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Saving, Trade, and the Confidence Fairy

Mises Daily: Thursday, July 14, 2011 by


The last-minute negotiations over the debt ceiling have brought the economic pundits out in force. In the midst of a terrible recession, the contrast between Austrian and Keynesian analysis is striking. The Austrians recommend the virtues of saving and investment, while Keynesians preach the opposite. Things are so topsy-turvy that in this article, I'm actually going to defend President Obama from Paul Krugman's barbs.

Krugman Pounces on Obama

In a blog post earlier this week, Krugman first quoted from President Obama's press conference on the budget negotiations:

I do think that if the country as a whole sees Washington act responsibly, compromises being made, the deficit and debt being dealt with for 10, 15, 20 years, that that will help with businesses feeling more confident about aggressively investing in this country, foreign investors saying America has got its act together and are willing to invest. And so it can have a positive impact in overall growth and employment.

Seems like boilerplate rhetoric. Who could object to the president of the United States explaining that there are bad consequences for economic growth if investors perceive the country as a banana republic, or (what is equivalent) that there are good consequences if investors think the long-term fiscal crisis has been solved? The only reason to complain is that these platitudes are phony; the Republican and Democratic "statesmen" in Washington will at best engineer a short-term fix that allows us to limp along until the next emergency arises in a few months.

Ah, but Nobel laureate Paul Krugman is a clever writer, and he can come up with reasons to complain about Obama's statement:

OK, so that's the confidence fairy at the beginning. But the "foreign investors" thing is actually worse.

Think about it: U.S. interest rates are low; there's no crowding out going on; we are NOT suffering from a shortage of saving.

So if foreign investors decide they love us, what does it do? It drives up the value of the dollar, which reduces exports, which leads to fewer jobs.

Does this sound familiar? It's closely related to the reasons Chinese accumulation of dollar reserves unambiguously hurts the U.S. economy when we're in a liquidity trap. And what we just learned is that the White House still doesn't get it.

In this short passage, Krugman not only contradicts basic Austrian analysis, but in his treatment of foreigners he even bungles Keynesian analysis. I'll deal with each issue separately.

The Confidence Fairy

Krugman's mocking reference to a "confidence fairy" is a running gag on his blog. In Krugman's view, the obvious problem with the world economy today is insufficient aggregate demand. Businesses aren't hiring workers or investing in their operations because sales are so weak. But because of a debt overhang in the private sector, total spending from consumers and businesses will be depressed for some time. That's why it's up to the government to fill the gap through extensive deficit spending.

But many policymakers and analysts draw back from Krugman's recommendations. They think that major governments already tried massive "stimulus" efforts, and that the world economy is still stuck in a rut. Contrary to Krugman, these advocates of "austerity"Download PDF recommend reining in deficits and even propose cutting government spending. In order to explain why fiscal austerity should actually promote economic recovery, austerity proponents often claim that fixing the government's long-term budget outlook will restore confidence. Krugman thinks this is a nonsensical theory for which there is no evidence, hence his running joke about the "confidence fairy."

Here we see the huge gulf between Austrian and Keynesian analysis. According to the Austrians, a recession was inevitable because real capital resources were misallocated during the housing-bubble years. The massive government and Fed interventions since then have only served to delay the economy's adaptation to the new realities.

Because everyone — including Krugman — admits that Americans in both the private sector and the government were consuming too much during the housing-boom years, the Austrians naturally conclude that the solution is to increase savings and live within our means. That goes not only for households, but for the government, too. There is nothing magical about government spending. In fact, resources allocated via the political process are much less likely to satisfy consumer preferences than resources allocated via market processes.

On the specific issue of the confidence fairy, Krugman is in a bit of a pickle. For one thing, it's hard to see how the austerity talk of "confidence" is any less rigorous than John Maynard Keynes's famous discussion of "animal spirits" when it comes to explaining business investment.

Even more troubling for Krugman is that he himself admits that private investors have been acting on the (alleged) myths of the anti-Keynesian economists. During his talk on Keynes, Krugman alludes to an investment bank making an apology for its erroneous predictions on interest rates (where the bad prediction was due to ignoring Krugman's analysis). Several times, Krugman has criticized Pimco's Bill Gross for saying that interest rates will rise because of the end of QE2, and Krugman often ridicules Peter Schiff and others for warning clients of hyperinflation. More generally — and I don't remember if Krugman himself has done this — progressives have mocked the ads for gold pushed on conservative talk radio.

Krugman et al. can't have it both ways. It can't be the case that the world is (a) full of imbeciles who lose boatloads of their clients' money because they listened to a Chicago School or Austrian economist give advice, while (b) investors aren't influenced by their fears over Obama and Bernanke's policies. Krugman and the other Keynesians need to pick one story and run with it.

Say's Law

Furthermore, the "explanation" that the problem with the economy is a lack of spending was exploded long ago by J.B. Say. Although there are some subtleties in the analysis, I would still put the classical wisdom of Say's law up against the elegant mathematical models coming out of Princeton any day.

This is the present context for the dispute: Right now we have very low private business investment, high unemployment, low consumer spending, and low growth rates in total output. The Austrian proposal is to take off the shackles on entrepreneurs and to stop interfering with price signals in the capital markets so that the "real" problems with the economy can be fixed. Once that happens, businesses will begin hiring again, unemployment will drop, real output will grow, and spending will take care of itself.

The Keynesians deny that there is any "real" structural problem at all. This comes from their aggregated view of the economy, in which the structure of production can't get distorted as it can in the Austrian theory. Instead, someone like Paul Krugman sees the same amount of tractors, real estate, and skilled workers on the eve of the bust as he does on the day after, so he can't understand why "real GDP" should fall at all. The economy must not be living up to its potential if it isn't cranking out stuff as fast as it (apparently) was at the peak of the housing bubble. Krugman's model literally can't handle the possibility that the economy was in an unsustainable position during the bubble, and that Bernanke's policies have only made things worse.

Is Foreign Investment Harmful?

As I mentioned in the beginning of the article, when Krugman turned his attention away from the confidence fairy and focused on foreign investors, he actually repudiated even standard Keynesian analysis. Recall that Obama had argued that foreign investment in the United States would help our economy. To this, Krugman replied, "So if foreign investors decide they love us, what does it do? It drives up the value of the dollar, which reduces exports, which leads to fewer jobs."

Hold on a second. Krugman has told us repeatedly that the problem with the world economy right now is that some people want to save more than others want to invest. (Specifically, the market-clearing interest rate "wants" to be negative, but alas that's impossible, and hence we're stuck with a glut of savings.) This is why Krugman thinks that it would help the United States if China stopped buying so much Treasury debt.

But Obama (or rather, his speechwriters) presumably weren't talking just about foreign investors buying IOUs from Uncle Sam. If someone is thinking about setting up, say, a car factory in another country, he will hesitate if that country is running the printing press like mad, or if it might have to jack up income tax rates in a few years because of mushrooming debt. But in that uncertainty, if the political leaders of the country agree to long-term budget cuts and so forth, then the investor might bite the bullet and spend the funds.

To repeat, this is exactly what Keynesians say needs to happen in order for the economic recovery to become self-fulfilling and for the government to gracefully leave the scene. Private investment needs to expand. But Krugman is so hostile to the idea that "right-wing" policy measures might achieve this outcome that he went so far as to rail against foreign investment per se in the United States.

Even on Keynesian terms, foreign investment in the United States would be a good thing, at least if it directly contributed to higher expenditures. For example, if a Japanese investor wanted to build a car factory in South Carolina, he would first need to sell yen for US dollars. That would indeed push up the value of the dollar, and hurt US net exports (other things equal). But so what? Unemployment would still go down and US wage income would go up as the Japanese investor used his newly acquired dollars to hire American workers to build the new factory and to begin operations.

Mises Academy: Robert Murphy teaches Production and the Market Process

To see the big picture, we can drop money for the moment. Suppose the Japanese investor literally sent clothes, food, and other goodies across the ocean to previously unemployed US workers. In exchange for these items, the US workers would assemble the new factory on behalf of the Japanese man. In this scenario, it's true that US imports would have risen, thus making the dreaded "trade deficit" worse. But the previously unemployed workers who now had earned some food, clothes, etc., would probably not see the problem with a change in the trade statistics.


Austrians have a commonsense approach to booms and busts. After a period of massive overconsumption and malinvestment, the proper remedy is for households to save and businesses to invest in lines indicated by the proper market rate of interest. In contrast, the Keynesians as led by Paul Krugman excoriate savings and even occasionally throw out the investment baby with the bathwater too.