Paul Krugman Is Asking the Wrong Question

As is well known now, Carmen Reinhart and Kenneth Rogoff have landed in a policy fight recently. A study they did has been used for several years by the authors and other people to argue that high national debt-to-GDP ratios lead to lower future GDP growth. In other words, lots of government debt will slow economic growth in the future, leaving us poorer and making it harder to afford the payments on that debt.

While Reinhart and Rogoff always had a more nuanced view of the issue than many of the people citing their study, they have been brought back to the forefront of this policy debate because some other economists found an error in their original work. Now economists are arguing about whether the error (which Rogoff and Reinhart admit) significantly changes the policy implications of their work. (To see some charts showing that Reinhart and Rogoff are still basically correct, see here).

In particular, New York Times columnist Paul Krugman has used the opportunity to once again argue vehemently in favor of more government spending and more government debt, claiming that arguments in favor of budget cuts to reduce the debt burden have been vanquished. Unfortunately for him, Krugman is asking the wrong question.

Before economists start arguing about whether some level of government debt is a bad thing, we should begin with the more important question that precedes that one in time: does more government spending help the economy in the first place?

After all, if government spending does not help the economy, we should avoid unnecessary government spending (and debt) regardless of any subsequent economic impact from the resulting debt. So before Krugman argues that debt is not a bad thing, he needs to prove the original government spending is good. At that, he and all the other Keynesians will fail.

Government spending, in and of itself, does not help an economy grow or help one in recession recover. For government to spend money it must come from one of four sources. Only one of those will yield economic benefits and that one is not available to us right now. But first, the other three.

The U.S. government today can finance its spending three ways: with tax revenue, through debt financing, or by printing money. Spending from tax revenue cannot help because you are simply replacing private spending (by the taxpayers) with government spending. There is no positive effect.

Spending from debt financing won't help because the money loaned to the government would have been loaned to some productive business otherwise whose use of it would have created economic growth. Again, no gain will occur and a loss is likely due to the government's uses of the borrowed money being less productive than the private sector's uses would have been.

Printing money doesn't work either as any gains are illusory and wiped away by the inflation that is destined to follow. We might be tricked into thinking things are better for a little while, but eventually prices adjust and we discover the truth.

That leaves only the fourth possibility. The government can actually boost the economy by stimulus spending if the additional spending comes from money the government had collected previously and saved for a rainy day. This is actually what Keynes recommended. Unfortunately, most Keynesians don't read Keynes.

Of course, when the government saves the money (called running a surplus), that actually reduces economic growth. However, that lost growth will be recaptured when the government spends the saved money during a future recession. Keynes correctly explained all this and argued for governments to follow such a policy in order to smooth out the business cycle.

Unfortunately for all of us, today's Keynesians seem to have missed this part of the story and believe that more spending and bigger deficits will help the economy. All empirical evidence is to the contrary. The U.S. government's stimulus spending during the 2007-2009 recession exceeded the total of all previous stimulus spending in U.S. history, even after adjusting all that past spending for inflation. Yet, with all that spending, the economy is still struggling to grow at the historical trend rate.

The problem is we funded all that government spending with the three sources that do not lead to more economic growth. The government had no money saved up when the rainy day arrived.

However, we can cheer up Krugman a little. There was no money saved up because President Bush had spent it all running large budget deficits after inheriting a budget surplus from President Clinton. So, while Krugman is wrong in his policy recommendations, he can at least blame Bush for the problem.