"Forgive Us Our Debts...."

One of the central working assumptions in Keynesian theory is the homogeneity of all assets. As economist Robert Higgs notes:

This way of compressing diverse, economy-wide transactions into single variables has the effect of suppressing recognition of the complex relationships and differences within each of the aggregates. Thus, in this framework, the effect of adding a million dollars of investment spending for teddy-bear inventories is the same as the effect of adding a million dollars of investment spending for digging a new copper mine. Likewise, the effect of adding a million dollars of consumption spending for movie tickets is the same as the effect of adding a million dollars of consumption spending for gasoline. Likewise, the effect of adding a million dollars of government spending for children’s inoculations against polio is the same as the effect of adding a million dollars of government spending for 7.62 mm ammunition. It does not take much thought to conceive of ways in which suppression of the differences within each of the aggregates might cause our thinking about the economy to go seriously awry.

In fact, “the economy” does not produce an undifferentiated mass we call “output.” Instead, the millions of producers who bring forth “aggregate supply” provide an almost infinite variety of specific goods and services that differ in countless ways. Moreover, an immense amount of what goes on in a market economy consists of dealings among producers who supply no “final” goods and services at all, but instead supply raw materials, components, intermediate products, and services to one another. Because these producers are connected in an intricate pattern of relations, which must assume certain proportions if the entire arrangement is to work effectively, critical consequences turn on what in particular gets produced, when, where, and how.

These extraordinarily complex micro-relationships are what we are really referring to when we speak of “the economy.” It is definitely not a single, simple process for producing a uniform, aggregate glop. (Emphasis mine)

I quote Prof. Higgs to answer Krugman's recent blog post on debt and GDP in which he points out that during the 1930s the debt/GDP ratio fell. In commenting on graphs he has in his post (which you can see on his link -- I'm not reproducing them here), he writes:

Debt actually fell as the economy slumped, through a combination of deleveraging and default. The ratio to GDP spiked only because GDP collapsed. Conversely, as the economy began to recover under the New Deal (before the big mistake of 1937), the debt ratio improved thanks to rising GDP, even though the nominal level of debt also rose.

What all this tells you is how important it is, in dealing with debt, to get the economy moving — and how devastating it is, even if you’re deeply frugal, if contraction and deflation rule.

The problem is that Krugman is operating on the assumption that private and government debt are homogeneous in nature when, in fact, they are not. Most private debt, and especially private debt of that era, is for capital formation and business expansion. Government debt (and especially the federal debt), on the other hand, mostly exists for present spending purposes and it not investment by any stretch of the imagination. (The one exception on the local and state levels is the issuance of capital bonds which are used for roads, bridges, and other physical infrastructure improvements. These bonds usually have pretty specific fees designed for repayment, as opposed to having a general obligation for taxpayers.)

In the Krugman-Keynesian view, however, there is only spending, and debt is useful to the economy ONLY in the fact that it permits more present spending, which supposedly is the grease that gives the economy "traction" and allows there to be future development. As Krugman has noted elsewhere, public debt might be rising, but it only is helping to replace the drop in private debt.

However, it is important to note that the mechanism for repaying private debt (which is undertaken for capital or business expansion) is the sale of goods and services in the future. The debt ultimately is repaid because real wealth is expanded, as opposed to the debt payments coming from the pockets of future taxpayers.

Krugman would argue that government borrowing today simply helps keep spending alive, and that will give the economy some "traction" so that the economy in the future will be stronger. What is lacking in that train of thought, however, is the mechanism for economic growth. In his view, economic growth occurs because people spend more money. End of discussion.

This view, I believe, is extremely shortsighted. In Austrian (and the old standard) views of economics, economic growth occurred because over time, people found ways to create more goods and services by using fewer resources, thus permitting those now-unused resources to be applied to other uses. That seems to be counter-intuitive to today's thinking in which we assume that growth occurs only because we are using more and more scarce resources (and that one day those resources will run out and we will be reduced to poverty via increased scarcity).

Again, this demonstrates a huge misunderstanding of what resources are and how we use them. Many products we now use are made from factors that at one time were not seen as resources at all. Crude oil once was seen as a nuisance product, and the modern silicon for computers is nothing more than something derived from sand.

Capital is useful because it serves as a tool for permitting us to make more goods from fewer factors of production, and especially labor. Contrary to the atavistic belief that capital creates mass unemployment, capital allows labor to be applied to uses to which labor before was too scarce to be used in this way.

Thus, to say that the only economic use of capital is the spending generated to create it (which I doubt even Krugman believes, although his analysis does not permit any other interpretation) is to misunderstand capital and to misunderstand the use and importance of debt. In other words, the guy simply does not "get it."

Source: http://krugman-in-wonderland.blogspot.com/2010/08/give-us-our-debts.html