A mighty big ‘if,’ sir

Doing battle with economists Eugene Fama and John Cochrane, who argue that deficit spending by government ultimately discourages private investment, Paul Krugman engages in one of those magic hypotheticals beloved by Keynesians:

Similarly, after a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal.

If interest rates are fixed! Does Krugman mean to propose fixed interest rates? It’s like the joke about the chemist, the engineer and the economist stranded on a desert island, where they discover a castaway cache of canned food. After the chemist and the engineer each suggest their own distinctive proposals for a way to open the cans, the economist says, “Step One: Assume a can opener.”

Government borrowing represents demand for credit, and if government responds to a recession by massive borrowing, this increased demand means that the price of credit (i.e., interest) can be expected to rise. The rise in interest rates thereby reduces the credit supply for private investment, and the economy cannot grow without private investment.

Generally, however, a heavily indebted government (as ours is) will attempt to defraud its creditors via inflation, paying back today’s dollar with devalued dollars, which in turn will cause creditors to charge the government higher interest to offset the anticipate loss. It was the U.S. government’s attempts to play this game — devaluing the dollar while simultaneously borrowing heavily and also inflicting job-killing taxes — that led to the “stagflation” spiral of the 1970s.

“Stagflation” was the ultimate disproof of the Keynesian theory of “equilibrium,” which saw government manipulation of the economy as a trick of balancing unemployment vs. inflation. The possibility of both unemployment and inflation rising simultaneously was something never contemplated by the Keynesians, nor did they ever envision the result of Reagan’s supply-side revolution, which nearly eliminated inflation while simultaneously resulting in full employment.

Neo-Keynesians like Krugman are trying to pretend that we did not learn what we learned, and that we do not know what we know. A Nobel Prize-winning ignoramus!

UPDATE: By God, the more I think about it, the angrier I get. You don’t have to have a Ph.D. to understand economic basics: Supply. Demand. Talk amongst yourselves.

For me, this all goes back to the feud between David Stockman and the supply-siders in the Reagan years. Stockman had a very good point, namely that for political reasons, the Reaganites refused to force a showdown with Democrats in Congress over the continued growth of federal spending. But the supply-siders argued that, (a) with tax cuts unleashing economic growth, and (b) the attendant growth in federal revenue, then (c) additional federal spending was affordable, and (d) what really counted, in macroeconomic terms, was the size of federal spending in relation to GDP. So, even though government was growing, in real terms, it was actually shrinking in comparison to the overall economy.

Thus spake the supply-siders, at any rate, but Stockman was still right about the lack of political courage among Republicans. If the federal government in 1980 was too big, too powerful, too expensive, and doing too many things it had no constitutional authorization to do — which was the fundamental premise of the Reagan campaign, vis-a-vis domestic policy — then this argument about the relative size of the government vs. overall GDP was just an excuse for not doing what Reagan had pledged to do.

And now, in 2009, we find that the clients of Uncle Sam refuse to give up a nickel of their slice of the taxpayer pie, so that Obama can propose a vast and expensive stimulus, and most so-called “conservatives” don’t have any coherent argument to offer in reply. The abandonment of sturdy principle thus results in ever-weakening opposition to the liberal Leviathan.

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