PRESTOPUNDIT -- "It's a team sport, baby!"

A bit of remedial economics for Larry Kudlow and Paul Krugman:

Larry Kudlow has greeted this little bit of statistical news with great enthusiasm. He sees a 'barnburner recovery' in this data. This, he thinks, is a true recovery. What is the source of this recovery? Capital expenditures rose 11%, up from 8% from the last quarter. A combination of tax cuts and expansionary monetary policy from the fed spurred an investment boom. As Kudlow writes, with the Fed accommodating investment with "15% growth in the basic money supply" and lower taxes increasing profitability investment will spend more on capital goods. Consumer confidence will improve also, but it is investment that drives the economy.

Kudlow has a dismissive tone towards demand side Keynesians, but his reasoning is not all that different. Kudlow views public policy as a means to stimulate the economy by stimulating investment spending. He does mention incentives hear and there, but he also fails to realize that it is consumer demand for final goods and services that are ultimately ‘driving the economy’. Economic efficiency does not derive from increasing investment spending and GDP. It derives from aligning the plans of consumers and entrepreneurs. This point warrants great attention. To see its importance, we should look at how a true Keynesian reacted to the announcement of higher growth.

Paul Krugman reacted cautiously to the latest news on GDP. This is somewhat odd, because the Bush Administration has been running huge deficits- exactly what Keynes prescribed for recessions. However, President Bush belongs to the wrong political party, so Krugman must invent some kind of problem pertaining to recent events.

Krugman reports that there was a significant pick up in investment spending. More importantly, consumer spending picked up as well. Consumer durables rose at an incredible 27% rate. Housing sales grew at 20% as well. What prompted this? "Consumers took advantage of low interest rates led to accelerate purchases that they would have made latter".

Krugman correctly recognizes that this cannot go on forever. Consumer expenditures cannot exceed consumer income, so consumer demand must fall. This boom may be temporary.

Paul Krugman has a unique talent for stumbling near the truth. It is quite true that low interest rates raise investment. Both consumer and investor spending cannot grow simultaneously for long. With increasing demand unemployment will fall. However, a general increase in spending- prompted by the fed expanding the money supply and decreasing interest rates- will increase prices in general. In other words, it will lead to inflation. This inflation will, as past episodes of inflation have, lead to another economic contraction and financial crash.

Krugman's penchant for bashing the Bush administration has led him close to the correct interpretation of the statistics in question. The current surge in demand cannot last indefinitely. There is, however, an important lesson that neither he nor Kudlow have yet learned. Economists Ludwig von Mises and Friedrich Hayek developed an explanation of how inflationary booms lead to busts. When central banks drive interest rates down, as the Fed recently has, business investors will invest in projects that they previously saw as unprofitable when the financial cost of repaying loans falls. They will think longer term. Consumers will act upon low interest rates to increase their consumption. Lower interest rates decrease the returns to deferred consumption (savings money is really just deferred consumption). They will think short term. With households revising their expectations in one direction and businesses revising their expectations in the other direction, we will witness increasing discoordination in the economy.

The problem we face is not in stimulating the supply side or the demand side. The problem we face is in coordinating the plans of all individuals on the demand and supply sides of markets with each other simultaneously. Prices in competitive markets bring us close to this coordination. Order emerges in society as an unintended consequence of private competition. Deliberate efforts to stimulate, or otherwise manipulate, the economy causes discoordination. Inflationary boom bust cycles are an example of this.

Things are not always as they initially appear. Strong surges in GDP growth appear to be a treat for all of us. Larry Kudlow and Paul Krugman appear to many as expert interpreters of economic data. Despite these appearances, inflationary monetary policies and deficit spending are tricks that lead to economic discoordination, and these experts have much to learn about economics.

Posted by Greg Ransom | TrackBack