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Since the crisis began, one of the
dominant themes in arguments over proper government policy has been the
Keynesian view that it is crucial to prop up total spending. The added twist
during this particular recession is the crushing burden of private-sector
debt, which allegedly makes it all the more urgent for governments to run
fiscal deficits.
In a previous
article I dealt with so-called deleveraging and argued that it was
a good thing, both for the indebted individual or firm, as well as the
general economic recovery.
However, prompted by a recent
scolding given by Paul Krugman, it's important to
revisit the topic in a more elementary fashion. When Krugman,
et al., casually claim that debt reduction would by sheer accounting
cause total spending to fall, they are simply wrong. Thus their mistake is
twofold: their faulty Keynesian economics leads them to worry needlessly
about nominal spending, while their sloppy accounting leads them to champion
debt as necessary for investment.
Krugman on Debt Reduction
In a post
ironically entitled "Arithmetic Has a Well Known Keynesian Bias"
— ironic because his Keynesian bias leads him to make an elementary
accounting mistake — Krugman explains that an
exasperated British pundit was
reacting to Cameron's
statement, semi-withdrawn but not really, that what Britain needs is for
everyone to pay down debt, said in obvious obliviousness to the fact that if
everyone cuts spending at the same time, income must fall.
But then, this kind of
obliviousness is very widespread, and my experience is that if you try to
point out the problem — if you try to explain that my spending is your
income and vice versa — you get a belligerent response. Y=E is seen as
a political statement, which in a way it is if one side of the political
spectrum insists on believing things that can't be true. (emphasis added)
As I mentioned in the opening, this
claim has been repeated ad nauseam during the last three years.
Specifically, the opponents of government deficit spending have been beaten
over the head with the alleged "fact" that as a matter of simple
accounting, widespread debt reduction implies a reduction in spending and
hence a reduction in income.
The second part of the claim is
true, as far it goes. Every time someone spends a dollar in a transaction it
is, at the same time, part of someone else's income. In my previous
article, I argued that this tautology does not make the
Keynesian case for government deficit spending.
Yet Krugman's
quotation above contains an even worse mistake. He is taking it for granted
that if people in Britain began paying down their debts, then that necessarily
would lead to a reduction in total British spending. He is simply wrong here,
as I'll show in the next section.
Debts and Spending: A Simple Fable
Imagine a simple world with three
people: Cathy the Capitalist, Larry the Landowner, and Willy the Worker.
Initially we are in a stable pattern where every period, the following
transactions occur:
·
Larry pays Willy $1,000 to work on his
land and harvest food.
·
Willy pays $100 in finance charges on his
outstanding debt of $500 to Cathy, which is rolling over at the interest rate
of 20 percent per period. (Willy each period just pays the finance charges,
keeping the outstanding carried balance intact at $500.)
·
Willy spends his remaining $900 on buying
some of the food from Larry.
·
Cathy spends her $100 in interest income
on buying some of the food from Larry.
·
Larry eats the remaining food that he
hasn't sold to Cathy or Willy.
In this scenario, every period $1,000
is spent on food, the only finished good or service. As officially measured
— notice that it misses Larry's "home consumption" —
gross domestic product (GDP) for this simple economy is $1,000 per period.
Now suppose that Willy listens to
Dave Ramsey and decides to become debt free. In this particular period, the
following might happen:
·
Larry pays Willy $1,000 to work on his
land and harvest food.
·
Willy pays $100 in finance charges on his
outstanding debt of $500 to Cathy, which is rolling over at the interest rate
of 20 percent per period.
·
In addition, Willy pays another $500 to
Cathy to extinguish his debt to her.
·
Willy spends his remaining $400 on buying
some of the food from Larry.
·
Cathy spends her $100 in interest income,
and her $500 in principal repayment, on buying some of the food from Larry.
·
Larry eats the remaining food that he
hasn't sold to Cathy or Willy.
Now in this scenario, total
spending is still $1,000, and measured GDP is still $1,000. Larry the
Landowner wouldn't see a drop in demand for his food. Willy reduced his
consumption and saved much more out of his income this period, but this
didn't affect even nominal income because Cathy's consumption filled the gap.
Maybe our scenario isn't likely,
depending on various assumptions we can make concerning Cathy's spending
habits, but it is certainly possible. So we see that an economy can
start out with one person having a large debt, then becoming debt free,
without necessarily altering total spending or total income, even when
measured in nominal (i.e., dollar) terms.
Let me be fair to Krugman. He might concede that the above scenario is what
someone like Cameron (or Dave Ramsey for that matter) has in mind when
calling for people to "pay down their debts," but if we're
technical about it — so Krugman might argue
— there really wasn't net aggregate debt reduction in the above
scenario. Yes, Willy paid down his debt by $500, but Cathy in a sense "dissaved" by letting her own financial assets fall
by $500. If we like, we can say Cathy's debt started out at -$500, and then
ended at $0, meaning her debt "increased" by $500.
Okay, I am happy to give Krugman that escape hatch. As we'll see, it doesn't
rescue him. I can still show how Willy can pay off his debt without
causing total money expenditures to fall, and without anyone in the community
even suffering a drop in financial assets.
To see this, revert to our original
scenario, where Willy owes Cathy $500. As before, Willy decides to pay off
his debt, through much higher saving. But this time, imagine the following
occurs:
·
Larry pays Willy $1,000 to work on his
land and harvest food.
·
Willy pays $100 in finance charges on his
outstanding debt of $500 to Cathy, which is rolling over at the interest rate
of 20 percent per period.
·
In addition, Willy pays another $500 to
Cathy to extinguish his debt to her.
·
Cathy spends her $100 in interest income
on buying some of the food from Larry, as she always has done.
·
Larry issues $500 in new stock shares for
his landholding corporation, which Cathy buys.
·
Larry pays Willy $500 to plow a parcel of
his land that was previously uncultivated.
·
Willy spends $400 + $500 = $900 on buying
food from Larry.
·
Larry eats the remaining food that he
hasn't sold to Cathy or Willy.
In this final scenario, consumption
spending is $1,000 while net investment spending is $500, meaning official
GDP is $1,500 — it has actually risen 50 percent! At the same
time, Willy paid off his debt, while Cathy swapped a $500 bond for $500 in
stock shares, so that (considering just these two) there has been a net
reduction in indebtedness in the community.
But what about Larry? Has he
simply replaced Willy as the new debtor in our economy?
No, he hasn't. Although Larry took
in $500 while raising funds for his corporation, he is not indebted to
Cathy, and so we can't say that his financial decision during the period
somehow offset Willy's debt repayment. Cathy doesn't have a debt claim
on Larry; instead she owns equity in his corporation. There is a whole
literature in finance on the important
differences between debt and equity, including the fact that debt
financing makes a firm leveraged, whereas equity financing does not.
It's not even the case that Larry
will have to reduce his future consumption in order to make dividend payments
to Cathy (to justify the initial valuation of her stock at $500). So long as
Larry's $500 investment is sound, the new field will increase future
harvests, possibly allowing Larry to maintain his original consumption of
food even though Cathy now has an ownership stake in the net profits of the
business.
Krugman's Biased Arithmetic
As our fanciful example
illustrates, there is nothing in the raw GDP accounting that requires a
period of deleveraging to yield smaller "total spending" and hence
"total income," even if we measure those items in nominal money
terms.
Of course, Krugman
might object that I have loaded the deck, and chosen a completely irrelevant
story. In our present real-world situation of depressed demand and excess
capacity, Krugman might claim, why would Larry
issue more stock and try to expand his operation?
Yet here we have left the realm of
GDP accounting, and we enter the realm of economic models. That is why
I said Krugman's post title —
"Arithmetic Has a Well Known Keynesian Bias" — was so ironic.
My fanciful example shows that the tautologous GDP
accounting (or "arithmetic") is consistent with a story in which
extra saving allows for more investment, which in turn provides an
opportunity for underemployed workers to earn more income. (Notice that in
the last scenario, Willy didn't reduce his food consumption. Instead, he paid
off his debt by working more and earning a bigger paycheck for the whole
period.)
Maybe the reader finds my story
compelling, maybe not. But my point is, there is
nothing wrong in the GDP accounting with my simplistic tale. The
immediate objections to my story would rely on assumptions about how the
economy works — assumptions that Keynesians typically make and that
their critics typically reject.
Conclusion
The old-school, commonsense
solution to an economy plagued by excessive debt is for people to work hard
and save more. Keynesian economists have been saying throughout our current
crisis that this folk wisdom overlooks basic accounting tautologies, but these
pundits are smuggling in a Keynesian theory without realizing it.
Contrary to the assertions of these
pundits, an economy does not need mountains of debt — whether
government or private — in order to grow. Corporations can still raise
needed financing through issuing equity. There are pros and cons to debt
financing, but it isn't necessary for a strong economy.
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