Fluffing off a Trillion Dollars. And a Third Thing

Krugman: Further Notes on ONE TRILLION DOLLARS

Yesterday I noted that the preoccupation with the size of the current deficit — which, as everyone reminds us, is ONE TRILLION DOLLARS — is completely misguided. Since then I’ve done some more arithmetic, which solidifies the point.

So, in fiscal 2012 (which ended September 30) we did in fact have a federal deficit of $1.1 trillion (pdf). The question is, however, whether this deficit represents, as everyone claims, a fundamental mismatch between what we want and what we’re willing to pay for — or whether it’s mainly just a reflection of the depressed state of the economy.

Krugman does some magic with numbers and makes that trillion dollars disappear one-two-three:

1. Growth and inflation: $400 billion

Krugman boldly goes where everyone has been before, writing:

we don’t need a balanced budget to have a stable fiscal situation; all we need is for debt to grow no faster than GDP.

Krugman figures nominal GDP grew about 4% over the past year, so that a 4% increase in the Federal debt shouldn't even be counted. Given a Federal debt of $10 trillion at the start of fiscal 2012, Krugman gets to say $400 billion of the 2012 deficit ought not even be counted.

(Conveniently, the trillion-dollar deficit means Krugman can come back next year and use the same argument to justify even more than $400 billion: Given a Federal debt of $11 trillion at the start of fiscal 2013...)

2. The Full Employment Budget: $450 billion

He doesn't call it full-employment budgeting, but that's what it is. The old-school, Arthur Okun style, JFK-era, full employment budget idea. I was shocked to see Krugman pull this one out of the hat. I'm not touching it; here is his paragraph complete. See for yourself:

OK, revenues were $2.45 trillion, which was 15.7 percent of GDP, at $15.5 trillion. The CBO estimates, however, that potential GDP — what the economy would have produced at full employment — was $16.5 trillion over the same period. And if the economy had been at more or less full employment, we wouldn’t just have collected taxes on the additional income; historically, the tax share of GDP varies strongly with the business cycle. If the economy had been at potential and revenue had been a historically normal 18 percent of GDP, revenue would have been more than $500 billion more than it was; even if revenue had been only 17.5 percent, it would have been almost $450 billion more than it was.

He even uses the phrase "full employment".

Revenues were low because the economy was running below potential, Krugman says. It's true, no doubt. But why are we below potential? And why is "potential" all downhill? Krugman doesn't get into it.

The full-employment idea is that it is "okay" for the Federal government to spend as much as it would bring in if the economy was performing at peak. This is exactly the same idea that was used back in the 1960s. Time magazine, 1965:

Kennedy's economists, led by Chief Economic Advisor Walter Heller, presided over the birth of the New Economics as a practical policy and set out to add a new dimension to Keynesianism. They began to use Keynes's theories as a basis not only for correcting [recession]... but also to spur an expanding economy to still faster growth.

Kennedy was intrigued by the "growth gap" theory, first put across to him by Yale economist Arthur Okun (... a member of the Council of Economic Advisers), who argued that even though the United States was prosperous, it was producing $51 billion a year less than it really could.

From article in Time. 86:64-7B. D. 31, '65. Reprinted in Stabilizing America's Economy, edited by George A. Nikolaieff. The Reference Shelf, Volume 44 Number 2. The H.W. Wilson Company, New York, 1972. Page 54.

(Permit me to point out that in the same Time article we read that "Some Keynesians believe that these policies violate Keynes's theories". That's what I think. Much of the criticism that has been directed at Keynes over the years applies not to Keynes, but to the "Keynesians" who added "a new dimension" to what the man said.)

In 1971 Roland Evans and Robert Novak described the full-employment budget:

An old proposal by liberal economists for the past generation, it envisioned the budget being balanced when expenditures were no higher than revenue would be if there were full employment (that is, unemployment no higher than about 4 percent).

Article: "Nixonomics: How the Game Plan Went Wrong," by Rowland Evans, Jr., and Robert D. Novak, syndicated columnists and authors of several books on politics, as it appeared in Atlantic Monthly, 228:66-80.Jl. '71. Reprinted in Stabilizing America's Economy, edited by George A. Nikolaieff. The Reference Shelf, Volume 44 Number 2. The H.W. Wilson Company, New York, 1972. Page 156.

And again, in 1972, in the Christian Science Monitor, Courtney R. Sheldon described the concept of the full-employment budget:

The dictum of this concept is that spending be held only to the level of tax revenue that would be collected if the jobless rate were at the full-employment level of 4 percent.

Article, "Nixon Primes Economy With Deficit Tide," by Courtney R. Sheldon, chief of Washington bureau. Christian Science Monitor, p 1+. Ja 25, '72. Reprinted in Stabilizing America's Economy, edited by George A. Nikolaieff. The Reference Shelf, Volume 44 Number 2. The H.W. Wilson Company, New York, 1972. Page 40.

3. Slump-related expenses: $150 billion

Government spending increased in the wake of the recession. Krugman says that a large part of the increase was for "'income security' payments — in this case, basically unemployment insurance and food stamps".

And there's your trillion dollars.


But there is something else, something far more important than Krugman's analysis of cost and spending. In his opening, Krugman brings up the trillion-dollar deficit, then asks a question:

The question is, however, whether this deficit represents, as everyone claims, a fundamental mismatch between what we want and what we’re willing to pay for — or whether it’s mainly just a reflection of the depressed state of the economy.

The correct answer to that question is: No.

A fundamental mismatch? No. The depressed economy? No. It is something else, a third thing. The deficit is a measure of how much policymakers misunderstand their trade. A measure of policy mistakes.

No, not spending. The deficit isn't a result of spending. It is a result of policy: of fighting inflation, and encouraging growth. The deficit is a result of these two policies, done in a very bad way for a very long time.

Policymakers pushed down the quantity of money in circulation to fight inflation:

Graph #1: Money in the Spending Stream per Dollar's Worth of Output
Click Graph for FRED Source Page

At the same time, they encouraged growth, spending, and the use of credit:

Graph #2: Total Credit Market Debt Owed per Dollar in the Spending Stream
Click Graph for FRED Source Page

The honest and honorable goals of fighting inflation and encouraging growth turned us into a nation with no money and inexplicable debt. That is why the economy refuses to grow. That is why tax revenue is down and "slump-related expenses" are up.

And that is why we have trillion-dollar deficits.