Excuse me while I dust off my nerd suit and jump into an extremely dorky debate. I won’t criticise you for falling asleep half way into this article….
Paul Krugman has made a bunch of big league predictions over the last few years.¹ He predicted lower rates, low inflation, marginal impact from QE, insufficient stimulus, etc. These were, as he’s noted, important predictions as they were non-consensus and would have had huge impacts on alternative policy outcomes. He made these predictions using a fairly simple IS/LM framework. I’ve noted over the years, that I made all the same predictions. Except, when Paul was confused about why Japanese interest rates were low relative to European rates, I was clear on this point, also noting that the USA wasn’t Greece. And even though we’ve made many similar predictions I’ve argued all along that Paul’s model was right for the wrong reasons.²
So, fast forward to today. Some Conservatives have noted Krugman’s recent flip from saying we needed a higher deficit to now saying that the higher deficit could come at the expense of private investment. This is a subtle change, but an important one. Paul isn’t saying that we don’t need government deficits to help spur the economy. He’s saying that the current environment requires a more specific type of deficit, mainly, one that isn’t just the result of a big tax cut for the rich. His argument against this is that this type of borrowing will “crowd out” private investment by driving up interest rates. Here’s exactly what he says:
What changes once we’re close to full employment? Basically, government borrowing once again competes with the private sector for a limited amount of money. This means that deficit spending no longer provides much if any economic boost, because it drives up interest rates and “crowds out” private investment.
Right off the bat regular readers will see an obvious error. Someone who understands banking would never say there is a “limited amount of money”. This is loanable funds thinking and it’s wrong. So, the key point here is that this idea of “crowding out” is based on a long time debate endogenous money theorists have had with Paul Krugman and “mainstream” economists. We basically argue that most economists don’t understand banking so they believe in things like the money multiplier or loanable funds. This idea of “crowding out” feeds directly into this because it’s based on the idea of a fixed pool of funds that the government and private sector compete for. This, of course, is not how modern banks operate. When banks make new loans they create new money, yes Paul, from “thin air“.
Now, I do think Paul is right that our spending could be better targeted (see Matt O’Brien on this). If Trump passes a big Bush style tax cut I think it will be be sub-optimal. There isn’t much evidence that cutting taxes for the rich is the optimal way to run a deficit. But there also isn’t much evidence that a tax cut for the rich will cause a deficit increase that drives up interest rates. In fact, our recent experiment during the Bush administration shows the exact opposite. And perhaps more importantly, 30 years of falling rates and surging government debt seems to blow a huge gaping hole in the idea that more government debt “crowds out” private investment by driving rates higher. In fact, it actually looks like more government debt puts downward pressure on interest rates. But as they say, we have to be careful confusing correlation and causation.
The bottom line is that I think Paul’s recent change in opinion is problematic for several reasons:
- It potentially discredits sound views by having an obvious potential political bias. Given that this is one of the most common criticisms of economics in general I don’t think Paul is helping the economics profession by appearing politically biased.
- More importantly, there does not appear to be any sound evidence supporting the view that higher government debt via tax cuts will drive up interest rates and “crowd out” private investment. So, even if he’s using a useful model of the economy the evidence doesn’t seem to support what the model says.
So, this again looks like a case of being right for the wrong reasons. Some people might say it doesn’t matter. Well, I say it matters bigly. After all, if we have models of the economy that are based on mythology then we will inevitably come to the wrong conclusions. But if our models are based on the way things actually work then we’re more likely to construct models that generate accurate predictions and sound probabilistic outcomes.
¹ – Some say “bigly” and others say “big league”. I prefer to use both interchangeably.
² – I actually want to apologize in advance for even writing this article. I didn’t want to. But I think it’s an important discussion to be having given the crisis in economic modelling that’s currently going on. I think disagreement is important, but people too often use Paul Krugman as a personal punching bag for political purposes and I should be clear that I am not attacking the person, but the ideas that are so widespread in the economics profession.³
³ – I also want to apologize for writing this footnote and pretending to be an economist. Economists deserve better than to have dopey asset managers take swipes at their views of the world. I suggest we leave this task to the President-Elect. Preferably via Twitter. Late at night. From a golden Russian hotel room.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.