Wednesday, March 07, 2012

Krugman's Horse and Cart

In a recent column, Paul Krugman came up with an explanation for why the recovery has been so slow compared with the Reagan recovery. It seems that it is all the government's fault for not spending enough.

A reasonable person might protest that the federal government is not on an austerity budget. Despite bipartisan talk about the deficit, government spending continues to rise.

Krugman's answer to that is that he is not talking about federal spending. He is talking about state and local spending. If they had been jacking up spending instead of cutting back then everything would be great.

There is one flaw in Krugman's argument - he is calling for deficit spending from entities that are required to balance their budgets. The only way that a state or city can spend more is to raise taxes (which many have done just to cover the shortfall caused by the recession). Even then we are talking about zero sum spending where government entities redistribute money. Unless you believe in the magic stimulus fairy, taxes represent as much drag on the local economy as spending increases it. Keynesian theory is based on government borrowing which states and cities cannot do except on a limited scale for capitol projects (like roads). Only the federal government can borrow to meet general spending.

Krugman's argument rests on the fact that state and local spending were higher at this point in the Reagan recovery so he figures that the spending must have caused the recovery. He has it backwards. The recovery happened independent of government spending. Instead, the expanding economy provided more tax revenue which accounts for the increased spending. Many of these entities had raised taxes during the lowest part of the recession so when things returned to normal their revenue was greater than it had been.

Of course, these entities never cut taxes to their pre-recession levels. They simply spent more. Columbus raised taxes from 1.5% to 2% in the early 1980s then raised them to 2.5% during the current recession. Doubtless they will raise it to 3% the next time a deep recession hits. All of this causes a drag on the economy which Krugman ignores.

When looking at ways to speed the recovery, Krugman will need to look further than government spending.

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