In memory of Dr. Andreas Höfert

Why Krugman is wrong and Bernanke as well

| Tags: Andreas Höfert

Developed economies have struggled since the financial crisis of 2007/2008 with low growth, recessions and even depressions. Stabilizing or jumpstarting them has been tried with both monetary and fiscal tools. The success of such policies is less than impressive. The US is growing at a slow pace, and due to the euro crisis, Europe is heading back into a recession. Something needs to be done, right? I'm not so sure anymore.

A popular definition of insanity is doing the same thing over and over but expecting different results. I do not assert that the Federal Reserve and Ben Bernanke are insane. But after almost four years of Fed fund rates at zero (to be continued to the end of 2014), two quantitative easing programs and an operation twist, just extended to late 2012, resulting in a tripling of the Federal Reserve’s balance sheet, it should be time to admit that monetary policy is not delivering the anticipated real boost of the economy.

The Bank of International Settlements expressed this openly in its latest annual report: “By itself, easy monetary policy cannot solve underlying solvency or deeper structural problems. It can buy time, but may actually make it easier to waste that time, thus possibly delaying the return to a self-sustaining recovery. […] Monetary policy cannot substitute for those policy measures that can address the root causes of financial fragility and economic weakness.”

Many developed economies are now stuck in a liquidity trap; low interest rates cannot entice highly indebted households to take on even more debt. Moreover, the flat yield curves are denting the profitability of many financial intermediaries, delaying the healing of their balance sheets and certainly not spurring them to lend more to the public.

Enter Paul Krugman, Nobel Prize-winning economist, New York Times columnist and self-proclaimed pop- or über-Keynesian, whose new book, End this depression now!, argues: since interest rates are so low, and everyone seems willing to lend money at super-cheap conditions to the government, especially in the US, public deficit spending is the right tool to boost the economy. This is the – admittedly simplified – advice that John Maynard Keynes would give us, the great British economist who was among the first to discuss the liquidity trap.

But given that last year the US public deficit-to-GDP ratio was a mindboggling 8.5% and is forecast to stay at this level in 2012, one must conclude also here, that fiscal policy is not delivering the desired boost to the real economy, either.

However, Krugman argues in his book that the public deficit spending witnessed in the last five years in the US, which sent the public debt to a stratospheric 15 thousand billion US dollars, or over 100% of GDP, was actually not enough. This flawed reasoning cannot really be debunked. Krugman can always say that if deficit spending is not functioning, it is because it is not enough. Throw more money on the fire, he seems to say, but for how long?

After four years of stalling and sub-trend growth in developed countries, it is time to admit that the healing process of over-indebted societies will be long and must endure painful structural adjustments. To hurl ever more liquidity and public debt at economies, thinking that what led us into trouble in the first place will also lead us out of it, is plain and simply wrong.