Krugman and the pied pipers of debt

September 30, 2009

Investors are celebrating an incipient “recovery,” but the interventions responsible are sowing the seeds of a more violent contraction down the road. The problem, quite simply, is debt. We’ve accumulated record amounts, yet many economists tell us we need more.

Leading the charge is Paul Krugman. He exhorts us to borrow our way back to prosperity, but he doesn’t acknowledge that his brand of Keynesian economics ignores debt’s consequences. If you look at a chart of America’s total debt burden, he’s leading us over a cliff.

(Click chart to enlarge in new window)


The problem begins with the flawed way Krugman and other economists measure well-being. Primarily, they look at measures of activity, like GDP. These tell us how much people spend, but say nothing about where we get the money.

Every so often, we overextend ourselves, buying too much useless stuff with too much borrowed money. So we cut back, dumping the third family car and swapping the McMansion for a townhome.

But this is problematic for Krugman and other economists. Less spending means falling GDP. It means “recession.”

They ride to the rescue with two blunt instruments — monetary and fiscal policy — that encourage more borrowing and thus more spending. More spending equals “growth” so economists congratulate themselves for engineering “recovery.”

But if recessions never happen, bad businesses and unpayable debts are never washed away. They grow like cancer inside the system.

Since the mid-1980s, we’ve intervened whenever the economy hiccuped, so sectors that should have shrunk sharply — like housing and finance — never did. Feasting on easy credit, these sectors have exploded as a percentage of the economy.

Now, since individuals and corporations refuse to borrow more, the only way to grow spending is for the government to borrow.

According to George Cooper, author of The Origin of Financial Crises, “what is missing from today’s debate is recognition that previous growth rates were artificially supported by an unsustainable credit binge, itself the result of the misapplication of Keynesian policy.”

Cooper counts himself a Keynesian but says Keynesian policy has become “dangerously distorted.”

“We should be using Keynesian stimulus only to arrest the rate of credit contraction not to reverse it. The harsh truth is that our economies desperately need a recession.”

That’s because they desperately need to de-lever. As you can see in the first chart, debt relative to GDP is at record highs.

If we want sustainable growth, spending that drives it must come from savings, not more borrowing. To get there, we must first pay old debts. And that means recession.

Krugman is clearly aware of the consequences of excessive borrowing.

“I’m terrified about what will happen to interest rates once financial markets wake up to the implications of skyrocketing budget deficits,” he wrote in 2003, citing a $1.8 trillion 10-year deficit projection from the Congressional Budget Office.

Fast forward six years, total debt has jumped 70 percent relative to GDP and optimistic projections put the 10-year deficitat $9 trillion.

This time, however, Krugman dismisses deficit “hysteria,” arguing that we can grow our way out of debt. “We did it during the Clinton administration,” he told me when he visited Reuters last week.

But we didn’t. While Clinton balanced the federal budget, Americans plowed through their savings. We kept growing because, in the aggregate, we were still accumulating debt.

(Click chart to enlarge in new window)


Krugman has also argued that we can handle larger deficits because we have in the past. After all, public debt peaked at 118 percent in 1945 compared with 65 percent today.

Two problems. First, the argument ignores tens of trillions of unfunded obligations for Medicare and Social Security, debt Krugman loudly lamented in his 2003 column.

It also ignores the higher private debt burden facing us today. According to economist Steve Keen, “Private sector debt accumulated in the 1920s was wiped out by the Depression, so in 1945 the private sector’s debt burden was only 45 percent of GDP. In that situation it was easy to wind down public debt from levels reached to finance WWII.”

Today, private debt is a suffocating 300 percent of GDP, making more public debt that much harder to pay down.

We know how this movie ends. Look at California — or Argentina.

We chortle from afar — “how did their budget get so out of whack?” — yet our own profligacy puts us squarely on that path. Like them, we’ve shown no political will to deal with debt. And so it will deal with us.

But we can print our own currency, you say. If all else fails, the United States can inflate its way out of debt.

Nonsense. If we try, our foreign lenders will cut us off.

As Krugman warned in 2003: “My prediction is that politicians will eventually be tempted to resolve the (fiscal) crisis the way irresponsible governments usually do: by printing money, both to pay current bills and to inflate away debt. And as that temptation becomes obvious, interest rates will soar.”

Yet today Krugman is leading the march, arguing that we can borrow indefinitely as long as deflation remains a threat.

Tell that to the Chinese.

What happens when they stop buying our bonds? To Cooper’s point, we’ll need government intervention to cushion the blow of de-leveraging. But there’s a difference between cushioning the blow and reinflating the bubble, which is what we’re doing, wasting trillions propping up housing and banking.

The risk is that we’ll have nothing left when we really need it, when the Great Leveraging becomes the Great De-Leveraging.


Krugman advocates stimulus spending for things that we MUST spend on, recession or no, if we want the country to remain competitive. What’s debatable is whether the trillions dumped into the banks this year is actually stimulus or just giving crutches to lame dinosaurs. Without well-functioning infrastructure (roads, bridges, rails, education system, health care system, ports, water navigation, airports, etc.), the country becomes less efficient, both in an absolute sense and relative to other countries which are constantly improving facilities, and costs of doing business increase as existing infrastructure ages and decays. These are facts whether there is a fiscal crisis or not. Since America has spent, in the last 25 years, only a fraction of what is necessary just to maintain its existing infrastructure, spending expressly for this purpose is now doubly mandated – as stimulus to keep unemployment a little lower and just to provide the facilities that business needs to grow. And calling it “communism” is like calling the Pope an Islamic Jihadist.


@Rolfe Winkler,You wrote:\”Mark/Andrew….you’re both wrong, IMHO. The Depression wasn’t caused by fiscal or monetary policy in the 30s. It was caused by insane leverage run up in the ’20s.\”It was the sudden deflation of an asset bubble in 1929, the stock market (total equity equaled about 165% of GDP) that initially tipped the balance. The flip side of the asset bubble was of course debt. As the asset bubble deflated this set off a wave of deleveraging that resulted in further asset deflation. The decline in net asset values led to a negative wealth effect that caused a negative shock to aggregate demand (much like today except now it is mostly real estate wealth).The current judgment of economic historians (see, for example, Barry J. Eichengreen, Golden Fetters) is that attachment to the gold standard played a major part in keeping governments from fighting the Great Depression, and was a major factor turning the recession of 1929-1931 into the Great Depression of 1931-1941.Countries that were not on the gold standard in 1929, or that quickly abandoned the gold standard, by and large escaped the Great Depression. Countries that abandoned the gold standard in 1930 and 1931 suffered from the Great Depression, but escaped its worst ravages. Countries that held to the gold standard through 1933 (like the United States) or 1936 (like France) suffered the worst from the Great Depression.Commitment to the gold standard prevented Federal Reserve action to expand the money supply (monetary policy) in 1930 and 1931, and forced President Hoover into destructive attempts at budget-balancing (fiscal policy) in order to avoid a gold standard-generated run on the dollar.Commitment to the gold standard left countries vulnerable to \”runs\” on their currencies, Mexico in January of 1995 writ very, very large. Such a run, and even the fear that there might be a future run, boosted unemployment and amplified business cycles during the gold standard era.The standard interpretation of the Depression, dating back to Milton Friedman and Anna Schwartz\’s Monetary History of the United States, is that the Federal Reserve could have but for some mysterious reason did not boost the money supply to cure the Depression; but Friedman and Schwartz did not stress the role played by the gold standard in tieing the Federal Reserve\’s hands, the \”golden fetters\” of Eichengreen. Friedman was aware of the role played by the gold standard, hence his long time advocacy of floating exchange rates, the antithesis of the gold standard.You also wrote:\”The rebound from the lows of the early 30s wasn’t the result of anything Roosevelt did so much as it was the result of previous debts being extinguished by the Depression.\”The recovery from the trough in GDP in 1933 was the result of two major policy changes that took place after the change in administration (FDR entered office in March). First, the Gold Reserve Act (effective January 30th, 1934) devaluated the dollar from $20.67 a troy ounce to $35 an ounce. Second, federal spending soared 40% in nominal terms in FDR\’s first year going from about $4.5 billion in FY 1933 to $6.5 billion in FY 1934. It was further boosted to $8.2 billion in FY 1936.Real GDP, which had fallen by an average of 7.8% from 1929 to 1933, surged by 9.5% from 1933 to 1937. The idea that debt extinguishment during 1929-1933 caused this sudden reversal in economic output is dubious. In nominal terms total debt decline by only about 10% between 1929 and 1933 and as a percent of GDP it actually soared from about 180% of GDP in 1929 to about 310% of GDP in 1933 (for Gods\’ sake, look at your own graph!). The sudden shift in monetary and fiscal policy in 1934 matches what happened both theoretically and in timing much better.Today our monetary policy is no longer bound by \”golden fetters.\” But there is a complication in the form that interest rate policy has already hit the zero lower bound (the liquidity trap). And extraordinary monetary policy such as quantitative easing is limited in practicality. Jan Hatzius of Goldman Sachs has estimated that it takes about $1.3 trillion in expanded federal reserve balance sheets (about what we have already done) to achieve the equivalent of a 1% change in the federal funds rate. Many economists (e.g. Hatzius and Glenn Rudebusch of FRBSF) estimate according to a Taylor Rule the federal funds rate should be about -5% right now (an impossibility). To expand the federal reserve balance sheet by the resulting $8.5 trillion would be highly dangerous and could have inflationary consequences down the road.A much better route is discretionary fiscal stimulus (as distinct from TARP and other measures). It substitutes for the decline in consumption and investment that the economy is suffering from right now. It accomodates the surge in private savings with a surge in public borrowing. The net effect is ironically that total indebtedness as a percent of GDP might actually fall even as the nominal government debt increases.This is exactly what eventually happened in the Great Depression, which was allowed to degenerate into a liquidity trap, as a zero interest rate policy was in in effect more or less constantly from July of 1932 through October of 1941. Between 1933 and 1941 total debt as a percent of GDP plunged from about 310% of GDP to about 160% of GDP (again look at your own graph) even as government sector debt nearly doubled in nominal terms. In a liquidity trap, the way to get out of debt, is to grow out of debt, and since the problem is a shortage of aggregate demand, the solution, ironically, is to increase government borrowing.That’s why it is shortsighted to advocate fiscal austerity under our circumstances. Fiscal austerity exacerbated the Great Depression and led to four long years of rapid contraction and soaring debt as a percent of GDP, again ironically the opposite of what was intended. We need to relearn the old common sense fiscal policy of running fiscal surpluses in times of prosperity and deficits in times of depression. To do the opposite would be like having two dance partners both trying to lead at the same time.

Posted by Mark A. Sadowski | Report as abusive

Two substantive corrections to my previous comment:”Real GDP, which had fallen by an average of 7.8% from 1929 to 1933, surged by 9.5% from 1933 to 1937.”should read:”Real GDP, which had fallen by an average of 7.8% annually from 1929 to 1933, surged by an average of 9.5% annually from 1933 to 1937.”And the quantitative easing that is currently required is $6.5 trillion, not $8.5 trillion (5*1.3=6.5 of course).Other than that I think what I tried to say is fairly clear albeit long winded. Sorry but this is an important topic to me that needs to be explained constantly.

Posted by Mark A. Sadowski | Report as abusive

I think you’re being a bit unfair to Krugman by repeating that 2003 quote that’s been floating around the internet. Massive deficit spending when interest rates are at a zero-bound and a depression is looming is Keynesian econ 101. That is most certainly NOT the situation we faced in 2003.I think you’re right though. He, and most, seem to dismiss the idea that debt/GDP cannot just keep growing forever.

Posted by Mark | Report as abusive

Armchair economists. It’s obvious that facts, if there are any, mixed with opinions, which there are nothing but, create one confusing mishmash of the “nobody has a flippin’ clue what’s gonna happen” blues.Y’all sound like you have the end all be all handle on how money works in the world. When in fact, nobody knows how it really works. All of these heads of state and finance are just poking hot sticks at a very angry beast hoping to calm it. If you leave it alone it will just starve and get angrier. If you poke it more it will surely get even more riled. And then, in the end the damn thing will no doubt bust out and eat us all.Y’all’s religiously toned economic diatribes are just teasing the beast. And about the only thing I believe I can trust right now is that I need to go buy GLD and IAU and maybe stock up on some Krugerrands and Canadian goldleaf. Maybe a couple of boxes of 12 gauge too…

Posted by Anonymole | Report as abusive

We remain trapped in outdated theories and paradigms. Let’s quote Einstein, as far as I recollect: ‘One cannot solve a problem if one thinks the same way as when the problem was created’.

Posted by ANON | Report as abusive

Andrew, we have a little war now, not then. That was a big war. The government maintained larger deficits relative to GDP than what we have now. The war getting us out of the depression is one of the great misrepresentations of history.As war production quickly accelerated in 1939(lend lease act) the administration became acutely aware of the effects of inflation from a rapidly heating economy. The first world war had brought rampant inflation here at home.The government first instituted wage and price controls as law. Rationing of goods and resources necessary for the effort and requiring defense contractors to pay very high wages left workers with far more money than they could spend. The end result was that Americans saved and bought war bonds with their disposable income. War bonds and taxes accounted for better than 75% of the funding of the war.When manufacturing had finally retooled for a peace time economy, Americans were eager to spend the money they saved through the war on products that were unavailable during those years(cars, refrigerators, televisions….).Why not implement similar polices today. We could build solar panels, electric generators, electric cars, natural gas conversion kits, etc., etc.,etc.. We could reinvent and rebuild our society in profitable ways that would enable us to pay off debt as we once did after WW II.

Posted by Anubis | Report as abusive

I am concerned about the debt. Krugman is also concerned. But people are suffering economically. And the ability of our economy to generate jobs is the real issue. We have plenty of “public projects” and investments that we can sensibly make now and then scale back later this part of our stimulus effort. The growing economy will lighten the relative debt burden, and the public investment will help us all in the longer term. Some of these investments are targetted at green projects and global warming, some at health care, some at technology. All these help in the long run, and can eventually be throttled back to make the financial situation sustainable.

Posted by concerned-citizen | Report as abusive

There is a case to be made for remaining neutral (emotionally and economically) to the inflation/deflation/public debt debate. Any policy choice has its winners and losers. Those whining about inflation and government crowding-out of private capital markets are those who are too entrenched (mentally and financially) in making their living in the financial sector and too unimaginative to figure out how to thrive in a high-inflation reality. Whether we like it or not things are what they are and there is always a way to prosper.

Posted by coudenhove-k | Report as abusive

Let’s start a letter-writing campaign to Hu Jintao and beg him to cut off the credit card. They — and we — will be better off in the long run!


Paul Krugman stopped being an economist a long time ago. After falling in love with his own press clippings, he became an ideologue… no longer dealing in, pun intended, hard currency… he’s become an intellectual Ponzi scheme himself.Krugman’s about as credible on the economy as Al Gore is on Global Warming. Advice from Krugman on the economy is about as useful as advice on dieting from Micahel Moore.

Posted by Phil Cohen | Report as abusive

Obviously we have equal fair and equal trade with China, They send us poison toys and meat, we send them toxic debt.

Posted by twm | Report as abusive

Excellent Article! Finally it is said loud and clear clear. Borrowed money does not make a recovery! Imagine you are running a business, will you call it success if you always have to borrow $2000 every day, to make $1000 ? That is what is happening with our GDP. The borrowing required to increase the GDP is more than the increase itself! It is not sustainable anymore.This is a deflationary crash. What is deflation? Let me explain shortly. When we borrow, banks create money. They do not lend existing money. In fact, they only create a promise to pay you. All bank accounts are promisses to pay you. When we write a check, it works like money, but the person who takes our check puts it back to the bank. So the bank does not really pay out any money. Here is how banks create money: banks_create_money.htmlAlmost ALL of our money supply is created this way. It is called bank credit. When we borrowed it for the last 50-100 years, we promised to pay it back with interest! The interest portion is not even created yet. It was supposed to be created when we borrowed more in the future. But now the borrowing and lending has stopped! There is an expectation that money supply will grow so that we can earn principle+interest and pay it back, but if money supply shrinks then it becomes impossible to earn enough to pay back what we owe. This is called deflation. Money supply is deflating. This is why the government allowed sub-prime! So that more people would borrow and more money would get generated. This way they postponed the crash. But now there is nobody left to borrow. Years of inflated bank credit is deflating now. If money supply deflates 50%, then all prices / salaries will decrease. We must get used to it. Read this book, it is a must: onquer_the_crash.html


thanks for the information great food for thought, its amazing how much we don’t want to account for?


If you spend all your life as a hammer, then all you see are nails. Economists, Krugman included, see the whole thing as financial. More money here, less there, pump this, deleverage that, borrow more to make more money. Myopic vision overwhelms the tunnel eyes of the elites. Just like one Greenspan.Why does the USA find itself in the current situation where a large portion of the economy of the past 2 decades was centered on manipulating money?Because the ex-super industrial power discovered that it no longer has the kind of industrial excellence, capacity, products and services to sustain the high standard of living it has got used to. Easier to make a living by moving money around – for a while.No amount of financial manipulations can fix America’s economic problems. Particularly now, when an excess of financial trickery has blew the fake economy back to reality.No economists can offer a solution. Disregard all of them.The solution can only come from the people if they are determined to create wealth the hard way, the honest way, the smart way.

Posted by The Real Deal | Report as abusive

The problem is false wealth. Debt is one aspect of that. The major on is derivative financial instruments. We need to take the double taxation off of dividends, tax gain from the sale of stock heavily, and make it impossible to make a profit on derivative instruments. The problem we are now in is a result of foolish stack of “wealth” that represented no actual product or service. Stock should be bought for their basic purpose: sharing in the the profit of a firm, not for their supposed future value. That way the CEO’s job description becomes to produce a good cash flow, rather than get on the psychological treadmill of getting the stock price to rise.What do you think?

Posted by Tom | Report as abusive

Problem, America makes little or nothing of real worth, Like in the 30′s thru? therfore we cannot recover? Except for the? Problems problems, common folks need solutions.I think the smarts are here, lets have it.


It is perfectly valid to point out that the debt we are accumulating may be a problem down the line. But, it only *may* be a problem. I’m with Krugman and a few of the commenters here. We need to keep stimulus going to dig ourselves out of this hole and that means racking up even more debt in the short term.I know this is not going to be a popular statement here, but the fact is that our upper income tax rates are too low. That changes next year when our reckless tax cuts for the wealthy expire. Not to mention our appalling 15% rate for qualified dividends and long term capital gains. Since when does unearned income deserve to be taxed less than earned income? We shouldn’t even have the 20% rate that starts next year. Far from promoting real investment, these rates promote unsustainable bubbles.The United States is capable of pulling in the revenue to pay off our national debt. We just have to do it and be careful where we pull the revenue from. I say we introduce a new tax bracket for the ultra wealthy and have the government start trying to recover all the money that was stolen from the taxpayers in the Great Financial Fraud. Let’s go after the people that got bonuses for running our economy into the ground.

Posted by Kirk | Report as abusive

The rich rules over the poor and the borrower becomes the lender’s slave — Proverbs 22:7

Posted by Greg Parker | Report as abusive

We know from those wise people in Washington that certain banks and friends are too big to fail. I would ask those wise people, at what point is a country to big to fail? Maybe we should have asked the wise leaders of the Soviet Union before it disappeared.

Posted by Jimmy Gilliam | Report as abusive

Parker, you are so correct in sighting that proverb. Now add to it “where your treasure is there your heart is also”.And with the two, those rich in the spirit will rule over those poor in it. In this understanding the citizen is not bound by the merchant tyrants that now rule our nation. Those rich in spirit, that is to say, those who are people of conscience and who strive to live in love, can use their gifts to elevate us above this money worship we now engage in.


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