Paul Krugman Confesses No Understanding of How Savings Spurs Investment

by Oct 18, 2013Liberty & Economy2 comments

How the Nobel-Prize winning economist feigns ignorance of how the free market works to push his big government central planning agenda.

Nobel Prize-winning economist Paul Krugman confesses that he doesn’t understand how higher rates of savings leads to more investment. A couple days ago, he blogged:

For those who don’t know or don’t get the paradox of thrift, it’s actually very simple: if people (or the government) cut their spending, and the Fed can’t offset this move by cutting interest rates, the economy will contract — and the economy’s contraction will reduce the incentive to invest, so that investment actually falls.

I know that many economists just refuse to accept this proposition, which seems absurd to them. But what, exactly, is their alternative? If you believe that a cut in spending under current conditions — it doesn’t matter whether it’s public or private spending — leads to more rather than less investment, what is the mechanism?

Then yesterday, he took issue with a guy named Eugene Fama for pointing out that savings leads to investment:

The immediate thing Fama should have asked himself, even if completely ignorant of the history of macroeconomics, is why the causation necessarily runs from savings to investment. Why not the other way around?

After all, he continues, in his Keynesian models — which led him to advocate a Fed policy of lowering interest rates “to create a housing bubble to replace the NASDAQ bubble” — it is the other way around!

The mystified Krugman continues:

In this case, ask what happens if consumers decide to save more. What do they actually do? They cut their spending. Now, how does the equality S[avings]=I[investment] hold?

He argues:

If consumers try to save more, firms may engage in involuntary investment, as inventories pile up, and consumers may find that they’re not saving as much as they intended to, because their incomes fall. Naturally, these unintended results will lead to further changes in behavior, with firms cutting production and consumers further reducing spending….

To reach the conclusion that higher desired savings lead to higher investment, you have to explain how the desire of consumers to save more gives firms an incentive to spend more. Lower interest rates could do the trick – but not in an economy where rates are already zero.

Krugman treats Fama like some kind of intellectual fool, calling his ideas indicative of “a dark age of macroeconomics” and closing with:

And I’m sorry, but I’m not going to be respectful or pretend that we’re having a serious debate when economists who should know better engage in such obvious fallacies.

So, to sum up, Krugman thinks that when people stop spending and instead save their money, the economy contracts, investment falls. This could perhaps be avoided if the Fed could lower interest rates (which it does by creating currency out of thin air to purchase debt instruments like U.S. bonds). There is no mechanism that he can see by which increased spending results in increased investment absent such Fed intervention.

So here’s the mystery mechanism Krugman pretends not to understand by which savings leads to investment:

When people save it is not because they like pretty pieces of paper with pictures of dead presidents on them. The only thing those pieces of paper (or digits in their bank accounts) are good for are exchanging them for goods or services deemed of value to the consumer. When people save, they are just deferring their spending into the future.

Now, when people defer spending, most tend not to stuff a bunch of currency under their mattress. They tend rather to deposit their savings into a bank account, where it can collect interest. He knows it’s false, but Krugman nevertheless treats interest rates for his purposes above as though they were somehow immovable other than through Fed intervention. Thus, only if the Fed lowers them could rates fall and thus investment result from increased savings. This is nonsense.

Interest rates are a price. Krugman views interest rates only in terms of Fed price fixing, but in a free market, they would be determined by supply and demand just like any other price. If banks were low on reserves and thus lacking lending ability, they would prefer to attract more depositors, which they would do by increasing interest rates. Conversely, if rates of savings were high and banks had plenty of reserves, they would want to attract lenders, by lowering interest rates.

Thus, it is very easy to understand what Krugman feigns ignorance of: that when rates of savings go up, interest rates go down. And by Krugman’s own argument, when interest rates go down, investment goes up. 

Voila! Mystery solved.

So let’s now deal with some of his other contentions. He argues that when consumers spend less, the economy contracts. No, it doesn’t. As follows from the elementary observation just made about how spending leads to investment, when entrepreneurs and investors see the lower interest rates, it sends the message to them that consumers are deferring spending, so they naturally take advantage of the low rates to borrow and invest in new technologies or otherwise expanding business in order to meet that future demand.

It is this process that creates economic growth. By advancing the means of production, society’s standard of living is improved since better goods can be made available for lower prices. Economic growth cannot occur without capital investment stemming from this deferred consumption.

To conclude that less consumer spending means economic contraction, Krugman just chooses to see less consumer spending while choosing not to see the consequent investment. (This is a manifestation of what is known as the “broken window” fallacy, which I won’t get into, but you can read about here.) Spend! Spend! Spend! is his mantra. Consumers aren’t spending enough? Lower interest rates even more so they will refinance their mortgages or borrow and spend even more money they don’t have on stuff they don’t need, etc.

A further corollary is that, since businesses take such opportunities to expand, higher rates of savings will not lead to consumers having less income, as Krugman contends. (Krugman doesn’t go into it here, but the mechanism by which he would argue that they would have less income if they spent less is that “my spending is your income, and your spending is my income”, or something along those lines. So if people spend less, according to this logic, then businesses make less profits and so must lay people off or lower wages. In fact, as follows from the above, the opposite is true; entrepreneurs may take advantage of low interest rates to expandSpending doesn’t cease altogether, it just shifts from spending on consumer goods to spending on capital goods. Again, we see Krugman committing the “broken window” fallacy.)

You begin to understand why Krugman’s contention “seems absurd” to many economists. Note also that while demanding others explain the mechanism by which savings leads to investment, he himself simply asserts that the opposite causal relationship is true, but without bothering to explain the mechanism. How does greater capital investment lead consumers saving more? He doesn’t say. He just says this is what Keynesian models teach and suggests that anyone who rejects enlightened Keynesian models is living in the dark ages.

So why would Krugman feign ignorance about this mechanism? It’s fairly simple, really. His ideology doesn’t follow from his understanding of economics; rather, they way he chooses to understand economics follows from his ideology. He favors big government central planning, particularly when it comes to the economy. Hence, we cannot rely on the free market to determine interest rates, but must have the government-legislated monopoly over the currency supply engage in price fixing! Hence, if consumers are spending less, government must intervene and do the spending for them, so the economy doesn’t collapse!

Of course, remember that interest rates are a very important price in the economy that sends signals to investors about the rates of savings, about the pool of capital available. Prices are signals that help direct scarce resources towards productive ends, and interest rates are no different. So what happens when the Fed engages in price fixing and pushes interest rates below where they would otherwise be? Well, it spurs investment in capital goods or assets when the capital is not actually there. The Fed can print currency, but it can’t create wealth from a printing press. Hence the unsustainable booms of the business cycle and consequent inevitable busts.

Which brings us to the “zero lower bound”. Krugman argues that since consumers aren’t spending and since the Fed can’t push rates lower than zero, the government must increase its spending to keep the economy from crashing. But government can only pay for its spending in three ways: taxation, borrowing, or inflation. Let’s briefly examine each.

If the government pays for increased spending through taxation, all that happens is resources are redirected out of the productive private sector and into the wasteful public sector. No growth there. On the contrary, this hampers economic growth. Government bureaucrats making arbitrary decisions by fiat cannot more efficiently direct scarce resources towards productive ends than the free market and its pricing system.

If government borrows to pay for its increased spending, it is simply deferring the taxation necessary to pay off the debt to the future. And the same axiom applies about the inefficiency of central economic planning as opposed to growth driven by the private sector.

If government runs the printing presses to pay for its spending, it is simply robbing the private sector of its wealth by a more stealthy means, by devaluing the purchasing power of the currency. No growth there. Again, on the contrary, the same axiom applies. Wealth cannot come from a printing press. Economic growth does not come from printing pieces of paper or punching digits into a computer. It comes from capital investment that advances productivity, thus allowing producers to provide on the market ever better goods or services at ever more affordable prices.

So what’s the solution? Well, we need to identify the problem. The problem is that government inflated a housing bubble, with the Fed implementing the policy Krugman advocated of lowering interest rates below where they otherwise would have been, resulting in an unsustainable boom that precipitated a financial crisis when the bubble burst. But then, instead of allowing the market correction to occur to liquidate the malinvestment and restructure the economy with honest market prices helping to determine how scarce resources should more efficiently be directed on a sustainable path, the government just engaged in even more price fixing, doing even more of what caused the crisis in the first place, with the Fed printing even more currency to push interest rates down even further.

Ironically, yesterday, Krugman also blogged:

I’m coming to this a bit late, but I see that there’s now extensive evidence that facts not only don’t win arguments, they make people on the wrong side dig in even deeper: “When your deepest convictions are challenged by contradictory evidence, your beliefs get stronger.” … I think it also explains a lot about how some people react to this blog.

Krugman himself is the perfect illustration of an anti-intellectual being proven wrong by the facts but reacting by just digging in even deeper and doubling down on his position.

It is self-evident that doing more of what caused the problem cannot possibly at the same time be the solution. Krugman treats the bust as the disease to be treated by creating another boom. The truth is that the unsustainable boom is the disease and the bust is the cure. Trying to prevent the market correction only prolongs the agony, as we saw in the Great Depression and as we have seen in the current Great Recession. Capital investment has to come from real savings, and not from easy credit created out of thin air by a central bank, for sustainable economic growth to occur.

Paul Krugman either understands this rather elementary observation but chooses to deliberately obfuscate it in order to push his big government central planning ideology on people, or he actually honestly believes that wealth can come from a printing press. Either way, he can’t be taken seriously, as further evidenced by his having advocated the Fed policy that caused this mess in the first place while calling for even more of the same on an even greater scale to get us out of it.

Read my book Ron Paul vs. Paul Krugman: Austrian vs. Keynesian economics in the financial crisis for more about this. Here’s what Barron’s had to say about it:

“Any work of economics that can make you laugh is at least worth a look. If in less than 100 pages it also informs you about a subject of great importance, it might just qualify as a must-read. Jeremy Hammond, a political journalist self-taught in economics and a writer of rare skill, has produced such a book….. This short work conveys more insight into the causes and cures of business cycles than most textbooks, and more about the recent business cycle than most volumes of much greater length. — Barron’s, August 31, 2013

Ron Paul vs. Paul Krugman

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About Jeremy R. Hammond

About Jeremy R. Hammond

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  1. Ian

    Rates can’t go down when you’re at the zero lower bound like now.


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