Kotlikoff versus Krugman: Economic Fallacies Exposed

In a recent column, Boston University Economics professor Laurence Kotlikoff challenges what he calls "Krugman's Four Dangerous Fiscal Fables."  The economics in academia must be getting worried that Mr. Krugman's Keynesian proposals might destroy their reputations as well.

Kotlikoff opens by listing the fables:

The first is that taxes can be cut to raise revenues and lower the deficit.  The second is that spending can be raised to raise revenues and lower the deficit.  The third is that the deficit can be financed by printing money with no real consequences.  And the fourth, and most dangerous, is that the deficit's accumulated value -- the official debt -- is a meaningful measure of our country's or any country's true indebtedness.

Paul Krugman, who has been pleading for more deficit spending on a continuous basis in his New York Times column, is hawking all four fables.  Pity our children if our policymakers continue to take his views seriously.

Kotlikoff deserves a clear win on at least two of his arguments.  But more significant is that the leftist media have begun to allow attacks on fellow traveler Krugman, the president's leading Keynesian propagandist.

A lot is at stake: if Krugman and other Keynesians are exposed as crackpots, then the big-government interventionists could lose the authoritarian power they've commanded for the past 80 years.  Before Keynes came along, it was thought (correctly) that government intervention only could harm economic growth.

Here's my ringside commentary on Mr. Kotlikoff's attempt to knock out the fables:

Fable 1. Taxes can be cut to raise revenues and lower the deficit.  Krugman is wrong because taxpayers have rational expectations.  For example, the temporary cut in the Social Security tax rate had little economic impact because most taxpayers were not fooled into blowing the windfall on discretionary spending.

Thinking rationally, they realized that the cut meant either that the SSA would have to collect billions of dollars more in the future or that Congress would have to reduce retirement benefits.  Either way, taxpayers knew they had to save rather than spend the Keynesian stimulus they'd been given, because they would need all of that money in the future.

Taxpayers outsmart Keynesians because taxpayers think in terms of their permanent, not temporary, income.  Granted, drug addicts do spend whatever's in their wallets, but a lot of that money winds up outside the U.S. and is a dead-weight loss to the economy.

Kotlikoff also is wrong, though, to imply that the government never can lower the deficit by reducing tax rates.  Suppose the government concurrently reduces taxes and permanent spending by $100B annually.  Yes, in the short term, that would have zero effect on the deficit.  But if taxpayers can be convinced that the government never will need that money, then they won't think that they must save it to cover future tax hikes.  Therefore, a larger portion of the $100B gets spent.  That, in turn, creates a virtuous circle in the economy and tax revenue rises to reduce the deficit.

Krugman might counter that it makes no difference whether the government or consumers spend the $100B, but that clearly is false.  Keynesians confuse income and wealth.  Government spending is less productive than private-sector spending, so by comparison, government spending destroys wealth, even though it might boost national income artificially by wasting money on unproductive work.

Fable 2: Spending can be raised to raise revenues and lower the deficit.  Kotlikoff successfully discredits this fable.  The only way it possibly could work is with a Keynesian multiplier of greater than one.  But it's just silly to claim that a huge, monopolistic (and bribable) government possibly can spend money more efficiently than agile, for-profit private enterprises in a competitive market.

Kotlikoff argues correctly that Krugman can't have it both ways by simultaneously promoting Fable 1 and Fable 2.  But if Kotlikoff claims that both are false, then he must think the Keynesian multiplier is exactly one, and it makes no difference who spends the money.  That probably is wrong, too, because most economists calculate the multiplier to be less than one.  Therefore, even though Fable 2 clearly is false, Fable 1 still could be partly true.

Fable 3: The deficit can be financed by printing money with no real consequences.  Krugman asks rhetorically, "Where is the inflation?  Where are the high interest rates?"  Gold dealers will flame me, but until I see inflation expectations rise, I must partially defend Krugman on this one.

As with temporary tax cuts, expectations are the key.  We can debate whether the current rate of inflation is two percent or four percent, but that's virtually irrelevant because inflation expectations remain low.  Yes, the Federal Reserve Bank is suppressing interest rates artificially, but expectations still aren't showing up in the TIPS spread, the yield curve (even after accounting for the Fed's tampering), or other economic predictors of inflation.

Until inflation expectations rise, the demand to hold money will stay at record highs, which means money velocity will stay at record lows.  Kotlikoff and most alarmists look at the huge increase in the money supply without acknowledging the equally huge increase in money demand.  As long as the two stay in equilibrium, there's no reason for the price (market value) of money to fall.

For the past 30 years, most people have been convinced that the U.S. government has no plans to monetize its debt with a policy of deliberately high inflation rates.  Furthermore, its two dominant liabilities, Social Security and Medicare costs, already are rising faster than the overall CPI, so inflation wouldn't free the government from much of its debt obligations anyway.  Those factors probably will keep inflation expectations low.  Yes, the Fed will make mistakes when it unwinds its positions, but as long as expectations remain tame, those mistakes will be viewed as temporarily inflationary, not deliberate or chronic.

Fable 4: The official debt is a meaningful measure of any country's indebtedness.  Kotlikoff spends half of his article on this fable and successfully discredits it.  As with the topic of government monopolies, the left behaves schizophrenically on this, too.  It prosecutes private enterprises that improperly report unfunded liabilities while it violates public accounting rules in the way it reports its own unfunded liabilities.

As ringside referee, I award Kotlikoff a TKO over Krugman in this match.  In a perfect world, that would call for Krugman to submit his Nobel Prize, but alas -- I'll have to let him keep it.