ideas. The result is that you still have Austrians today quoting Hayek and von Mises. There is very little (some, but little) innovation, precisely because there is no introspection. And where innovation does occur, it's largely political/philosophical/ideological innovation.

Austrians are happy to highlight the disagreements between "left Rothbardians", "minarchists", or denizens of the anti-democratic Hans-Hermann Hoppe. If you throw the more traditional libertarians and Randians into the mix, it is a quite interesting intellectual stew. But the point is, it's mostly political philosophy: their economics is stagnant pond water. One of the few exceptions to this is Roger Garrison's macroeconomics, but even he simply formalizes Hayek. I don't know him too well, so I want to be careful about passing judgement too harshly, but he doesn't really seem to add anything new to Hayek's Pure Theory of Capital. Moreover, there's nothing in Hayek or Garrison that really refutes Keynesian macroeconomics - it simply presents another view. And I think that view is valuable. Austrian ideas on capital structure are interesting. But it's not really a response to what other people are saying - it's just sort of floating out there on its own.

Anyway, I've been thinking about this "Austrian problem" for a while now. There's a lot of energy there. There are a couple genuinely interesting insights that would be useful to incorporate into more mainstream econoimcs. But as a whole, it doesn't really measure up because it isn't really introspective in any meaningful way, and it habitually caricatures and distorts what the other side of the argument is saying. A good example is Jonathan Finegold Catalan, who writes for Economic Thought, and occassionally the Mises Institute. Catalan is a student at San Diego State University, and I've really enjoyed following his blogging because I identify a lot with him - a young guy, trying to strike out on his own on a blog, deeply interested in economics and the history of economic thought. But it's been getting hard to maintain interest. Post after post after post has been degenerating into an imputation of ideas to people he disagrees with - almost always Paul Krugman. I don't always agree with Krugman either, but I get frustrated with this scripted version of "what Krugman said" that the Austrian School works from. One of the things that they like to talk about is this "consumption myth" - that Krugman and Keynesians think all consumption is good and savings is always bad. They make off the cuff remarks about government always being a solution. Barney Frank said arguing with the LaRouche crowd is like arguing with a kitchen table. I would give somewhat more credit to the Austrian School: it's like arguing with a broken record for them.

[_Droopy]

The fact that Graham has no idea who this person is, what his intellectual background is, and that this person may, in point of fact, be much smarter than Graham, along a number of fronts, and may even be smarter and more knowledgeable in economics than Krugman, doesn't register in his frontal lobes because Mr. Graham, whatever his virtues, isn't well read or educated enough to comprehend what serious, sustained, creative, close reasoning and thinking really is.

He attacks a person he has no bloody knowledge of at all but, as usual, ignores any arguments made because they utterly swamp him on sight. We know, we know, this guy must be getting checks from the Koch brothers...

[_Droopy]

So you criticize Catalan and then run to an obscure blog by an obscure doctoral candidate and center-left Keynesian - a theory that was debunked and discredited in the first third of the 20th century by free-market theorists, including the Austrians, and which, like other forms of statist interventionism of the Left, clings to life in the academy and in government no matter how much economic and social havoc it wreaks, and expect everyone to bow down and genuflect to this person because...what, he's a doctrinal candidate and Catalan isn't?

Kuehn is associated with Austrian economics and the Mises Institute, although he doesn't appear to subscribe to certain key aspects of its thought. Fine and good. He has plenty of very educated and knowledgeable critics at the Institute, as well (which can be seen in its blog section), but, tellingly, he seems to get along with Mr. Catalan and respect his input a great deal more than Mr. Fitzgraham:

http://mises.org/journals/qjae/pdf/qjae14_4_3.pdf

(See the bottom of page 442).

[_Gadianton]

Savings, or capital accumulation, is the most important direct factor in wealth creation. The volume of capital directly influences the cost to borrow said capital, otherwise known as the rate of interest. Naturally, the greater the supply of capital, the lower the cost to borrow, providing an incentive for entrepreneurs to borrow and invest.

Investment in lines of production, whether it is the creation of a new factory or an investment in a new method of production, is what leads to rises in productivity. A rise in productivity leads to an increase in the quantity supplied of any given good, allowing for a reduction in price. It is this increase in the quantity supplied that leads to an increase in real wages, and an increase in the general wealth of society.

It is thus nonsensical to oppose savings on the grounds that an increase in savings will necessarily lead to a decrease in wages. Real wages rely directly on investment; without increases in productivity, wages are bound to stagnate at best.

99.9% of pro and anti Keynes online know nothing about the Keynesian model, so I wonder how they can agree or disagree with it. I can't talk off the top of my head about the paradox of thrift in detail, i'd have to look it up; there's a lot of moving parts (even though I'm aware of short examples as some have been brought up on this board, but not adequate for rigorous analysis). I can refute it far more easily than this guy, however, by asserting the classical model that when everybody saves, prices fall, markets clear. 'nuff said. But that just assumes away the argument in my favor. This guy likewise is just assuming a similar simplistic model that he assumes Keynes misunderstands and ending the discussion by asserting the model.

Keynes rejected a simplistic model where savings and investment are simply governed by the natural rate of interest and all prices infinitely flexible. Hey, if you want to buy a car next year, you might save more because you want a car, right? Not because interest rates fell by .2 percent. Simple insights like this lead to a far more complex model of the economy, in this case in the way of consumption and investment functions. Once the thing is built, the paradox of thrift naturally falls out. To prove the intuition wrong, you'd have to show how the paradox of thrift doesn't follow from the assumptions, or show why the assumptions are wrong.

I don't have a problem with a student taking on Keynes or Krugman, everyone has to write papers in school analyzing the thinking of people far smarter than they are. I do have to laugh at the apparent lack of need to learn real economics though -- not that Krugman instills this need in anyone. Everyone wants to be an economic historian, go back to some discussion from 1940 and point out where so-and-so went wrong. Even real historians can't settle questions this way because, there's what Keynes said, and then there is the Keynesian body of scholarship which goes well beyond this and exists in real textbooks and papers. it's what the modern textbooks and papers say that should be analyzed, not these ancient little snipits, which have the tendency to make the situation look easier than it is.

[_Analytics]

https://mises.org/daily/4193



Paul Krugman and the Consumption Myth


In "China's Water Pistol," Paul Krugman turned commentary on China into a general attack on those who remain wary of the United States' large public debt. In it, he sums up the Keynesian views on saving, consumption, and government spending. Whatever his intentions, all Krugman does is underscore his own lack of understanding of economic theory.

Yet, it is his misguided view of economics that is most prevalent amongst those pseudo economists who shape national policy. For the sake of the hundreds of millions of individuals who have their livelihoods at stake, it must be made clear that it is capital accumulation — not consumption — that drives wealth-creation.

Krugman makes the following three assertions:

Given the "paradox of thrift," all types of savings are bad for the economy.

Government must make up for a loss in private investment.

The United States' economy would grow if China were to sell its US treasury bills.

Unsurprisingly, Krugman is wrong on all three points. What his argument boils down to, after wading through the myriad of contradictions that make up the majority of his writing, is the belief that our economic woes can be solved through inflation. His final assertion is the most telling, as it illustrates his faith in the principle that more money — a return of US dollars from China — would bring about more prosperity.

What Krugman offers us is a path, not to prosperity, but to poverty. Without savings there can be no investment, and as a result no job or wealth creation. The irony is that without savings government spending cannot be financed, and so the Keynesian bias against "thrift" is absolutely self-defeating. What Paul Krugman fails to wrap his head around is the fact that money is not synonymous with wealth or capital. When the Federal Reserve prints a million dollars it does not also produce steel, nails, or any other type of capital good. The conflation of money and capital is one of the crippling weaknesses of mainstream economic thought....

Okay--that's as far as I can read. Let me just make two points:

"[Krugman assets that] given the "paradox of thrift," all types of savings are bad for the economy."

That's not true. He asserts that since right now we are in a liquidity trap, right now in aggregate we are saving too much. Any extra marginal savings is bad, because interest rates can't go down any further, and borrowers can't productively put to use the capital that's already available--much less any more more.

"Without savings there can be no investment, and as a result no job or wealth creation. The irony is that without savings government spending cannot be financed, and so the Keynesian bias against "thrift" is absolutely self-defeating...."

That misses the point. Krugman's whole message is that savings and borrowing need to be in balance. Normally they naturally return to equilibrium because when people save more, that drives down interest rates, which encourages more borrowing. But in the current situation, savings and borrowing aren't in balance--there is too much savings and not enough borrowing, and the normal mechinism of interest rates going down can't remedy the problem, because interest rates are already at zero.

Before criticizing the Nobel laureate, this blogger really ought to read The Return of Depression Economics and the Crisis of 2008 and find out what the Nobel laureate actually believes.

[_Kevin Graham]

Yes, it is really kinda sad, and embarrassing, for droopy to point out the fact that this supposedly reputable "think tank" is so desperate for willing preachers of their relic of an ideology, that they have to offer a platform to every Tom, Dick and Harry who is willing to relay their same talking points. The only thing interesting about this guy was his name.