Paul Krugman’s Rusty Chains

Howard Gold Founder & President, GoldenEgg Investing

The Nobel-winning economist loves to play the Marley to conservatives’ Scrooge, but it may be he who gets the visit from the ghosts of depressions past, writes editor-at-large Howard R. Gold.

Update: An earlier version of this column called it a "liquidity trap" when consumers are saving or paying down debt rather than spending. The correct term is "paradox of thrift," and the text has been changed to reflect that.

He is by far the best-known economist of our time, a Nobel laureate, and a popular columnist for The New York Times.

And he’s the most prominent, unapologetic Keynesian in a profession that until recently had considered the Master of the 1930s passe. But the financial crisis and the Great Recession have given John Maynard Keynes’ ideas new currency, and elevated Paul Krugman to international celebrity.

Still, his certitude and breezy dismissal of dissenting opinions are troubling in a discipline whose aspirations to scientific validity have been shattered in recent years. And Krugman exposes deep problems in Keynesianism through his vast body of writing, including a new book, End This Depression Now!, which sums up his ideas clearly and concisely in a way that’s accessible to a general audience.

I’m approaching this column with some trepidation—Krugman has one more Nobel Prize than I do—but the problems with his thinking have been flagged by others, mainly conservatives. I contacted Krugman and his publicist by e-mail and forwarded some questions but hadn’t heard back by deadline.


Can Paul Krugman’s preferred theories work in a peacetime economy? Opinions are sharply divided.

I see three main problems in Krugman’s approach:

  • how much of today’s unemployment is structural
  • whether countries’ long-term debt matters
  • and Keynesian economics’ track record

Krugman believes the financial crisis and Great Recession created an output gap—the difference between the economy’s potential and what it’s currently producing—through a huge shortfall in demand.

Consumers are saving or paying off debt rather than spending. Since consumption represents 70% of the economy, that depresses aggregate demand. Keynesians call it the "paradox of thrift."

With consumption and business investment hobbled, Keynes and Krugman say there’s only one way to fill the gap: The government has to step in with stimulus spending and the Federal Reserve needs an inflationary monetary policy to kick start the economy.

But what if the problem isn’t only a dearth of demand?

Krugman is adamant that current US unemployment is not structural—i.e., that it has deeper causes such as a mismatch of skills between workers and the available jobs. "Structural unemployment is a fake problem, which mainly serves as an excuse for not pursuing real solutions," he wrote. “…All the facts suggest that high unemployment in America is the result of inadequate demand—full stop.”

Actually, economists are divided on this issue—studies by the Chicago and San Francisco Fed support Krugman, while a recent International Monetary Fund paper pegged the structural contribution to long-term US unemployment at 40%. That’s 2 million people…hardly trivial.

And two long-term trends may be suppressing job growth:

  1. Globalization. The US lost 6 million manufacturing jobs from 1998 to 2009, only half of them in the last two recessions. That leaves 3 million. Where did they go? A 2011 report from the liberal Economic Policy Institute said the US trade deficit with China cost 2.8 million US jobs from 2001 to 2010. And in the 2000s US multinationals added almost 2 million jobs in rapidly growing Asia and Latin America while cutting nearly 900,000 in the mature US. How is that caused by a Keynesian output gap?
  2. Housing. The bursting of the housing bubble was the main reason median US household net worth has plunged to its lowest level since 1992. And the number of new housing starts is a fraction of what it was, eliminating housing’s traditional leading role in economic recoveries. With more than 3 million foreclosures so far and over 20% of all US households under water on their mortgages, this problem will linger for years. And gone for good is the $1 to $2 trillion in cash-out refinancing money that hit the economy during the housing bubble.



Then there’s the issue of debt. Krugman has had a running battle with economists Carmen Reinhart and Kenneth Rogoff, whose research showed that countries’ growth slows when their debt-to-GDP ratio gets too high (around 90%). This matters because if it’s true, it would limit the amount governments could spend on stimulus before they get diminishing returns.

Yet Krugman wrote, “It’s a claim that has been pretty thoroughly debunked—yet it continues to circulate among Very Serious People as a known fact, and you can make a strong case that slow growth caused high debt, not the other way around.”

Some studies back him up. But research by the IMF, European Central Bank, and the Bank for International Settlements take the opposite view. So, not quite “debunked.” (Krugman supports debt reduction, by the way, but not right now.)

Still, Keynesianism must rise or fall on its success in the real world. And that brings us to the Obama stimulus plan of 2009.

With the output gap at an estimated $2.9 trillion, Krugman thought the stimulus should be really, really big, and he faults the president for not pushing for more than the $800 billion he ultimately got. Krugman called for $1.2 to $1.3 trillion at the time, and he never tires of reminding people of that.

He also thinks the 2009 package included too many tax cuts, in what he viewed as a misguided attempt to placate Republicans. (I think the whole plan should have focused on infrastructure spending.)

Result? Some independent studies showed the stimulus added roughly 2.5 million jobs by its apex in late 2010, but its impact faded as federal subsidies to states ended and state and local governments laid off workers.

But Keynesianism got its ultimate test during the Great Depression, when President Roosevelt and Congress created an alphabet soup of new agencies that employed millions of people doing make-work projects and building useful roads, bridges, dams, and public buildings that still stand.

“By almost any measure, the economic surge since 1932 had been remarkable,” wrote biographer Jean Edward Smith of Roosevelt’s first term. “National income had risen by more than 50%, 6 million new jobs had been created, and unemployment had dropped by more than a third.”

Yet 8 million were still unemployed in 1936, and unemployment never fell below 14% in the decade. So despite these “remarkable” gains, Roosevelt’s Keynesian policies did not get the US out of the Great Depression.

It took World War II to do that, and here Krugman waxes nearly poetic. “World War II is the great natural experiment in the effects of large increases in government spending, and as such has always served as an important positive example for those of us who favor an activist approach to a depressed economy,” he wrote.

Krugman appears to be saying that we could have gotten out of the Great Depression earlier if Roosevelt and Congress had spent as much domestically as we did during World War II, when deficits reached 30% of GDP. If so, he has things completely backward.

Remember, the US had been attacked by Japan at Pearl Harbor and faced a mortal threat from Nazi Germany. Sixteen million Americans served in the armed forces (there goes unemployment!), while companies like General Motors (GM) and Boeing (BA) converted factories to produce tanks and fighter planes (there goes idle capacity!), bringing millions of women into the labor force. War bond drives, price controls, and rationing were all part of a general mobilization of the population that could take place only in wartime.

A similar level of spending during peacetime would raise fears of a huge increase in government control. That’s why massive government stimulus and bailout programs provoke such a strong reaction. So in the real world, the checks and balances of democratic politics won’t let Keynesians test their hypotheses by allowing the government to spend without limit.

Keynesianism is not the only theory to have reached its limits. The loose monetary policy recommended by Milton Friedman in sharp downturns also hasn’t gotten growth going. Supply-side tax cuts failed to produce significant job growth in the 2000s. And we can’t return to the Utopian world before the Fed, income taxes, and World War I envisioned by libertarian followers of Ron Paul.

Some of these policies have helped forestall the worst. The current depression, as Krugman calls it, is not as bad as the Great Depression was, probably because we used the tools at hand.

But if this recession or depression has taught us anything, it’s that there are no magic bullets anymore. So, maybe policymakers should focus on strengthening the economy for the long run, and give the markets time to heal themselves.

Howard R. Gold is editor at large for and a columnist at MarketWatch. Follow him on Twitter @howardrgold and read his commentary on politics and economics at