Deflation, Inflation and Why Paul Krugman Fears Austerity

This is very disconcerting, fellow forecaster. Paul Krugman is making sense… up to a point.

“We are now, I fear, in the early stages of a third depression,” the Nobel laureate wrote in a NY Times Op-Ed yesterday, dipping his toes into a pool we’ve been sloshing around in for some time.

“It will probably look more like the Long Depression [of the late 1800s],” the Krug continues, “than the much more severe Great Depression. But the cost – to the world economy and, above all, to the millions of lives blighted by the absence of jobs – will nonetheless be immense.”

We choke on our morning brew admitting it…but Krugman is onto something.

That is, until he follows his comments up with this piece of advice to G-20 meeting attendees: This depression will actually be “a failure of policy… governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.”

Deflation now, inflation later. That much we can agree on. But how are we going to get over a spending binge with even more spending…? And borrowing and spending…? What of the deficits and debt we’re already drowning in?

Krugman’s fear is derived from the lip service the U.S. G-20 delegation is paying to “austerity measures” following the summit. They and other “advanced economies have committed to fiscal plans that will at least halve deficits by 2013 and stabilize or reduce government debt-to-GDP ratios by 2016,” reads the headline statement from the weekend meetings.

But in the end, we don’t believe Krugman has anything to worry about. In the opening minutes of I.O.U.S.A., we ran a montage of presidents declaring war on the nation’s deficits and national debt going all the way back to Eisenhower.

To that list we could also add this famous promise in a 2007 Op-Ed in The Wall Street Journal penned by then president George W. Bush: “We can balance the federal budget by 2012. In early February, I will submit a budget that does exactly that.”

“Too many people,” counters our own Dam Amoss, editor of Strategic Short Report, “confuse economic activity, measured by GDP, with economic progress. Progress usually involves rising living standards driven by rising productivity and falling consumer prices; as happened in the US industrialization in the late 19th century.

“The road to serfdom, originally outlined by Hayek, is now taking the global economy down one of two paths:

“Painful austerity plans and deflation that salvage what’s left of today’s currency system by promoting savings and encouraging new capital formation; or endless stimulus injections into economies with the promise of austerity ‘once the economy recovers.’

“The second path one is more likely in my view, because it’s more politically popular – especially once the European ‘pro-austerity’ camp discovers just how addicted their economies are to the welfare state. Hopefully, a critical mass of people who value freedom over the illusion of economic security can move to wean us off today’s frighteningly powerful roles for governments and central banks.

“But based on the decisions we’ve seen in recent years – decisions driven mostly by political considerations – I’m not holding out much hope at this point.

“Unfortunately, most Western economies are now thoroughly addicted to government spending. Each fiscal and monetary injection into zombie banks will likely have to be larger in order to offset the withdrawal symptoms of losing the last stimulus plan.

“Entrepreneurs figure this game out and gradually withdraw from participating in the economy in a healthy, productive manner. This loss of entrepreneur confidence in the system will ultimately accelerate the demise of all paper currencies. “


Addison Wiggin
for The Daily Reckoning