WWPKD? Much more than Ben Bernanke has done. In a recent New York Times op-ed, Krugman criticizes the Federal Reserve chairman following his much-anticipated Jackson Hole announcement for not doing enough to reduce unemployment and foster economic growth. But he spares Bernanke his strongest criticism, which he reserves for the “political intimidation” that has caused Bernanke to back away from what he regards as more sensible Fed policies. So would Krugman do? What Bernanke proposed for Japan in 2000. Krugman writes that “we learn a lot by asking why Ben Bernanke 2011 isn’t taking the advice of Ben Bernanke 2000.” He refers to a paper Bernanke wrote that Krugman thinks was “on the right track”—“as well I should,” he discloses, “since his paper was partly based on my own earlier work.” So here are Krugman’s proposals for what the Fed should do:
• Purchase U.S. “long-term government debt (to push interest rates, and hence private borrowing costs, down)”.
• Announce “that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates”.
• Announce “that the bank was seeking moderate inflation, ‘setting a target in the 3-4% range for inflation, to be maintained for a number of years,’ which would encourage borrowing and discourage people from hoarding cash”.
• Depreciate the U.S. dollar, which is to say, to devalue it in terms of other currencies.
But hasn’t the Fed already done these things? Well, pretty much, Krugman admits. And, he admits, it hasn’t brought recovery. But, he insists, that’s not because they are bad ideas, it’s just because Bernanke wasn’t radical enough about implementing them. Krugman acknowledges, “Last year, the Fed actually did institute a policy of buying long-term debt, generally known as ‘quantitative easing’ (don’t ask).” In fact, the Fed has already instituted two rounds of “quantitative easing”, or “QE”, dubbed QE1 and QE2. Krugman is calling for QE3, but thinks Bernanke isn’t going to do it because he feels intimidated by opponents of QE.
It’s telling that Krugman urges his readers not to ask about “quantitative easing”. Former Fed Chairman Alan Greenspan once admitted that he engaged in “Fedspeak” to leave his listeners (e.g., members of Congress) completely befuddled about what he had just said. That’s not to say Fedspeak such as “quantitative easing” is never meaningful. Actually, in this case, it means pretty much what it says. The root of “quantitative” being “quantity”, it is the term given to the Fed’s purchase of U.S. Treasury bonds or other government securities, which increases the base money supply; that is, it increases the quantity of money in circulation, which in Keynesian economic theory is supposed to “ease” the pain of a hurting economy (for reasons we will return to).
It’s not as confusing as it sounds, and if you understand what “quantitative easing” really means, you will understand why you are not supposed to ask. Essentially, Treasury securities are I.O.U.’s—promises to pay at a future date the principle amount borrowed plus interest. They represent U.S. debt. So the Treasury issues these I.O.U.’s to buyers, including the Federal Reserve (which is not really federal at all, but is a system of for-profit privately owned banks that pays its stockholders an annual 6% dividend). In return for these I.O.U.’s, the Fed loans the government money. Where does it get this money that it loans out at interest to the government? Why, it simply creates it out of thin air! POOF! Neat magic trick, huh? The printing presses are turned on, and the fiat currency in the form of Federal Reserve Notes—that is, “dollars”—is created.
So these paper notes, which we think of as “money”, are spent into the economy and deposited in various banks across the country. And then comes the even neater magic trick of fractional-reserve banking. When you deposit your “money” in the bank, the bank then loans it out to others, with a requirement only to keep a certain “reserve” in the bank—say 10%—to give to depositors who wish to withdraw their “money” from their account. This is possible because usually less than 10% is ever withdrawn at any one time. In other words, the bank doesn’t actually have everyone’s deposits of “money” in its vault, which is why it is problematic if too many people wish to withdraw too much of their “money” at one time, which is called a run on the banks.
So if $10,000 in hard currency is deposited into bank A, it can then loan out $9,000, keeping $1,000 in reserve. Now say the borrower goes and spends that $9,000 to make a purchase, and the seller deposits his earnings in bank B, so that bank can now loan out $8,100, keeping $900 in reserve. The new borrower buys something and the new seller deposits the cash in bank C, which then loans out $7,290, keeping $810 in reserve. And so on.
Except that banks don’t really loan currency that way. That is to say, banks don’t really loan out their deposits of Federal Reserve Notes, but instead issue loans by expanding the money supply. Say that same $10,000 in hard currency is deposited into bank A, but this time, the bank doesn’t just loan out $9,000, keeping $1,000 in reserve. Rather, the $10,000 in deposits is the reserve from which the bank can then loan out an additional $90,000. It is still meeting its requirement to keep 10% in reserve. So if the deposits don’t account for the loans, where does that loaned “money” come from? Why, it is simply created out of thin air! The bank punches some keys on a computer and—POOF!—extra digits show up on a borrower’s account statement. Neat trick, huh? That’s the magic of fractional-reserve banking.
The bank hasn’t turned on some printing press and created more Federal Reserve Notes to place in its vault to represent the amount of the loan, the $90,000. The “credit” was just signed into existence when the borrower put his John Hancock on the loan agreement. So the “money” that was “borrowed” never existed in the first place. But the borrower can still go buy a car or a house or whatever, because the seller will accept those digital numbers being transferred to his or her own account as value for the item sold. Works great, doesn’t it? Well, sure, except that the borrower now owes the principal plus interest on the “money” the bank “loaned” him by creating it out of thin air, and, of course, if he doesn’t repay it, the bank will take the house he bought with the “money” he borrowed—which is to say, in either case, that the borrower must repay something of real value representing the fruit of his labor in return for having borrowed something of no real value representing no labor or production. But, hey, that’s fair because that’s what he agreed to when he signed his name to that contract. A deal is a deal.
So this is how most “money” comes into existence. Through the inflationary magic of fractional-reserve banking, the money supply is increased. And when a borrower repays his or her loan, it decreases the total money supply. That is, paying off debt is deflationary. Those digital numbers representing the principal return to the place from whence they came. Created out of nothing, they return to nothing. And then there is the interest…. Federal Reserve Notes actually account for only a small fraction of all the “money” that is transferred through the economy day to day.
Returning to “quantitative easing”, it is just another name for the expansion of the money supply. It is the monetization of U.S. debt. Every Federal Reserve Note in existence represents debt. To pay off that debt, every single Federal Reserve Note would have to be repaid to the Fed, which is to say every single paper dollar—each having been borrowed into existence in the first place—would have to be removed from circulation to pay the principle on Fed’s loan to the government.
Ah, but then there is the interest on that debt. If the total base money supply (that is, all the hard currency in the form of Federal Reserve Notes) is required to pay off the principal, where does the interest come from? Why, it has to be created into existence, too! That is done through the Fed “purchasing” more Treasury securities (it’s usually said the Fed “buys” securities, but what that really means is that the Fed is making a loan to the government at interest). Thus, the Federal Reserve monetary system requires that the U.S. government never be able to pay off its debt. (In fact, the only time the government has ever completely paid off its debt was during the presidency of Andrew Jackson, who killed the Second Bank of the United States, an early forerunner to the Federal Reserve modeled after the Bank of England.) When you hear the term “debt monetization”, it means just that: turning U.S. government debt into a supply of “money”. Under this system, money is debt.
The Federal Reserve monetary system not only requires that the government never be able to pay off its debt, but also that the money supply be steadily increased over time in order to create the “money” for borrowers to be able to repay the principle plus interest on their loans. That is why the Federal Reserve sets a target rate of steady inflation. Ever wonder why your grandparents could talk of paying 10 cents for a loaf of bread? Well, there you have it. Money is subject to the law of supply and demand like any other commodity. The more dollars there are in circulation, the less each dollar is actually worth. As a consequence, in order to stay profitable, businesses must raise their prices. So if a loaf of bread cost $0.10 in 1930, today the same loaf of broad would cost $1.35. One dollar in 1913—the year the Federal Reserve was created—was worth more than $22 in terms of 2011 dollars. The U.S. dollar has lost over 95% of its purchasing power since the Federal Reserve Act of 1913.
So you can begin to see why Krugman says to his readers, “don’t ask” about “quantitative easing”. It requires a little bit of explaining—too much to really cover in a New York Times op-ed—and you aren’t really supposed to know anyway (hence the existence of “Fedspeak” and other gibberish invented by economists to obfuscate how things really work).
So, to summarize, when Krugman prescribes QE3 as part of the solution to the U.S.’s economic troubles, what he is saying is that the U.S. government should borrow more money into existence (or, as he puts it, the Fed should make “purchases of long-term government debt”). This, Krugman argues, would “push interest rates, and hence private borrowing costs, down”. Naturally, if you borrow money, you want to get the lowest interest rate possible. So does the U.S. government. When U.S. securities are perceived as being a safe investment, purchasers of U.S. debt are willing to accept a low rate of return. Low risk, low return. If perceptions change, and Treasury securities are seen as riskier investments—for fear, say, that the U.S. government will not be able to make good on its debt, but might default—then they will want a bigger return on their investment, and thus the interest paid on securities rises. Higher risk, higher return. All Federal Reserve Notes come into existence through the monetization of debt. But when the Fed monetizes the debt for the purposes of pushing interest rates artificially low and creating economic “stimulus” during a crisis or recession, then it is known as “quantitative easing”. Same thing, different name.
So the prescription here includes the Federal Reserve manipulating interest rates, pushing them artificially lower than they would be if they were determined by the free market. This is also a manipulation of perception, creating the illusion of investor confidence in U.S. Treasury securities. When the government borrows at a low interest rate and that debt is monetized, it translates, as Krugman notes, into lower rates of interest on private borrowing (that is, the borrowing by private citizens of the “money” supply that was created from debt monetization and deposited in banks across the country). The point of this, of course, as Krugman says, is to encourage more people to borrow more money. That is to say, the purpose is to incentivize people to go into debt, or get further into debt. The incentive of artificially low interest rates played no small part in the housing bubble that led to the financial crisis in 2008.
Okay, so now we come to Krugman’s second prescription. Krugman acknowledges that the Fed did in fact announce that “conditions ‘are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013’”. That is to say, the Fed set a target of keeping interest rates low (near zero) for at least two more years. Krugman’s criticism here is that it wasn’t enough because it didn’t amount to a “promise” to keep interest rates low, but was rather merely a projection possibly subject to change given a change in economic “conditions”.
His third prescription follows logically from the first two, that the Fed set a target of “moderate inflation”—which is to say it should increase inflation from the “low” level of around 2% to the more “moderate” rate of 3-4%.
His fourth prescription—the devaluation of the U.S. dollar—also follows from the previous three, being a natural consequence of such monetary policies. Krugman’s criticism here is that the U.S. dollar hasn’t been devalued enough. That is to say, he doesn’t think Americans have lost enough of their purchasing power, but should sacrifice even more of the fruits of their labor, because that would be good for the economy.
How so? Well, devalued dollars make U.S. exports more attractive to foreign consumers, helping to offset the enormous U.S. trade deficit. Paying off government debt in devalued dollars is also effectively a form of default-by-stealth. And in the economic theory of John Maynard Keynes to which Paul Krugman subscribes, such policies are a “stimulus” to the economy because it encourages people to borrow more, and if they borrow more, they will spend more, and that’s a good thing—remember Krugman wants to “encourage borrowing and discourage people from hoarding cash” (with “hoarding” meaning a person saving more money than Krugman thinks they should). So going into debt and spending borrowed money is good for the economy. But doing the opposite, saving money to either pay down your debt or “hoarding”, is bad. In fact, if too many people pay down their debts, it leads to—gasp—deflation. Horror of horrors. Are you beginning to see the picture? In the prevailing economic theory that dominates mainstream thinking, the health of an economy is largely measured by how much people spend money they don’t have to buy shit they don’t need.
Krugman is also a firm believer in the Keynesian thinking that, during a crisis, such as a recession, the government should increase deficit spending in order to create jobs. If you’ve been reading his articles in the Times, you will have noticed this constant theme. Cut spending during a recession? The horror! No, rather, the government must spend more so it can create more jobs in the public sector. Of course, spending more means either raising taxes or borrowing more and going further into debt.
Raising taxes really just means taking money out of one person’s pocket to put it into another’s, so there is no real net benefit to the economy. Or it means taking money from a privately owned business to pay the wages of a government employee. Of course, that then has other unintended consequences. The business may need to lower the wages of its employees, or lay someone off, so that the government employee can have a job. Or, if the business wants to keep all its employees and maintain their wages, it may need to raise the cost of its goods or services in order to compensate for the loss of revenue from higher taxes, to pass the expense on to the consumers. In the end, the creation of public sector jobs comes at a cost to the private sector and/or to consumers. And that’s not even considering the question of whether the same job could be done more efficiently by the private sector or the public sector (hint: the government doesn’t exactly have a great record when it comes to wasteful spending).
The other way the government can increase spending in order to (ostensibly) create jobs is by borrowing the money. It could do so by borrowing from foreign nations or monetizing the debt. But every dollar borrowed must be repaid along with interest. So borrowing to create public sector jobs for people today simply places an extra burden upon future generations. It is still taking money out of one person’s pocket and putting it into another’s, only with a time differential (that is, taking from future generations) and now with an interest attachment, so that the effect on the economy over time is a net loss. And if the borrowing comes in the form of debt monetization, there is the inflationary effect on the economy and loss of purchasing power of the dollar.
And looking to the bigger picture, the idea that higher employment means a healthier economy should not be an unquestionable axiomatic assumption. If everyone could maintain a high standard of living while doing little to no work at all, wouldn’t we consider that to be a pretty healthy economy? Isn’t the whole point of “improving” the economy so that we can free up time from our jobs to do other things? Or to earn a living doing things we like to do, rather than having to labor from 9 to 5 doing something we hate? Money for nothing and chicks for free? What good is an economy in which everyone is employed but has to slave away in order to survive? In such an economy, how could art, literature, and science flourish? Must we have high employment for high employment’s sake?
Krugman has argued that “even useless spending” can be good for the economy. Unlike the disaster capitalists of the Chicago school of economics, he says he doesn’t think this makes war or natural disasters good things. But to the Keynesian economist, they can boost the economy by leading to an increase in public spending. So if a tornado sweeps through the town and destroys things, it can create jobs, because now there needs to be reconstruction. A lot of broken windows have to be replaced. And if one couples the idea that “useless” spending can be good with the idea that we must have full employment, a simple solution could be found by paying one group of people to go dig up a bunch of holes and another group to go fill them in. Would that increase in public spending boost the economy? If nothing of value is actually being produced, what is the net effect of such spending on the economy at large?
The trouble with most economic analysis is that it seeks policies with near-term, rather than long-term, interests in mind, and considers only the immediate, foreseen consequences, without consideration for the extended, unforeseen consequences. What is seen with increased public spending is a rise in employment in the public sector. But what is unseen is the consequent loss of jobs, the lowering of wages, and/or the rising of prices in the private sector. What is seen is a government employee who now has a job he didn’t have before and consequently has money that he can spend back into the economy (and spending, remember, is good). What is unseen is that a private-sector employee has lost his job and thus has no income to spend into the economy, or who has had his wages cut and thus has less money to spend into the economy. Unseen is the loss of purchasing power of the consumer who either has to pay higher costs for goods and services due to higher taxation or due to debt monetization and inflation.
So, yeah, the carpenters in the tornado-swept town can be put to work, and the window repairmen have plenty to do. These guys will have more money in their pockets to go spend into the economy (and spending, remember, is good). But what about the business owner whose storefront window was shattered? Now he’s out the same amount he paid to the fixer-uppers. Maybe he had planned to invest that money into machinery to increase production, but now those savings are gone and he will have to continue at his present level of production in order to accumulate the capital once more to be able to invest in the expansion of his business. Or maybe he will forge ahead with his plan to increase production, but now he will have to borrow the money and pay interest on the loan, an extra cost he will now have to pass on to his customers. Maybe the owner had planned to hire someone to sweep his shop and help out, but now he isn’t able to, and thus a potential job is lost. The job created is seen. The job lost is unseen. But both must be taken into consideration when assessing the net effect on the economy.
It should also not be seen as axiomatic that the “health” of an economy is measured by how much people spend. Krugman would have his readers believe that “hoarding”—that is, saving—is a bad thing. Say you have $5 dollars in your pocket as you walking downtown. You pass the bicycle shop and admire this great mountain bike. You imagine owning it and cruising down the bike trails. But, of course, $5 won’t buy the bike. You move on. You pass by the ice-cream parlor, and the smells waft out across the sidewalk. You go in and spend your cash on a waffle cone. You have just decided that that waffle cone is worth more to you than that five bucks in cash. Now let’s say the following week your downtown again with another $5 in your pocket and you pass the parlor, and you remember what a tasty treat you had had the week before. You turn to enter, but before you get to the door, you remember the bike. You think to yourself that if you can just avoid spending your money for two-months, you would have enough saved to actually buy it. You’re tempted, but in the end, you turn and walk away. You have just decided that the five bucks is worth more to you than the waffle cone, not because you think the greenback paper is really pretty or has any intrinsic value, but because you think you can better meet your wants/needs in the future with your accumulated cash balance. You have made a different subjective valuation than you had just the week before. You chose to be a saver instead of a spender. Now the ice-cream parlor owner may consider you a “hoarder” of your hard-earned wealth, but the bike shop guy will probably think your decision is financially sensible. What constitutes “hoarding” is also a subjective judgment.
Saving is really just offsetting spending from the present into the future. So instead of spending your earnings from your job every week, you begin to save for that bike. Now, you had been keeping your stash of cash in your piggy bank, hidden in the darkest recess of your closet. But with your increase in savings, that just won’t do anymore. So you go down to the bank and open an account and deposit your earnings there. So now, because of hoarders like you, the bank has greater reserves from which it can make loans. So maybe some young entrepreneur has an idea for a new product. He puts together a business plan and goes down to the bank to take out a loan to start it up. And he has to hire some employees, so some new jobs are created for the town.
The idea that spending is good and “hoarding” is bad is also an assumption that operates within a framework where only immediately foreseen consequences are taken into account. If you spend your five bucks, the ice-cream parlor owner makes a profit, and you have helped the local economy. But if you don’t spend your five bucks and instead save up and buy that bike, you have still helped the local economy, to an even greater extent, only at a later date.
It should be fairly obvious that the wealth of nations doesn’t really derive from its citizens spending and consuming, but rather from saving and producing. Unfortunately, this is not at all obvious when one reads the business and financial press, where we are told by guys like Paul Krugman that the government must go deeper into debt to provide “stimulus” to the economy, to incentivize people to go out and spend, spend, spend their hard-earned cash, to borrow more and more and go deeper and deeper into debt.
The crux of the problem should come clearly into view when one considers the debt problems of the United States. The U.S. national debt is currently at over $14.7 trillion dollars. The federal budget deficit, presently at over $1.4 trillion dollars, is adding to that debt. And that number doesn’t include “unfunded liabilities”, which are debts for which the public is ultimately liable, but for which there is currently no means of funding. This includes Medicare and Social Security. All told, U.S. unfunded liabilities currently total more than $115 trillion. Thus, the true total U.S. debt is around $130 trillion. That’s well over a million dollars for each and every American taxpayer.
It is in the face of numbers like these that Paul Krugman is encouraging more borrowing, more spending, more inflation, more devaluation of the dollar. What happens when the U.S. government is no longer able to pay even just the interest on its debt? Given a choice between default or debt monetization, what would the government do? WWAGD? As Alan Greenspan recently explained, “The United States can pay any debt it has because it can always print money to do that.” Yep. There you have it. Keynesian thinking pretty much dominates the thinking of economists like Paul Krugman, Ben Bernanke, and Alan Greenspan.
Keynesians seek to create a booming economy through interference in the free market and artificial manipulation of interest rates, inflation, and so on. The trouble is the forces of the free market eventually will try to restore balance, which is why every “boom” is followed by a “bust”. Keynesians labor to try to prevent the busts by a continuation of economic policies that created the problem in the first place. Thus it is that guys like Bernanke couldn’t foresee the financial crisis of 2008 and the collapse of the housing bubble—(why anyone still puts any faith in anyone who could be so consistently wrong as Ben Bernanke is surely one of the great mysteries of our time)—while guys like Ron Paul, Peter Schiff, and others of the Austrian school of economics who consider that the way to avoid the busts is to not create an artificial boom in the first place, were able to predict it years in advance.
And the guys who got it right on the 2008 financial crisis and predicted the recession to ridicule and scorn among the mainstream financial “experts” are also predicting the consequences of the kinds of policies that the Fed has implemented and which Krugman is calling for even more of, which include, if the ship doesn’t dramatically alter its course, hyperinflation, the collapse of the U.S. dollar, and the destruction of the U.S. economy. The standard of living Americans have come to expect and take for granted is unsustainable. Government spending is unsustainable. The monetary system itself is unsustainable.
Yet Krugman criticizes those who have opposed the Fed’s policies and the kinds of escalation of Fed policies Krugman is prescribing for “political intimidation that is killing our last remaining hope for economic recovery.”
So which group of prophets do you want to listen to? The guys who got it wrong and were blind to the consequences of their own economic policies, or the guys who got it right and tried to warn everyone of what was coming? Whose prescriptions would you put your faith in? What outcome will you bet your future on?
If the kinds of Fed policies Krugman prescribes are “our last remaining hope for economic recovery”, God help us all.
This article was originally published at Foreign Policy Journal.