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Krugman’s Adventures in Fairyland

Mises Daily: Saturday, November 23, 2013 by


After studying and teaching Keynesian economics for 30 years, I conclude that the “sophisticated” Keynes­ians really do believe in magic and fairy dust. Lots of fairy dust. It may seem odd that this Aus­trian economist refers to fairies, but I got the term from Paul Krugman.

According to Krugman, too many people place false hopes in what he calls the “Confidence Fairy,” a creature created as a retort to economist Robert Higgs’s concept of “regime uncertainty.” Higgs coined that expression in a 1997 paper on the Great Depression in which he claimed that uncertainty caused by the policies of Franklin Roosevelt’s New Deal was a major factor in the Great Depression being so very, very long.

Nonsense, writes Krugman. Investors are not waiting for governments to “get their financial houses in order” and protect private property. Instead, he claims, investors are waiting for governments to spend in order to create enough “aggregate demand” in the economy to bring about new investments and, one hopes, full employment.

According to Higgs, the “humor columnist for the New York Times, Paul Krugman, has recently taken to defending his vulgar Keynesianism against its critics by accusing them of making arguments that rely on the existence of a ‘confidence fairy.’ By this mockery,” Higgs says, “Krugman seeks to dismiss the critics as unscientific blockheads, in contrast to his own supreme status as a Nobel Prize-winning economic scientist.”

It seems, however, that Krugman and the Keynesians have manufactured some fairies of their own: the Debt Fairy and the Inflation Fairy. These two creatures may not carry bags of fairy dust, but they might as well, given that their “tools” of using government debt and printing money to “revitalize” the economy have the same scientific credibility.

Let us first examine the Debt Fairy. According to the Keynesians, the U.S. economy (as well as the economies of Europe and Japan) languishes in a “liquidity trap.” This is a condition in which interest rates are near-zero and people hoard money instead of spending it. Lowering interest rates obviously won’t spur more business borrowing, so it is up to the government to take advantage of the low rates and borrow (and borrow).

If governments issue enough debt, argue Debt Fairy True Believers, the econ­omy will gain “traction” as government spending, through the power of pixie dust, fuels a recovery. Governments spend, businesses magically gain confidence, and then they spend and invest. (At this point, we are apparently supposed to just overlook the fact that the Keynesians are saying that we need the Debt Fairy to resurrect the Keynesian version of the Confidence Fairy.)

The Inflation Fairy also plays an important role, according to Keynesians, for if bona fide inflation can take hold in the econ­omy and people watch their money lose value, then they will spend more of their savings. In turn, this destruction of savings will, through the power of Keynesian sorcery, revive the econ­omy. Thus inflation undermines what Keynesians call the “Para­dox of Thrift,” a theory that says if a lot of people withhold some present consumption in order to save for future con­sumption, the economy quickly will implode and ultimately will slip into a Liquidity Trap in which no one will spend anything.

These fairies can work their magic if (and only if) one condition exists: factors of production are homogeneous, which means that government spending will enable all lines of production simultaneously. The actual record of the boom-and-bust cycle, however, tells a different story. It seems that the Debt and Inflation Fairies enable booms along certain lines of production (such as housing during the past decade), but as everyone knows, the fairy dust lost its magical powers and the booms collapsed into recessions.

Austrians such as Mises and Rothbard have well under­stood what Keynesians do not: the structures of produc­tion within an economy are heterogeneous and can be distorted by government intervention through inflation and massive borrowing. Far from being creatures that can “save” an economy, the Debt Fairy and the Inflation Fairy are the architects of economic disaster.

Despite Keynesian protestations that the U.S. and European governments are engaged in “austerity,” the twin fairies are active on both continents. The fairy dust they are sprinkling on the economy, however, is more akin to sprinkling ricin on humans. In the end, the good fairies turn into witches.