Friday, November 28, 2014

Four Fallacies of the Second Great Depression

LONDON – The period since 2008 has produced a plentiful crop of recycled economic fallacies, mostly falling from the lips of political leaders. Here are my four favorites.

The Swabian Housewife. “One should simply have asked the Swabian housewife,” said German Chancellor Angela Merkel after the collapse of Lehman Brothers in 2008. “She would have told us that you cannot live beyond your means.”

This sensible-sounding logic currently underpins austerity. The problem is that it ignores the effect of the housewife’s thrift on total demand. If all households curbed their expenditures, total consumption would fall, and so, too, would demand for labor. If the housewife’s husband loses his job, the household will be worse off than before.

The general case of this fallacy is the “fallacy of composition”: what makes sense for each household or company individually does not necessarily add up to the good of the whole. The particular case that John Maynard Keynes identified was the “paradox of thrift”: if everyone tries to save more in bad times, aggregate demand will fall, lowering total savings, because of the decrease in consumption and economic growth.

If the government tries to cut its deficit, households and firms will have to tighten their purse strings, resulting in less total spending. As a result, however much the government cuts its spending, its deficit will barely shrink. And if all countries pursue austerity simultaneously, lower demand for each country’s goods will lead to lower domestic and foreign consumption, leaving all worse off.

The government cannot spend money it does not have. This fallacy – often repeated by British Prime Minister David Cameron – treats governments as if they faced the same budget constraints as households or companies. But governments are not like households or companies. They can always get the money they need by issuing bonds.

But won’t an increasingly indebted government have to pay ever-higher interest rates, so that debt-service costs eventually consume its entire revenue? The answer is no: the central bank can print enough extra money to hold down the cost of government debt. This is what so-called quantitative easing does. With near-zero interest rates, most Western governments cannot afford not to borrow.

This argument does not hold for a government without its own central bank, in which case it faces exactly the same budget constraint as the oft-cited Swabian housewife. That is why some eurozone member states got into so much trouble until the European Central Bank rescued them.

The national debt is deferred taxation. According to this oft-repeated fallacy, governments can raise money by issuing bonds, but, because bonds are loans, they will eventually have to be repaid, which can be done only by raising taxes. And, because taxpayers expect this, they will save now to pay their future tax bills. The more the government borrows to pay for its spending today, the more the public saves to pay future taxes, canceling out any stimulatory effect of the extra borrowing.

The problem with this argument is that governments are rarely faced with having to “pay off” their debts. They might choose to do so, but mostly they just roll them over by issuing new bonds. The longer the bonds’ maturities, the less frequently governments have to come to the market for new loans.

More important, when there are idle resources (for example, when unemployment is much higher than normal), the spending that results from the government’s borrowing brings these resources into use. The increased government revenue that this generates (plus the decreased spending on the unemployed) pays for the extra borrowing without having to raise taxes.

The national debt is a burden on future generations. This fallacy is repeated so often that it has entered the collective unconscious. The argument is that if the current generation spends more than it earns, the next generation will be forced to earn more than it spends to pay for it.

But this ignores the fact that holders of the very same debt will be among the supposedly burdened future generations. Suppose my children have to pay off the debt to you that I incurred. They will be worse off. But you will be better off. This may be bad for the distribution of wealth and income, because it will enrich the creditor at the expense of the debtor, but there will be no net burden on future generations.

The principle is exactly the same when the holders of the national debt are foreigners (as with Greece), though the political opposition to repayment will be much greater.

Economics is luxuriant with fallacies, because it is not a natural science like physics or chemistry. Propositions in economics are rarely absolutely true or false. What is true in some circumstances may be false in others. Above all, the truth of many propositions depends on people’s expectations.

Consider the belief that the more the government borrows, the higher the future tax burden will be. If people act on this belief by saving every extra pound, dollar, or euro that the government puts in their pockets, the extra government spending will have no effect on economic activity, regardless of how many resources are idle. The government must then raise taxes – and the fallacy becomes a self-fulfilling prophecy.

So how are we to distinguish between true and false propositions in economics? Perhaps the dividing line should be drawn between propositions that hold only if people expect them to be true and those that are true irrespective of beliefs. The statement, “If we all saved more in a slump, we would all be better off,” is absolutely false. We would all be worse off. But the statement, “The more the government borrows, the more it has to pay for its borrowing,” is sometimes true and sometimes false.

Or perhaps the dividing line should be between propositions that depend on reasonable behavioral assumptions and those that depend on ludicrous ones. If people saved every extra penny of borrowed money that the government spent, the spending would have no stimulating effect. True. But such people exist only in economists’ models.

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    1. CommentedMichael Harrington

      Seems to me like the Four Strawmen. The true cost of the policy errors being promoted by neo-Keynesians is found in the fact that government borrowing does not in itself create real wealth. Policy must promote prudent financial behavior that yields productive outcomes. Borrowing and spending our way to prosperity is as absurd as it sounds. Skidelsky ignores the true criticisms of neo-Keynesian policy actions like ZIRP.

    2. CommentedCarol Maczinsky

      If we would close the tax havens by lethal force all these problems would not exist. Virtue still matters even if it does not pay off. I want to live in a world of Kantian prudence, not Kenesian excessive spending.

    3. CommentedAvraam Dectis

      Brilliant column, hopefully it gets many reprints. Hopefully this is not a bridge too far, but I would go an additional step:

      The real problem is we are trying to control a modern fiat money economy with outdated gold standard mechanisms.

      Concepts of debt, deficit, surplus and national taxes are gold standard anachronisms. The only things that truly matter are productive capacity, interest rates and inflation rates.

      A thought experiment illustrates:

      Imagine if we decided that we were going to do our grand children a great favor
      by running huge surpluses so large that by the time they entered the
      working world they would never have to work. Next, imagine if when that
      time came, a new disease wiped out all the productive adults - leaving
      only people under 18 and the extremely infirm.

      Would the saved up fiat money be of any use without anyone to take the money and provide services? No - it would be useless. We could not even buy foreign goods because the foreigners would not be able to buy anything with the money they received. The only true store of value a country has is its productive capacity. Debt and surplus are anachronistic gold standard accounting illusions.

      National taxes are also anachronistic leftovers from the gold standard. We do not need taxes to obtain fiat money. The only justification for national taxes is inflation avoidance and we can avoid inflation with interest rates. For example, if we funded the government largely through floated bonds, the huge bond market that would result would be a very handy lever to control rates, in addition to all the existing tools. Bonds could be paid off through QE type mechanisms. If inflation began to rise, higher interest rates would be the effective response.

      A poll of voters would show that they would be very happy to avoid federal taxes at the possible risk of higher interest rates. This could be a huge winner for the party brave enough to defy convention.

      Far more money would enter the pockets of the 99% and inequality would be reduced.

      Redesigning the governmental funding system to adopt productive capacity, interest rates and inflation rates as the prime economic levers would be hugely efficient, progressive and popular.

      Avraam Dectis

    4. CommentedJose araujo

      I can add 3 another fallacies, if I may, that applies to Euro countries and has to do with internal vs external debt/savings. Namely the fallacy that Italy is better off because its debt is mostly internal when compared to Greece or Portugal.
      With perfect capital circulation it makes no sense to differentiate between savings in the euro zone. Why would a Portuguese national lend Money in better conditions than a German to the Portuguese Government or institutions? Rational behavior would advise for the Portuguese to move their money abroad.

      Second fallacy is that periphery countries because of the money available with the Euro (LATVIA is also used has an example) that they used to spend in Central European Imports. Well GDP=C+G+I-M+X, this tells us that GDP already discounts imports, so an economy doesn’t grow because they have money to spend on import goods.

      Third fallacy is leverage, and how leverage is bad… Well we know from Modigliani and Miller that leverage doesn’t change the asset value, and if you think about it, it makes perfect sense, Why would the source of finance change the asset value? Companies either pay interest or distribute earnings, what it means is that each and every company, specially the public companies, are 100% leveraged, either the assets are from banks or from shareholders, the value created is the same, just the distribution is different.

    5. CommentedVesa T

      "Economics is luxuriant with fallacies, because it is not a natural science like physics or chemistry!

      Indeed. I could go further. Economics is more like a religion. Prof. Skidelsky is a true believer in the matter that the debt, any debt does not mean anything, goverment can always borrow more and print more ad infinitum. Some other economist however are against that, so they are believers that debt matter.
      For ordinary people who are not economists is hard to choose who is right, when even prominent economists disagree. However, to my commons sense, I still believe that there are limits how much can we borrow and print. Maybe the limits are not yet to show, but for example to validate the borrowing by saying that the borrowing costs for certain countries with high debt (like Japan) are still low, is sounding like the famous last words.

        CommentedJovan Puric

        I agree with you ... I believe that the limit is reached when the currency becomes worthless in the eyes of the buyers/sellers ...

        CommentedTomas Kurian

        If you believe that there are limits to how much we can borrow and print, than you must also accept that there are limits how much we are allowed to save, as savings are created only at the expense of debt or money printing.
        (

        Otherwise, economy with unlimited savings ( and without unlimited debt, offseting the money withdrawn with savings) would soon collapse into itself in endless deflation.

        It is OK and workable, but than we must accept limits to savings and tax the unmoving capital. ( a la Cyprus)

        And this is what most people don´t understand: you cannot have unlimited savings and limited debt. Those two categories mathematically don´t work together.

    6. CommentedGunnar Eriksson

      I basically very much support the views purported in the article, and would wish it would be spread to popular media.
      The question of spending or not would need to consider what the spending achieves. If money is put in the hands of low earners or unemployed and ensure investment in effectiveness and sustainability the money is well spent.
      If the money, as now is the case, mainly is spent on asset speculation it is exacerbating and delaying a healthy development.

      How damaging the future debt burden will be depends much on the taxation system. Taxes need to be moved from work income to wealth.

    7. CommentedTejas Wolf

      If you change the title of this essay to "Four fallacies of Keynesianism" it becomes interesting and correct.

    8. CommentedProcyon Mukherjee

      Skidelsky is so much right on all the four fallacies; however the crux of the issue that what is true for an individual household is not true for the whole economy and vice versa, needs a deeper scrutiny. I would take the example of a bank and consider its limited role of making credit available at a cost. As a going business the bank has within its right to maximize its return on equity, which would mean limiting its equity and increasing its leverage. This when we see for all banks doing the same, there is an overhang of debt for the economy, while the ability to service that debt for the macro-economy is limited by the income, which is GDP. When we have a loose monetary regime, we have this problem compounded, when we have a tight regime we have shortage of supply while demand remains high and that is reflected in the interest rates, discounting, et al. Now, if in either case we try to live with an unbalance, which is the case, we have either too much savings or too little, but if savings is directed to increase liquidity, but not to illiquid investments, we do not help in creating the right engine for growth. The problem of our times is that too much savings is going to too illiquid investment that does not bode well for either the present or the future. It helps to inflate asset prices, doing precious little to demand.

    9. CommentedTomas Kurian

      Well, if only those in power were not so dumb.

      It is unbelievable that we have to go through this again, the 30ies and Great recession and all its errors repeats itself right in front of our eyes.

      This era will be known in the future as another Dark ages, where stupidity ruled over people and our successors would be questioning our sanity for allowing this to be happening.

      But of course the main problem is in greed, money hoarding and inability to recycle such unmoving capital.

      How it can be solved you can read at:, chapter 16 - Periodic taxation of accumulated capital

    10. CommentedZsolt Hermann

      I would say that all four "fallacies" are actually falling into the same category and they are all actually true.
      Denying them follows our greatest misunderstanding driving us deeper and deeper into crisis.
      We still try to stubbornly maintain that humanity somehow exist outside of and of course above the natural system we evolved from.
      Although our whole biological make-up, even our psyche, conscious is based on the same natural laws as any other part of the system, and although in truth we have never invented anything new, explored anything unique that was not already present in nature, for some reason we think we can separate from nature, we can do whatever we like, we can devise totally artificial, unnatural laws and sub-systems, we can base our life on excessive demand ignoring available resources and means.
      There is absolutely no miracle, unexpected in the global crisis which turns out to be unsolvable whatever we throw at it.
      We simply cannot cheat the system we are part of, the system is vast and infinitely more powerful than we can ever be.
      Evolution has not stopped with humans, and humans are still bound by the system they exist in.
      We are at crossroads: either we adapt, and learn to live within the boundaries of the system or we will not survive.
      Our uniqueness and potential comes from the fact that contrary to animals our adaptation, partnering the system can come and remain fully conscious, knowing exactly why and how we have to be part of the general balance and homeostasis.

        CommentedSean Mac

        Very good point. We cannot cheat ourselves thinking we can indefinite live above our means--not only in our economic system but our ecosystem and our natural resources.

        CommentedEdward Ponderer

        The mentality that we are somehow observers safely out of the natural system (even though disproved on even the most ephemeral sense of the quantum theory), is unfortunately almost a subconscious human failing which we don't recognize and bring to the light of correction at our peril.

        Did you ever notice that of all the paradoxes discussed in science, philosophy, or the literature of science fiction, one never addresses the obvious reality of reversing causality without this human causal agent present. Consider the broken glass that flies upward to the hand that isn't there to have dropped it, to the steak dinner that never returned to the cow, to the countless interaction junctions in time and space at the mineral, vegetative, animal, and human levels that are not available for reversal. It is not just a different present that the time traveler would return to, but it is already a very different past!

        Since we cannot change the past or present, I would suggest that we start accounting ourselves part of the natural system, and work on taking the whole into a brighter future.

    11. CommentedJason Gower

      I am not an economist by trade but know a little bit about credit and risk. I understand the vicious cycle of decreasing demand and economic expectations; so I get short-term demand-side concepts. I also subscribe to the theory of "there is no free lunch" and thus am struggling quite hard to understand these explanations of debt and spending (long-term). Have we already moved to the point of accepting quantitative easing as mainstream? As an explanation for the soundness of massive long-term debt accumulation no less? As if there is an endless supply of currency(ies) and nobody is paying for this? Debt does not magically disappear because the central bank prints more currency; holders of that currency are paying for this. Is this not a hidden tax? Further, maybe output gaps are large enough now to contain inflation but is it realistic to believe that there is no limit to this? What happens to borrowing rates when creditors expect inflation? Maybe we see where this is heading. Is this not a vicious cycle akin to playing with fire?

      Further, the anecdotal statement about government spending being ok because ‘governments are rarely faced with having to “pay off” their debts’ is dangerous. What happens when governments can’t roll their debt, and face egregiously high interest rates in the market with increasingly shorter tenor because of all of the above? Do they print more currency then? Apparently so. But wait a minute, see my previous point.

      Finally, the “living beyond our means” cliché is most often heard from politicians speaking about government deficits and in this case I am again failing to understand the author’s point. If the debt is funded domestically, then yes, the country as a whole is no worse off; wealth could be re-distributed as he says but is domestically zero sum. On the other hand, when the deficits are funded internationally the country is absolutely borrowing from its collective future to fund today’s spending. The alternative is to default in the future in which case the creditor (foreign investor) is worse off but this too leaves the creditor worse off given its default on massive amounts of debt on international markets.

      So, I believe it is absolutely correct to question if a country(ies) are living beyond their means. I think it is pretty clear that many have in the past forty or so years on this debt driven consumption binge. I would posit that the bigger question or point of delineation is: what exactly is being funded with these massive debts? Is it productive investments with a return in excess of borrowing cost or simply further consumption that is akin to a consumer maxing out ten credit cards on 5 star hotels, restaurants and the latest fashions. Or perhaps the author simply accepted that this current system of debt driven consumption that the developed world has concocted over these past decades is our only way forward as its underlying principal is forever increasing debt to fuel growth. But the music has to stop at some point and somebody will pay for all of this debt. I believe this is a true proposition in all cases.

        CommentedJason Gower

        Thanks for the response; I was hoping to get feedback. Fully agreed that the 2008 monetary policy response had positive initial impact; the question is now what? What has all of this massive stimulus actually done? Is the common man that you reference really better off? Does he have better educational or career prospects than before? Is US infrastructure in better shape? Has the "wealth effect" from massively inflated US equity markets really been worth the pain that will come on the back end? What does your theory say to misallocation of capital and the long-run economic costs of such? Isn't that how we got here in the first place?

        Further, the beauty of debt is that it is quite straightforward; whether at the household or state level. No need for any fancy economic theories to describe taking from future income/output to spend today....that is quite self-explanatory. You did not clarify who ultimately pays for the debt? How does it vanish? I don't understand. What if the higher "revenue" that you reference to pay for the higher debt, never materializes? In fact the multiplier effect of government spending has been shown to be exagerrated and with diminishing returns. The logic makes sense but that is not what we are seeing in reality. Perhaps the problem instead is the entire system has been concocted based on your line of thinking and there is no alternative to continuing to spend and add more and more debt. Well it will blow up eventually...history has proven that. Shifting around the pieces with unconventional monetary policy does not remove the fundemental idea of what debt is; instead it amounts to shuffling the deck chairs on the titanic.

        CommentedBob Sieling

        I think this post deserves some response as it expresses the profound misunderstanding our general public has about economics and macroeconomics in particular. What our poster misses is in the title, “Second Great Depression.”

        Surely he should understand just as one drives differently in heavy snow than a bright sunny summer day, economic policy is necessarily different in a depression than full employment. The fallacies enumerated in this article apply generally for all times but do not imply any particular policy for a specific economic environment. The essay primarily debunks many of the misguided objections raised against sensible economic policy for our current time. And the general public’s objections often are based in a false perception that the central government is analogous to a family budget. This fallacy is clearly exposed.

        The economic strength of a nation not measured by its balance sheet but by its collective assets and productive capacity. Jason laments an exaggerated cost of debt while ignoring the tremendous cost to families, society and our children’s futures inflicted by this second depression. A straightforward honest analysis would confirm the cost of debt in this situation would be more that offset by the consequential current and future economic benefit.

    12. CommentedRichard Foosion

      >>So how are we to distinguish between true and false propositions in economics?>>

      We could look at empirical evidence, which happens to strongly support your article.