Krugman’s fundamental fallacy

Our favorite Nobel prize-winning economist is back. In his latest missive, Paul Krugman tells us not worry about getting our financial house in order, but rather, to kick the can down the road and borrow and print more money. In fact, he says, it is the responsible thing to do. What I would like to focus on is the central fallacy of Krugman’s prescription:

“Start with a basic point: Slashing government spending destroys jobs and causes the economy to shrink.”

This is really the core tenet of Keynesianism. The idea is that government spending can stimulate private sector economic growth. However, here’s the question you have to ask yourself: Where does all the money to pay for this new government spending come from? What many don’t seem to realize is that the government has no wealth of its own. Everything the government has it takes from the private sector.

Sometimes is it easier to understand the effect of a policy by considering what happens at the extremes. If more government spending equals more private sector economic growth, then it should follow that the optimum solution is for the government to spend all private sector capital. But, immediately a problem becomes evident. How does the private sector economy grow when there is no longer private sector capital? It becomes clear, at the extreme, that the only way the private sector economy can grow is through less government spending and less wealth confiscation.

I can hear the objections of the Krugman-ites. Even they acknowledge that raising taxes in the current environment will hurt the private sector economy. The trick here, they will say, is not to raise taxes but to have the Fed fund (monetize) new government debt. But, this is a deception. Printing money (inflation) is a tax. When your cost of living rises faster than your income, the result is a net reduction in your standard of living. The government has taxed the purchasing power of your money instead of taxing a nominal dollar amount. To understand this, it is critical to recognize the difference between currency and wealth. Currency is a medium of exchange and a (temporary) store of value. Wealth is represented by the underlying goods and services for which a currency is traded.

For purposes of easy math, let’s say your life’s saving is $10,000 and the price of wheat is $10/bushel. Your actual wealth, in this case, can be represented by 1000 bushels of wheat — remember, you can’t eat dollars. Now let’s say the government enacts a savings tax of 50% leaving you with just $5,000, or in terms of actual wealth, 500 bushels of wheat. In reality, such a tax would almost never happen because it would be political suicide.

On the other hand, what happens when the Fed enacts the Krugman Stimulus Plan and prints so many new dollars that their value is cut in half? Well, in the case of your savings, you didn’t lose a single dollar, but the price of wheat has gone to $20/bushel. So your actual wealth is represented, once again, by only 500 bushels of wheat. Did you see what just happened there? Not a single dollar was taken, yet you still lost half of your wealth.

Krugman’s fundamental premise is a fallacy. Additional government spending always results in the loss of private capital and a contraction of the private economy, not growth. Regardless of the scheme that is used to fund new government spending, it is always the private sector economy that suffers because of it.