Paul Krugman's Depression Economics

In the aftermath of World War II, General Lucius Clay, Governor of the U.S. military zone in Germany, mentioned to West German Finance Minister Ludwig Erhard that "My advisors tell me that you should not try to balance the budget, but should engage in deficit spending." Erhard's response was, "My advisors tell me the same thing, but we are not going to do it."

If ever a country could justify Keynesian deficit spending, it was West Germany after the war. Having seen its factories destroyed, its wealth plundered, and the death of millions of its youngest and able-bodied, West Germany's ill economic health made our struggles today seem positively pedestrian by comparison. But with no resources to expropriate from a private sector very much on its back, West Germany defied the Keynesian consensus, and moved in favor of real stimulus through tax cuts which stimulated the supply-side of its economy, along with a stable mark made that way through its peg to a dollar defined in terms of gold.

Within a few short years this formerly decimated country was the most prosperous in all of Europe. For those who think Marshall Plan spending authored its turnaround, they need only study Japan's rise from the same war's destruction, which occurred alongside tax cuts, a stable yen pegged to the dollar, and no Marshall Plan funds.

And while the U.S. economy didn't suffer nearly the battering from the 2nd World War that other countries did, many economists clamored for heavy post-war spending to keep things moving. Instead, federal spending declined from $84 billion in 1945 to $30 billion in 1946, but the economy did just fine, unemployment falling to 4.1%. Going back even further in time, the U.S. suffered a downturn in 1920-21 much greater than that which occurred in 1929, but thanks to spending cuts, light tax decreases and a stable dollar, the U.S. economy roared back to health not long after.

All of this takes on great relevance given New York Times columnist Paul Krugman's recent assertion that we may well be headed for a third Great Depression. To believe Krugman, deflationary monetary policy and "belt-tightening" among G20 governments speaks to "a failure of policy" that has us on a path toward economic decline.

Regarding his deflation suggestion, there he quite simply has things backwards. Deflation is always and everywhere a monetary phenomenon of overly strong currencies, and with every major global currency down versus gold and most other commodities, there's no deflation to speak of.

As for government spending, he's right that tapped out governments, perhaps chastened by the developments in Greece, are moving to reduce the very "government stimulus" that has done nothing to revive economies anywhere it's been tried. That stimulus has failed is quite logical considering we live in a world of limited capital. When governments seek a disproportionate share, there's less available for private-sector businesses to access in order to grow.

To put it very simply, government spending is a huge tax on true economic productivity, so contrary to Krugman's deeply held views, global economic revival will be at least partially authored by the spending cuts he decries, not the increases that he endorses. If government austerity were an economy killer as Krugman supposes, West Germany would never have recovered from World War II, and Japan wouldn't have either.

Considering growth more broadly, it must be remembered that "recessions" and "depressions" are false notions. Thanks to our ravenous desire for the better things in life, we only know how to be productive and grow. In short, there's no such thing as "economic" recessions or depressions. Instead, our productivity plummets when governments get in the way of our natural desire to produce. Recessions are always and everywhere authored by governments; they're never economic.

Once this is understood, it's easy to see why our economy struggles now, much as it did in the 1930s. When governments increase taxes and regulations, make it more difficult to trade, and devalue money, recessions and depressions are the frequent result. In that sense, President Obama may well oversee our lurch toward depression, but solely because he's copying nearly every economic play from FDR's failed 1930s playbook.

With taxes, FDR proclaimed that it was time for the "princes of property" to share more of their wealth, and the result was that he increased the top tax rate to 79%, lowered the threshold to reach it, plus increased the estate tax. President Obama similarly seeks to "spread the wealth around" with higher tax rates, and doesn't seem troubled by nosebleed taxes on estates. FDR oversaw massive spending increases much like Obama, and spending is of course a tax on productivity like any other.

As for regulations, FDR foisted wage controls on the economy, strangled the nascent rise of the electricity industry with the creation of the Tennessee Valley Authority, plus he foisted an "undistributed profits tax" on all corporations which made job-creating expansion near impossible. Obama has already passed regulation of the health care industry, and is presently trying to do the same with the financial services and energy industries. FDR waged a war on business that only ended once he realized he couldn't fight a war against commerce and in Europe at the same time.  And if Business Roundtable CEO Ivan Seidenberg is to be believed, Obama's war on business is happening in the here and now.

Concerning trade, FDR inherited the Smoot-Hawley tariff which put up barriers to the natural flow of goods, and worse, retarded the natural move toward individual economic specialization that fosters the very production that is wealth creation. Obama inherited and expanded on the very bailouts that the Bush administration foisted on the economy, and which are by definition protectionist for propping up businesses that should be allowed to fail, or be swallowed by domestic or foreign competitors. The shabby treatment of British Petroleum is yet another protectionist act which imperils U.S. multi-nationals, while chilling investment stateside. All that, plus Obama's prostrate countenance toward unions means that any alleged free-trade pacts with foreign countries will be far from free, which points to more, not less in the way of the specialization so necessary for growth.

Considering the dollar, FDR oversaw a major decline of the greenback from 1/20th of an ounce of gold to 1/35th. Obama's Treasury Secretary Geithner has achieved much the same, with the gold price having risen from roughly $750/ounce to $1,240/ounce. Currency devaluation is inflation, inflation is anti-investment, and there are no jobs without investment.

The nice thing about all this is that if President Obama chooses, his actions (meaning, doing nothing) could steer us away from a long-term recession or depression. Basically he'd have to do the economic opposite of what instinct tells him to do, or better yet, the opposite of what Paul Krugman advocates.