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Is Paul Krugman a Voodoo Economist?

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Readers ask me if Paul Krugman could be correct that deficits don't matter and that neither does printing endless reams of money with which to purchase the Treasury's debt instruments that finance the deficits.

If people at home and abroad who hold dollars and dollar-denominated financial instruments do not care that trillions of new dollars are being created in order to cover the large gaps between revenues and expenditures in Washington's annual budgets and to support "banks too big to fail," that is, if these dollar holders do not see the value of their dollars diluted by the new dollars, which are appearing in greater quantities than new goods and services, Krugman is right.

The problem for Krugman is that the likelihood of such indifference goes against supply and demand. Economists believe, including Krugman, that if supply increases faster than demand, price drops. So, if there is anything at all to economics, an excess supply of dollars must cause the dollar's value to drop.

A drop in the dollar's value can occur in one of two ways. The way most people think of is via monetary inflation. Too many dollars chasing too few goods drives up prices, and each dollar buys less and is thus devalued. However, in our current situation, the excess dollars are in the banks. As the banks are not lending, the excess dollars are not getting into the money supply or prices. The banks are keeping large reserves in order to meet demands that can arise from their uncovered derivative bets, and the banks are using some of the money that the Federal Reserve is making available to them to speculate on stock market futures, thus pushing stock prices to unrealistic levels.

The other way through which the dollar can lose value is via its exchange rate to other currencies. Foreign holders of dollars, watching five years of dollar creation in order to finance federal budget deficits and seeing no end, can come to the conclusion that their dollar holdings are being diluted. If they make this decision, they will decide to get out of dollars or to reduce their exposure to the US dollar.

When they sell dollars in the currency market, the value of the dollar in terms of other currencies will fall. As the US is now an import-dependent country, domestic US prices will rise as a result of dollar devaluation in the currency market. The appearance of domestic inflation on top of the dollar's falling exchange value would, if economics is correct, cause a greater haste on the part of dollar holders to get out of dollars.

In other words, once it begins there is a downward spiral.

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Apparently, Krugman believes that the dollar is so unique and so wonderful, like America, that its value cannot be harmed by abuse.

The question whether federal budget deficits matter or don't matter is a different question. It depends on the cause of the deficit. Some readers have poked fun at Krugman and at me, saying that Krugman sounds like a voodoo supply-side economist from the Reagan era claiming that "deficits don't matter." In other words, Krugman and I are peas in a pod.

These comments illustrate the power of the presstitute media to instill misunderstanding. Here we are three decades after Reagan and vast numbers of literate Americans have no idea what Reaganomics was.

Supply-side economics is not about deficits. Its novel feature is elucidation of the impact of fiscal policy on aggregate supply. For Keynesian demand-side economists, who dominated US economic policy until the Reagan era, fiscal policy can only impact aggregate demand. If government gives people a tax cut, they spend more money and raise aggregate demand, thus boosting employment. If people are hit with a tax hike, they have less money to spend, and inflation falls.

What supply-side economists said is that some kinds of fiscal policy, such as changes in marginal tax rates (the tax rates on additions to income), change incentives and, therefore, increases or decreases aggregate supply. (In Keynesian economics, supply is a passive responder to aggregate demand.)

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Marginal tax rates are the rates that apply to additions to income. In a progressive income tax system, the rates rise with income. Marginal tax rates determine the price of leisure in terms of income foregone by not working. Marginal tax rates also determine the price of current consumption in terms of future income foregone by not saving and investing the money. The higher the tax rate on additions to income, the cheaper are leisure and current consumption in terms of foregone present and future income. The lower the tax rate on additions to income, the more expensive are leisure and current consumption. In other words, high tax rates discourage labor supply, the supply of savings, and the growth of GDP.

Supply-side economics was an important contribution to economics. In the 12th edition of his famous textbook, Paul Samuelson, the doyen of economics before his death, acknowledged the correctness of the supply-side point.

Are deficits important? As I said, it depends on their cause. The so-called "Reagan deficits" were really Federal Reserve chairman Paul Volcker's deficits, because Volcker, mired in Keynesian thinking, could not understand the supply-side policy. The Treasury met with Volcker regularly. We tried to help Volcker understand the new policy, but Volcker could only think of tax cuts as a stimulus to demand, which was the way his economic advisory board also thought of tax cuts.

Consequently, Volcker viewed "Reaganomics" as wildly inflationary (the inflation rate was double-digit prior to Reagan). He thought he would be blamed by Reagan for the higher inflation that Volcker thought would result from what Volcker mistook to be a Keynesian stimulus policy. To protect himself and the Federal Reserve from blame, Volcker dramatically reduced the growth of the money supply prior to the tax cuts going into effect. Volcker reasoned that if the growth of the money supply was reduced, monetary policy could not be blamed for the inflation that he thought would be caused by Reagan's fiscal policy.

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Dr. Roberts was Assistant Secretary of the US Treasury for Economic Policy in the Reagan Administration. He was associate editor and columnist with the Wall Street Journal, columnist for Business Week and the Scripps Howard News Service. He is a contributing editor to Gerald Celente's Trends Journal. He has had numerous university appointments. His book, The Failure of Laissez Faire Capitalism and Economic Dissolution of the West is available here. His latest book,  How America Was Lost, has just been released and can be ordered here.

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Your thinking is passé. Here's what PK is on the ... by Brad Parker on Thursday, Oct 31, 2013 at 3:01:10 PM
To be fair to Reagan, it was his policies that sen... by Richard Pietrasz on Thursday, Oct 31, 2013 at 4:09:25 PM
Reaganomics has failed.  In exactly the ways ... by Samson on Thursday, Oct 31, 2013 at 4:54:14 PM
Reaganomics succeeded for the Reagan gang.What thi... by Richard Pietrasz on Thursday, Oct 31, 2013 at 11:09:10 PM
Remember, with today's fed reserve bookkeeping, it... by Samson on Thursday, Oct 31, 2013 at 4:52:19 PM
The debt-money system is unsustainable.  Cred... by Scott Baker on Thursday, Oct 31, 2013 at 5:07:27 PM
What is not sustainable in this day and age is 57%... by Michael Dewey on Thursday, Oct 31, 2013 at 6:12:44 PM
I thought Paul Volcker had the right idea. He wrun... by Peter Duveen on Thursday, Oct 31, 2013 at 10:16:42 PM
How interesting that  PR does not notice that... by Mark Sashine on Friday, Nov 1, 2013 at 8:00:46 AM
Two items: Glass-Steagall needs to be reimple... by Janet Gaudiello on Friday, Nov 1, 2013 at 12:03:46 PM
Roberts' defense of supply-side hardly needs to be... by Jim Arnold on Friday, Nov 1, 2013 at 2:07:23 PM
Dr PCR analyzing Krugman???Now I may have seen eve... by BFalcon on Friday, Nov 1, 2013 at 2:32:01 PM
No worse than the last Roberts article before this... by Robert S. Becker on Friday, Nov 1, 2013 at 5:50:39 PM
He is a case of misinformation gone wild.... by BFalcon on Saturday, Nov 2, 2013 at 1:17:00 AM
Roberts also often suffers from the Knee-jerk Hype... by Robert S. Becker on Saturday, Nov 2, 2013 at 1:49:53 PM
I don't know, but I find people's approval for the... by BFalcon on Saturday, Nov 2, 2013 at 2:20:52 PM
You are likely correct.Roberts' biggest flaw is th... by Richard Pietrasz on Sunday, Nov 3, 2013 at 2:49:46 PM
More Right-wing supply side crap....Do they never ... by Ralph Demers on Friday, Nov 1, 2013 at 2:43:09 PM
Hmmm...Roberts is right about the fact that the go... by Jerry Lobdill on Friday, Nov 1, 2013 at 4:11:56 PM
Small farms and employee owned companies along wit... by intotheabyss on Friday, Nov 1, 2013 at 5:08:11 PM
Worker owned Cooperatives, modeled after Mondragon... by Michael Dewey on Friday, Nov 1, 2013 at 7:19:46 PM
Did you see this interesting update on Mondragon a... by Robert S. Becker on Saturday, Nov 2, 2013 at 1:46:35 PM
Thanks, the other day had vaguely heard that Fagor... by Michael Dewey on Saturday, Nov 2, 2013 at 3:17:41 PM
Is Paul Krugman being presented here as a rabbi we... by Mort Persky on Saturday, Nov 2, 2013 at 12:57:46 AM
Mr Krugman's capable hands, yes."Mr Roberts"/ Dr P... by BFalcon on Saturday, Nov 2, 2013 at 1:15:52 AM
The five hundred pound gorilla in the room is our ... by molly cruz on Monday, Nov 4, 2013 at 12:05:18 PM