Paul Krugman: How a Simple-Minded Analogy Has Wreaked Havoc

The world—especially Europe—has tragically misunderstood debt, Paul Krugman writes in his column Monday. And the results are catastrophic. As a result of too much austerity, and a scolding insistence that debtor nations continue to slash spending, Greece may have to exit the Euro, deflation is setting in, and Europe continues to stumble badly in the wake of the Great Recession.


Apart from Krugman, Janet Yellen gets this. She along with other responsible economists view the global economic troubles since 2008 mostly as due to “deleveraging.” This, Krugman explains, is "a simultaneous attempt by debtors almost everywhere to reduce their liabilities. Why is deleveraging a problem? Because my spending is your income, and your spending is my income, so if everyone slashes spending at the same time, incomes go down around the world."

The problem has come about mostly because of a simple-minded analogy, one that sounds true and scores political points, but just isn't how it works. "As Ms. Yellen put it in 2009," Krugman writes. 'Precautions that may be smart for individuals and firms — and indeed essential to return the economy to a normal state — nevertheless magnify the distress of the economy as a whole.'"

We are far from having returned the economy to a "normal state," despite years of punishing austerity, and some of the lowest government spending rates in decades. Krugman cites a recent report from the McKinsey Global Institute titled “Debt and (Not Much) Deleveraging.” It found, "basically, that no nation has reduced its ratio of total debt to G.D.P. Household debt is down in some countries, especially in the United States. But it’s up in others, and even where there has been significant private deleveraging, government debt has risen by more than private debt has fallen." 

Governments are not households or even small businesses that need to make sure not to overspend and go into crippling debt, and it is a misunderstanding to see them that way. Here's why, according to Krugman:

An indebted family owes money to other people; the world economy as a whole owes money to itself. And while it’s true that countries can borrow from other countries, America has actually been borrowing less from abroad since 2008 than it did before, and Europe is a net lender to the rest of the world.

Because debt is money we owe to ourselves, it does not directly make the economy poorer (and paying it off doesn’t make us richer). True, debt can pose a threat to financial stability — but the situation is not improved if efforts to reduce debt end up pushing the economy into deflation and depression.

European leaders completely bought into the notion that the economic crisis was brought on by too much spending, by nations living beyond their means. The way forward, Chancellor Angela Merkel of Germany insisted, was a return to frugality. Europe, she declared, should emulate the famously thrifty Swabian housewife.

Result? Slow-motion disaster. Some belt-tightening was necessary, but austerity became so savage, and coincided with even richer economies tightening their belts, and growth virtually halted, inflation fell, and worse, deflation started in the hardest-hit countries. This is a very bad; the deflation spiral is very hard to escape.

Krugman has been sounding that alarm for a while now, and his dire predictions appear to be coming true. He concludes:

Nobody knows what happens next, although bookmakers are now giving better than even odds that Greece will exit the euro. Maybe the damage would stop there, but I don’t believe it — a Greek exit is all too likely to threaten the whole currency project. And if the euro does fail, here’s what should be written on its tombstone: “Died of a bad analogy.”

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