Krugman’s Achille’s Heel on the Economy and Stimulus

Sometimes Paul Krugman writes a column, like the one that ran in Sunday’s New York Times (September 4, 2011), that reminds me about a core difference between my career as an economist and his: I chose the path of the applied economist, focusing on implementation and the practical effects of policy. He took the academic route, more comfortable with modeling and quantitative analysis but capable of producing lots of academic journal articles and theoretical insight. (Of course, his path led him to the Nobel Prize in Economics while I’m just policy wonk who toils with the practical ramifications of policies I criticize and recommend.)

That’s the only way I can rationalize his continued call for more government spending to bring the economy out of the doldrums. His most recent column, “The Fatal Distraction,” sings a familiar song for a bigger, badder stimulus to spur economic growth:

“Ever since the acute phase of the financial crisis ended, policy discussion in Washington has been dominated not by unemployment, but by the alleged dangers posed by budget deficits. Pundits and media organizations insisted that the biggest risk facing America was the threat that investors would pull the plug on U.S. debt. For example, in May 2009 The Wall Street Journal declared that the “bond vigilantes” were “returning with a vengeance,” telling readers that the Obama administration’s “epic spending spree” would send interest rates soaring.”

After dismissing concerns about the national debt, deficit, regulation, and everything else limited government people care about, Krugman asserts:

“The answer to the first question is that we should have a lot of job-creating spending on the part of the federal government, largely in the form of much-needed spending to repair and upgrade the nation’s infrastructure. Oh, and we need more aid to state and local governments, so that they can stop laying off schoolteachers.”

The problem is low demand, not lack of incentives to invest, Krugman says. Companies are making money. They aren’t investing because demand isn’t there.

Which brings me to my real problem with Krugman’s analysis and what I think is the Achille’s Heel of the spend, spend, spend wing of the progressives: They ignore the fact that how resources are allocated and for what is critical to long-run economic growth and sustainability. Their solution is simply to spend–large amounts, dumping as much money (as they think) the economy can withstand. Spend money on bridges, highways and trains to nowhere, teachers that don’t teach well, government programs that don’t work or are unnecessary. Government needs to spend, even become the primary employer, in order to put money in checking accounts so that people will spend.

Krugman has learned nothing from the Housing Bubble and the triggers of the Great Recession. The housing market imploded because of an allocative inefficiency (brought on by federal policy); home prices did not reflect real value, as determined by households in the marketplace. Houses became overpriced, supply and demand were out of whack, investors and fianciars misread the price data, and we built too many houses because housing prices were distorted. So, the market had to be brought back in line. And the bubble (inevitably) burst.

Now, Krugman is arguing for dumping billions of more dollars into a system that still hasn’t reset to more realistic levels. (See my colleague Anthony Randazzo’s analysis here as well as here for more from Reason on the housing bubble and bust.)

The problem isn’t as simple as low aggregate demand. The core problem is that the economy needs a microeconomic reset, where supply (production) and demand (consumer) are brought back together through an undistorted and smoothly functioning price system. That means the government has to back off, not become more active. Moreover, dumping more money into the system as Krugman recommends, is really throwing good money after bad, and will make the economy inevitably worse off. In short, across the board increases in spending are likely to reinforce the very factors that cause the economy to collapse in the first place.

But, then again, my professional work is in applied economics, not theory.