KrugmanWatch – About that deflation risk

posted by Nima

February 19, 2009 · Posted in General Economics 

Paul Krugman is a terribly confused economist. His shallow theories justify virtually every measure of government intervention and sound palatable to the common man who seeks intellectual justification for false policies.

We shall expose his falsehoods on a regular basis in this blog.

In About that deflation risk Krugman writes:


There has been a distinct change in tone from the Obama team today, as they seem to have become suddenly aware that there’s a real risk that the stimulus plan will either fail to pass, or be emasculated to the point that it doesn’t come close to doing the job. Obama himself has warned of catastrophe if we fail to act, and — finally!– denounced the tax-cut philosophy.

It is of course not surprising that Krugman blindly supports the common notion that there was some kind of tax cut philosophy at work under the Bush administration and that the financial crisis is proof that it failed. It is probably unnecessary to point it out again, but whoever cares to look at the actual numbers will immediately realize that all these tirades against a supposed tax cut philosophy are complete nonsense. As I explained in Obama Makes an Unnecessary Gamble:

The tax cuts were completely insignificant, the spending kept on growing. In fact, the only period in the post war history of the US where taxes where higher than now was from 1997 through 2002. That aside, taxes are at an all time high right now. So please , everyone, stop spreading the nonsense that what has happened in the past 8 years is a proof that a policy of limited government, little government spending and low taxes has failed.

So to everyone reading Krugman, assuming he is even remotely right on tax cuts, please can that notion immediately. Krugman goes on to write:

Meanwhile, Larry Summers has finally made the point I’ve been pushing for a while — that we’re at major risk of falling into a deflationary trap.

It’s at best amusing, but certainly not surprising that Krugman is about 3 years late with this realization. In fact he still talks about the possibility of a deflation. He doesn’t realize its past existence. The US had begun slipping into a deflationary period in mid 2006 already, when the True Money Supply growth had begun dropping below 3%. This was precisely when the housing bubble begun to deflate and one by one the other bubbles, viz. stocks, commodities, foreign exchange, followed. My economic indicator, the true money supply, enabled me to predict these developments a long time ago. This asset price deflation keeps going on to this date. Now, almost 3 years later, after the money supply has actually begun to grow by more than 3% again, Krugman begins to realize that there might be a deflation looming.

But worse yet, he doesn’t even know what the essence of a deflation is. A deflation is a correction of the previous misallocations created by inflation: The over-employment of resources in risky longer-term projects and an underemployment of resources in the consumer goods and basic materials industries, coupled with an over-consumption of consumer goods and a lack of capital from savings. The Business Cycle would certainly be an appropriate read for Mr. Krugman.

The worst thing the government can do is to try and fight the deflation. It will accomplish nothing but to slow the correction and create a long and painful period of adjustment, very much like the lost decade in Japan.

I thought it might be useful to present a bit of evidence behind that concern. The figure above plots an estimate of the output gap — the difference between actual and potential GDP, as a percentage of potential — and the change in the inflation rate. Both series are taken from the IMF WEO database, for convenience, and use data from 1980-2007.

It’s not a perfect fit — this is economics, not physics, and anyway stuff besides the output gap bounces inflation around from year to year. But still, there’s a clear correlation, driven largely but not entirely by the deep slump and disinflation of the early 1980s, and an implied slope of about 0.5 — that is, every percentage point by which real GDP fall short of potential tends to reduce the inflation rate by about half a point over the course of the year.

What exactly is this supposed to be evidence for? Krugman plots a change in inflation rate against a so called output gap which is supposed to be the gap between actual and potential GDP. How does he determine potential GDP? Either way, all this is based on inflation and GDP data provided by the government, data that is highly unsatisfactory and insufficient. It may be too much to ask of Krugman to expect him to have looked into alternative measures that actually provide useful information, such as True GDP. Either way, we all know we are seeing effects of a long term deflation as I explained above, Krugman doesn’t need to provide more proof for it. But he is dead wrong in viewing it as an evil.

And right now the CBO is saying that in the absence of a policy action the average output gap will average 6.8 percent over the next two years. Do the math: if anything like the historical relationship between output and inflation holds, we’re looking at major deflation.

OK, maybe that relationship won’t hold — getting to actual deflation may take a deeper slump than merely reducing the inflation rate. And maybe a regression driven in part by 80s data isn’t a good guide to current events. But deflation is a huge risk — and getting out of a deflationary trap is very, very hard.

We truly are flirting with disaster.

Yes, we are in a deflation and have been for many years. We don’t need Mr. Krugman to dwell on the obvious for us. Nor do we need to listen to his utter nonsense regarding its dangers. All we need to do is look at good data. Everyone shall decide for himself if he trusts indicators that correctly predicted future developments years ago, or if he trusts a Keynesian clown who saw absolutely nothing of this coming in time, who can do nothing but sway with shallow common notions, and apply a substantially flawed kindergarten theory whenever he needs to.

To get a taste of what expects you when reading The Conscience of a Liberal, this well qualified amazon review certainly tells a lot:

Paul Krugman continues to spin dubious conclusions from fuzzy thinking. First of all, Krugman should be discredited simply because he buys into the idea that the government has shrunk in the last few years. Anyone who thinks that George W. Bush has been an exemplar of limited government has obviously been living underneath a rock for the last eight years. The War on Terror has been a mammoth by itself, but Bush’s appointment of inflation-happy Fed chief Ben Bernanke, the Medicare Prescription plan, “No Child Left Behind”, etc. and compassionate “conservatism” in general have been every bit as welfare statist as a liberal like Krugman. Also Krugman falls for a whole lot of historical nonsense like many. For instance, he talks about the huge gap between rich and poor during the Industrial Revolution, completely ignoring the role that high tariffs, the National Banking Act, and government subsidies for numerous industries such as railroads had in the whole way. Not to mention new laws that were passed during the Industrial Revolution which exempted many industries from punishment for violating other people’s property with pollution. He claims that the New Deal is what created the Middle Class in the 50’s. Apparently someone forgot to tell him that after FDR died and WWII ended, most New Deal programs were abolished (Social Security might still be with us, but it’s headed for a collapse) and federal spending was cut by over a trillion dollars. Plus, the prospects of peace really helped out the Stock Market. Much of this and more was covered in the far more scholarly “Depression, War, and Cold War” by Robert Higgs, someone who’s far more of an economist than Paul Krugman with his discredited Keynesian ideology is. Advertisement: Get your shortlink before someone else does at

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One Response to “KrugmanWatch – About that deflation risk”

  1. Mike Harmon on February 19th, 2009 4:20 am


    I’m just getting started with my new blog. Would you want to exchange links on our blog-rolls?

    BTW – I’m up to about 100 visitors per day.

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