Wednesday, January 28, 2015

Paul Krugman Has Got It Wrong on Debt

Every economist gets many things wrong. I get many things wrong. Unlike some other people, I am not going after Paul Krugman because I'm mad at him. I respect him, as I respect many other economists. But I think he has got the problem with debt all wrong.

On December 29, 2011, Krugman wrote:

I admit to having been surprised by the reaction to my two posts on the burden of debt. I thought I was saying something that would be obvious once it was pointed out; instead, many of the comments were baffled, and quite a few were utterly enraged.

I suggest you take the time to read all three posts -- they are short ones, as usual.

There is a certain attitude that guides Krugman's thinking on debt. It is linked to what I call the "Debt is one person's liability, but another person's asset" tautology. Why a tautology? Because debt is not debt if there is no creditor. In economics, this kind of tautology is also known as an accounting identity.

This particular tautology is often used to support the argument that debt is a lot more benign thing than an individual might think (the "micro-view"). This is also how Paul Krugman (implicitly) uses it in his posts. Yes, if there is a debt, a liability, there must be a credit (the flipside of debt, seen from creditor's perspective). What I call a credit is an asset in the tautology. I call it a credit to separate it clearly from non-financial assets.

Now, what if the people who use this tautology to prove that debt is a much more benign thing than many think, actually have got it the wrong way? What if it is credit (the asset), not debt (the liability), which is the real macroeconomic problem?

(All this is about "The Most Significant Problem in Economics". If you have time, it might be useful to also see my first post for an overview of how I view "money".)

Let us travel 300 years back in time, to early 18th century France -- to the time of John Law and The Mississippi Bubble (1716-1720) *. This was one of the first well-documented, large-scale "credit explosions" -- not at all unlike the South Sea Bubble which took place more or less at the same time in England. When I look at the economic consequences -- short-term and longer-term, separately -- of these credit expansions, I fail to see how an economist back then should have found any comfort in the most obvious fact that there was not only debt, but also credit in the economy.

It is not debt, but credit which creates a sense of great prosperity across the economy when it expands. It lifts other asset prices (real, or financial, like stocks; which assets, depends on how the credit is used), and this increase in asset prices not only encourages/forces people to take on even more debt, but also makes more credit available, as these assets serve as collateral for debt. All this, simultaneously, makes people feel wealthier and so makes them spend more. The additional spending provides increased profits and jobs in industries where it is directed -- for instance, in the car and luxury goods industries. The economy is booming. What I describe here is a dynamic -- a positive feedback loop, or a spiral -- that Hyman Minsky studied closely. George Cooper has called it the "paradox of gluttony" (evidence here, and for instance, here), which is a smart way to point out that this can be seen as the other side of the better known "coin" called the "paradox of thrift".

I have a lot to say about why the paradox of gluttony must turn eventually to a paradox of thrift. About how, as William White puts it, "They have created so much debt that they may have turned a good deflation into a bad deflation after all.". It is all based on a fairly simple theory I have developed. But to keep the length of this post reasonable, I save it for later. (If you have any connections to Mr White or BIS, I would really like to hear from you.)

And don't get me wrong. I am not trying to make a historical argument here. This is about the logic behind credit and debt. I don't find much logic behind the attitude Paul Krugman and others profess as they try to comfort, or prove wrong, the thousands of experts like William White -- experts who are very worried about our national and global debt levels.

* Charles Mackay's "Extraordinary Popular Delusions and the Madness of Crowds" gives a good overview of the Mississippi Company bubble; Janet Gleeson's "The Moneymaker" is a very informative and entertaining biography of John Law.


Further reading:

Jeffrey Sachs: "Paul Krugman has got it wrong on austerity"

Myself: "MMT Is The Most Flawed Monetary Theory..."

Myself: "Macroeconomics Is Not Yet a Science"

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