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Friday, July 16, 2010

Krugman's Whoppers

If there’s one thing I hate to see in an intellectual, it’s smarminess ― even though I’m a prime offender myself. Of course, my status as an intellectual is debatable at best, so I reckon I’m off the hook. I especially hate it when such smarminess exudes from a figure who basks in the near-universal admiration of the public, even while being considered a charlatan by those who know something about his area of supposed expertise.

Paul Krugman is a case in point. He’s well-known as an op-ed writer for the New York Times and is a media darling. He is also Professor of Economics at Princeton and won the Nobel Prize for Economics in 2008. Thus, you would be warranted in assuming that the man knows a thing or two about economics. Certainly that’s the way the reading public views him. But even the greatest geniuses make mistakes. And when such mistakes are made, the bigger person will point them out civilly, and in a spirit of correction rather than triumph.

However, I am not a “bigger person”. I am a petty man, and I am content to glory in petty triumphs. As such, I would like to triumph in an obscure error Krugman made several years ago, and I would like to do this not in the spirit of correction, but in the spirit of giving the man a little taste of his own medicine. Methinks the great economist is in need of some cutting down to size.

Way back in 1996 historian David Hackett Fischer published an ambitiously thick book entitled The Great Wave: Price Revolutions and the Rhythm of History (Oxford University Press). It was very well-received, especially by the business community, which is an unusual honour for such an academic and esoteric work. On the other hand, many academics criticized it, and in fairness with some good reasons. It is a very interesting book but, as with any such work, not without its flaws.

One of Fischer’s critics was His Most Serene Eminence, Paul Krugman. In a review in the July/August 1997 issue of Foreign Affairs he ripped Fischer’s book apart, accusing the latter of committing many errors both factual and theoretical. One of these errors in particular Krugman rather uncharitably described as a “whopper”. The relevant passage is worth quoting at some length, for it fair reeks of that smarminess I referred to earlier:

Fischer’s impatience with analytical thinking extends to his own ideas; the book contains quite a few whoppers, assertions that fall apart if given even a moment’s serious thought. His discussion of the origins of the great price rise after 1500 provides an illuminating example. Fischer points out, correctly, that prices in Europe began rising well before New World silver began to arrive ― which, he argues, refutes any monetarist explanation. There is no mystery here: as he admits, there was a surge in European silver production in the late fifteenth century, mainly from mines in Bohemia and what is now southern Germany…. But Fischer insists, without evidence, that the rise in European silver production was a result rather than a cause of inflation ― that mines were opened and expanded to meet the “desperate need for liquidity” produced by rising prices.... Think about that for a minute. We can be sure that fifteenth-century mine owners neither knew nor cared about Europe’s need for liquidity ― they were simply trying to make a profit. Now ask yourself: does inflation (a rise in the price of goods and services in terms of silver) make it more or less profitable to open a silver mine? The clear answer is that it makes the mine less profitable: a pound of silver extracted from the mine would buy fewer goods and services than before. Had Fischer devoted even a few minutes to thinking his story through, he would have realized this.

Thus Krugman. Now let us devote a few minutes to thinking his story through. Imagine that I own a fifteenth-century silver mine. I hire workers to dig up silver. What do I do with the silver they dig up? Krugman seems to imagine that I spend all of it on immediate consumption, and that since inflation has reduced its value, my silver won’t stretch as far, and so I will not care to mine more of it.

But if I don’t mine more silver, next year because of inflation I am able to consume even less than I could have if I had expanded production in the first place. Krugman’s argument is the equivalent of saying that because my $50,000 salary will only be worth $45,000 next year due to inflation, I will therefore refuse the raise my boss offers me. Furthermore, Krugman finds himself without an explanation for why it was that in the following century, miners in the New World flooded the market with silver, thereby contributing to the inflationary environment.

Krugman’s fallacy seems unspeakably elementary. The only way to make sense of such a slip-up is if Krugman is assuming a situation in which the marginal cost of further mining is greater than the decline in marginal return. But if this is so, it is an assumption he nowhere states, and it is purely speculative in any case. Furthermore, such a state of affairs could be largely microeconomic in nature and need not have anything to do with inflation per se, which is a macroeconomic phenomenon (although inflation would obviously exacerbate a decline in marginal return).

Let us give Krugman the benefit of the doubt (which is more than he bothers to give Fischer). Let us instead imagine, much more plausibly, that as a silver mine owner, I don’t spend all my silver at once on consumption. Instead, like other producers of goods, I sell my silver to buyers. Such an exchange would obviously have to be performed via some medium other than silver. For example, I might accept some other good which I believed I could sell on for more silver than it cost me to purchase it (which is essentially arbitrage).

Or I could accept gold in exchange for my silver. And indeed this is precisely why for most of European history there were two metals of exchange in circulation, gold and silver. And because the supply of gold was not tied in any natural way to the supply of silver ― after all, a silver mine is not a gold mine, nor do silver and gold have the same distribution in the earth’s crust ― the silver-gold exchange rate would fluctuate. This is a simple fact of monetary history about which Krugman of all people should have been cognizant.

There is yet a further possibility that Krugman doesn’t bother to consider. Again, assume that I am the owner of that fifteenth-century silver mine. I am aware that there is inflation, and so I am considering whether or not to expand my mining activities. It is entirely possible that I might believe the inflation is temporary, or that the value of my silver will rise, and that it is therefore worthwhile for me to sit on some of the silver I extract in the hope that inflation will abate. After all, one of the things that made precious metals the favoured medium of exchange for so long is their non-perishable nature.

Whatever way you cut it, Krugman’s errors here seem amateurish, and they are made egregious by the uncharitable nature in which they are expressed. I am aware that I have been just as uncharitable here, but I am frankly tired of Krugman being held up as some kind of omniscient economic sage. I know it might be hard to believe for many, especially ignorant journalists (there's a redundancy!), but Paul Krugman can’t walk on water.

In truth, his work has never really impressed me. It certainly doesn’t seem to impress many professional economists. Perhaps my lack of enthusiasm for his work has to do with the fact that he is an unreconstructed Keynesian, Keynesianism being the equivalent in economics of trying to build a perpetual motion machine. Of course, I’m no economist, but some would say that neither is Krugman.

The worst thing about Paul Krugman is that people listen to his half-baked economic nostrums. That’s why I’m frightened by his most recent whopper, advising the US government to adopt a “kitchen sink strategy” ― that is, to throw every bit of money at its disposal at the economy until it improves. This is shockingly stupid and irresponsible. It is unethical to advocate bankrupting future generations to pay for present consumption. It is to commit an intergenerational injustice. In any case, not only has the US government run out of kitchen sinks to throw, but it lacks a pot to piss in.