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There's one saving grace about Paul Krugman's column at the New York Times: when an Austrian economist wants to explain how mainstream economics leads to ruin, he can always trust Krugman to set up the target in a clear, concise manner. This saves us a lot of work, because we don't have to first build up the position before knocking it down.

Even the casual reader of the financial press knows that it is dominated by Keynesian "demand-side" thinking. For example, during the debate over the stimulus checks earlier in the year, the main objection was that taxpayers might use some of their rebate to pay down credit card bills, rather than blowing the whole thing at the mall. But the reader will never see a careful, step-by-step exposition of the worldview that generates such crazy notions.

Enter Paul Krugman. In a recent piece, "When Consumers Capitulate," the newest Nobel laureate spells out the method behind the madness. Let's take the opportunity then to show just why this focus on consumer spending is not only mistaken but downright dangerous.

"The Paradox of Thrift"

Krugman first tells us the (allegedly) bad news: "The long-feared capitulation of American consumers has arrived…[R]eal consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent."

Now let's stop for a moment. Many left-leaning writers—including Krugman—have been warning for years that the US trade deficit was too high, and that the national savings rate was too low. So one would think that a drop in consumer spending would be a good thing. Ah, not so fast: Krugman tells us that "the timing of the new sobriety is deeply unfortunate….For consumers are cutting back just as the U.S. economy has fallen into a liquidity trap."

And now to the actual theory behind all these musings. Krugman writes,

[O]ne of the high points of the semester, if you're a teacher of introductory macroeconomics, comes when you explain how individual virtue can be public vice, how attempts by consumers to do the right thing by saving more can leave everyone worse off. The point is that if consumers cut their spending, and nothing else takes the place of that spending, the economy will slide into a recession, reducing everyone's income. In fact, consumers' income may actually fall more than their spending, so that their attempt to save more backfires — a possibility known as the paradox of thrift.

My friend Bill Anderson actually derives sustenance from his hatred of Paul Krugman; at lunch one time, Bill skipped a sandwich and instead just bought a New York Times. Now one of Bill's frequent remarks is, "Paul Krugman is not an economist." When I first heard that, I thought Bill was being unfair in order to score a funny point. But the above excerpt from Krugman changes all that.

The most central lesson of economic science—going back further than Adam Smith's "invisible hand" metaphor at least to Mandeville's 1732 Fable of the Bees—is that in a system based on private property, private vices can actually be harnessed for the benefit of the public at large. Specifically, a market economy steers greedy businesspeople into staying up all night, thinking about how best to satisfy their customers.

Besides this truth (discovered relatively recently in human history), people have always known that a wise person refrains from possible consumption in order to accumulate savings. The reason humans in the 21st century are so fantastically wealthy compared to those in the 11th century is not merely a matter of technological innovation. It is also the result of the growing inventories of machines, tools, and equipment (i.e., "capital goods") that have been bequeathed from generation to generation. "Everybody knows" that thrift leads to prosperity, while prodigal spending leads to ruin. There's even a famous story in the Bible on this topic.

It is truly shocking to learn that Krugman not only tells his students the exact opposite—namely that private virtue leads to public vice, and that saving makes the community poorer—but that he actually relishes the demonstration. Fortunately for one's sanity, we can uncover the fallacies pretty easily.

The Misleading "Circular Flow" Model

In a nutshell, the problem with Krugman's Keynesian analysis is that it is static, meaning that it doesn't involve the passage of time, and consequently it can't begin to grapple with the capital structure in a modern economy. The "circular flow diagram" illustrates the way Krugman views the economy:

So during a recession, Krugman thinks that (for some reason) consumers freak out and start spending less. This reduces the revenues earned by firms from the sale of goods and services. But then this means firms have less money with which to hire factors of production (natural resources, labor hours, and capital equipment). That means the income earned by the owners of these items—i.e., everyone in the economy—goes down. But with less income, people in their role as consumers can't spend as much on goods and services, so business receipts fall even further, and so on until the decentralized market economy crashes into a major depression. To repeat, Krugman thinks the free market can't solve this problem, because individuals rationally respond to the onset of the crisis by increasing their cash balances, which only makes the crisis worse.

According to Krugman, in order to escape from this vicious cycle, the government must coax consumers to start spending again, perhaps by cutting interest rates or giving tax refunds. But sometimes (as in the present situation) those remedies are inadequate, and then it is the duty of the politicians to be the adults and spend tens of billions in borrowed money to do a Control-Alt-Delete on the economy.

There are so many problems with Krugman's thinking that it's hard to know where to begin. For starters, if government pump-priming can boost firm revenues, which raises national income, which allows further business expansion, etc. etc., then why employ this technique only during recessions? Why not recommend that the government always engage in deficit spending, in order to create jobs and boost GDP?

"Well," the Keynesian would say, "in a state of full employment, further additions to aggregate demand wouldn't allow firms to hire more workers. The new demand for products and services at that point would serve merely to push up prices, not increase real output."

Ah, now we're getting somewhere. With all the talk of consumer spending and national income, we often forget that actual production must occur before people can consume anything. It doesn't matter how many green pieces of paper are in your wallet; you can't "demand" a TV set unless the store has an actual unit on the shelf. Pushing it back one step, no matter how many customers are lining up outside his store, the manager of Best Buy can't stockpile his shelves with TVs unless the manufacturer has previously assembled them. And of course, the manufacturer can't do so—regardless of how much money he is offered by the Best Buy manager—unless he can find enough workers, and enough of the relevant parts, to actually make the TVs.

We now see why the circular-flow diagram above is a very misleading model of the economy. It leads us to think that output of finished consumer goods can immediately rise and fall with "spending." This framework would hold if there were no capital goods, meaning that all consumer goods and services were produced immediately, as workers took gifts of nature and produced the finished item on the spot.

For example, in an economy composed of masseuses and jugglers, the circular-flow diagram might be useful. If someone wanted a massage and had the cash, the masseuse could go right to work. The only physical constraint on output in the "massage sector" would be the number of masseuses, and the fact that they needed to sleep at some point. Besides the input of the masseuse's labor, the only other item involved is a table, and the same table can be used in the production of thousands of massages before needing to be replaced.

Things are different with most of the goods and services produced in a modern economy. In almost every sector, the workers show up and rely on tools and equipment that greatly magnify their productivity. Moreover, the overwhelming majority of workers don't apply their tools directly to raw natural resources. Instead, they use their tools to transform materials that are shipped to them from other firms.

It's useful to take a step back and just consider what happens every day in the worldwide market. There are billions of humans scattered over the planet. Some of us work on oil rigs, pulling up barrels of crude. Some of us work on farms, gathering wheat. Some of us work on oil tankers or drive tractor trailers, bringing the (somewhat) raw materials to others. As consumers, we only see the tail end of a "pipeline" that could be traced back many years. The finished goods you buy at the store are made of components that passed through probably thousands of different hands, in dozens of countries, before all coming together into the item you throw in your grocery cart.

Once we grasp the stunning complexity of the true "economic problem"—how all of this interlocking human activity is coordinated so that production flows smoothly and predictably—we see the absurdity of Keynesian pump-priming remedies. During a recession, it's not as if all output in all sectors falls by the exact same percentage. On the contrary, some sectors shrink more than others. This is because some sectors suffered huge losses, and they need to release some (or all) of their workers and other resources to more profitable sectors. This reshuffling takes time, especially because critical intermediate goods need to be produced so that operations further down the "pipeline" can resume. (In this article, I tell a quick story describing this process for a hypothetical island of 100 people.)

The Keynesians are right that in a condition of "full employment," their proposals won't cause more physical TVs and pickup trucks to roll off the assembly lines. But even in a state of widespread unemployment, the Keynesian solutions don't help. To repeat, this is because we can't simply increase activity in all sectors by, say, 1% to raise output back up to pre-recession levels. Generally speaking, this is physically impossible. No matter how much money consumers or the government throw at it, Ford can produce 1,000 more Rangers only if it can purchase 4,000 more of the appropriate tires. And the tire producer in turn can only meet Ford's request if it can buy the appropriate amount of extra rubber. And the rubber producer can only do this if…and so on.

When the recession is the result of a central-bank-induced artificial boom (such as the recent housing boom), the downturn is a period of readjustment, when misallocated resources are channeled back into more appropriate lines, consistent with consumer preferences and technological realities. When the government steps in and tries to prevent this readjustment, it simply maintains an unsustainable deployment of scarce resources. Bottlenecks occur in the millions of different "pipelines" tracing the flow of natural resources through millions of different workers' hands and onto the store shelves.

There Is Nothing Paradoxical About Thrift

In closing, it will be useful to spell out exactly what happens in a market economy when consumers decide to save more of their income. The first thing to realize is that people do not decide to "spend" or not; rather, they decide whether to spend in the present versus in the future. For example, imagine that thousands of couples in a large city one day decide to skip their weekly restaurant outings in order to save up for a summer cruise. At first, it seems that this would hurt the economy. After all, local restaurants see their sales drop, and so they buy fewer items from their suppliers and lay off some workers. The suppliers and workers in turn have less income to spend, and so sales are hurt elsewhere too.

However, so long as the entrepreneurs involved in the cruise industry anticipate the eventual increase in demand for their services, they will exactly offset the above effects when they hire more workers and other items in preparation for the busy summer months. The new savings (which were previously spent on restaurants) drives down interest rates, perhaps allowing the cruise operators to borrow money and pay for an additional liner. Thus the decision to save more doesn't reduce total income or employment, once everyone adjusts to the new spending patterns. It is really no different from a scenario where thousands of people become health conscious and decide to spend their money on vegetables rather than fast food.

Now it's true, in the present circumstances of our financial panic, consumer spending has fallen because of fear, not because of a fundamental shift in the desired timing of consumption. But still, the point remains that people cut back on present consumption in order to be able to "spend money" in the future. The difference between our present situation and the cruise-liner story above is just that people right now aren't sure exactly when, and on what, they will be spending this extra savings.

Even so, the best solution is still for the government to mind its own business and let people work things out voluntarily. The uncertainty isn't phony; people really don't know what's going to happen next month. In this situation, it is entirely appropriate for humans to stop cranking out so many iPods and designer clothes, allowing a temporary build-up of the resources that go into the production of these nonessential items.

What is especially ironic in all of this is that even on his own terms, Krugman's recommendations make no sense. That is to say, even if we put aside all of the real, physical readjustments that must occur to revamp the economy in light of the unsustainable housing boom, it would still be the case that the government ought to do nothing. If the present crisis really were largely the result of irrational panic and hoarding then government activism would only make people more uncertain about the future. In particular, no one has any idea what Paulson & Bernanke will announce next regarding financial companies and mortgages. If we're trying to reassure consumers that everything is normal, why would we resurrect tools from the New Deal playbook?

There is one more contradiction we should mention. The essence of the paradox of thrift and the liquidity trap is the insight that businesses won't expand operations if there is no demand for their product. But if Krugman and other pump-primers can see that the interruption in spending is only temporary, then so can the business owners involved. And to the extent that it is not temporary—for example, homebuilders are seeing much lower sales, and this isn't simply due to irrational hoarding—then government spending to "fill the gap" only screws things up even more.

For long-run sustainable output, businesses want to have finished products emerging from the pipeline just when consumers want to buy them. Market prices and the profit-and-loss system provide the best means of allowing entrepreneurs to make these forecasts. If the government starts buying, say, office copiers even though it doesn't really need them, that might provide jobs temporarily in a few firms, but the owners know that they can't trust this demand because it is subject to political whim. Thus the government's efforts will simply confuse entrepreneurs who are trying to configure their capacity to meet future demand.

Conclusion

In his discussion of the "paradox of thrift," Paul Krugman proves that he is not an economist—or at least, not a very good one. His policy recommendations are based on a Keynesian model bereft of time and the capital structure of production. Recessions are rooted in misalignments in this unbelievably complex structure, and there needs to be a period of below-normal output as these pipelines are fixed. Most important, consumers are doing the right thing when they increase their saving during a downturn. If solving a recession really were as simple as getting people to spend, then we wouldn't keep experiencing them.