Krugman was on British Television, [https://www.youtube.com/watch?v=_r-AKruzmkk] explaining that if we all try to “slash” spending at the same time, meaning both the private sector and the govt, then there will be trouble.
If the private sector feels it has too much debt, and so does the govt, well then we run up against the fundamental fact that
We Are Not a Household, We Are an Economy.
And that your spending is my income. And my spending is your income. And if we both try and do the slashing at the same time what we end up doing is producing a depression. That leaves us worse off.
And then he quotes the great Irving Fisher [the guy who predicted there would never be a depression again, right before the Great Depression happened] that…
…in such a situation “The more people try to save, the more they owe.” We’re actually worsening the debt problem by not having the govt act as the flywheel, the stabilizing factor, when the private sector is engaged in this ferocious deleveraging.
Well, isn’t he right? If we all stop spending, won’t we all go broke? Won’t we all lose our jobs if no one is hiring? Won’t the stores all have to close if no one is buying? If the silly private sector is foolishly and selfishly trying to pay its debts, shouldn’t the wise govt look at the big picture and borrow even more money to make sure we all get our paychecks?
Devil’s Advocate: Well, Dave, the Nobel Prize Winner got you this time. All your Austrian Economics has just been poured down the drain by his brilliant yet simple explanation. I have a great deal on a John Maynard T-shirt you could wear as a sign of penitence.
Smiling Dave: Just explain one little detail, then I’ll buy the T-shirt.
DA: Shoot.
SD: When that foolish private sector pays its debts, what does it do exactly?
DA: They take a pile of money and give it to the bank that lent it to them.
SD: And the bank then incinerates it.
DA: Of course not. They lend it or spend it.
SD: So by paying my debts, although I spend less, the bankers will spend more by exactly an offsetting amount?
DA: Of course, what do you think? Paying your debts is not destroying the money, just handing it over to someone else to spend.
SD: So when I pay my debts, how is there less spending?
DA: Dave, you forget that there is no guarantee the banks will spend the money they get in return. Look how they have been hoarding money these past few years.
SD: Let’s raise a more general question. If A buys something from B, what is to guarantee B will spend the money he got? Maybe B is a sink for the money. And yet, Krugman is not worried about that, just assumes that he will spend it and everything is fine.
It’s only when B gets the money as the repayment of a debt that suddenly Krugman is worried. Why?
First of all, not all loans are taken from banks. So if B is not a bank, there is no reason to assume some strange thing, that if B got the money from selling something, he will spend it, but if he got it because he lent it long ago to A, then he won’t.
As for banks, they will always lend money. How else will they stay in business? It’s like a football team deciding not to play football. How will it generate income?
Now some people may argue that banks have not lent money these past few years, but there is a govt meddling that created that. [Do a search for “banks not lending money”]. Take away the meddling and of course they will lend.
DA: You know you are contradicting yourself, Smiling Dave. You have been arguing the Austrian position all over this blog, that there is nothing wrong with saving money, that it’s a good thing. Now you turn around and explain that Krugman can sleep nights, we will have plenty of spending, like it’s a good thing.
SD: Good catch there, Devil. I still hold to the Austrian position, that saving is a blessing, and even so called hoarding does no damage. The point of this article is to show that Krugman, even if we grant him for the sake of argument that spending is important, has no justification to cheer lead for govt meddling in the economy, and borrowing money to spend it just because the private sector is being responsible and paying its debts. Whoever gets the money from those repaid debts will spend it, or lend it. Relax, Nobel Prize Winning Krugman.
DA: Dave, how can you be so impertinent as to contradict a Nobel Prize Winner?
SD: I’ll see your Nobel Prize Winner Krugman, who won a prize for his stuff on international trade, and raise you Nobel Prize Winner Hayek, who got his prize for explaining recessions. You know, the topic of this very article. Krugman is talking outside his area of expertise. He should read some Hayek, or better yet my blog.
DA: I have one last question, and I think it will shoot you down in disgrace, Dave. 90% of the “money” lent is created from checks with no cash backing. So that when a person repays his debt to a bank, the money disappears. So it is incinerated.
SD: Devil, when that money disappears, the bank is now allowed to write a new check for an equal amount. The way it works is that the govt only allows banks to write checks for about ten times the cash they have. And they use that privilege to the max. So when $1,000 of “money” disappears because someone returned a loan, that gives the bank the right to create new fake money, in the form of a check with no backing, in the sum of $1,000, and lend it right back to someone else.
Bottom line, maybe the money disappeared, but it popped right back into existence two minutes later.
DA: Could I interest you in a von Mises T-shirt?
SD: You might want to read these articles, too, my son.
https://smilingdavesblog.wordpress.com/2013/10/27/when-people-repay-their-debts-money-disappears-will-that-hurt-the-economy/
https://smilingdavesblog.wordpress.com/2013/12/01/is-money-destroyed-when-a-bank-collects-a-debt/
End of article.
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Smiling Dave on Austrian Economics. 
Hi Dave,
All debts repaid to banks are not necessarily and automatically onlent or spent by them at the same time, don’t you think? It depends on supply and demand. If demand falls (for whatever reason: loss of confidence for example), banks cannot pay all they have received as repayment.
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Oups! “banks cannot lend all they have received as repayment”.
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Let’s raise a more general question. If A buys something from B, what is to guarantee B will spend the money he got? Maybe B is a sink for the money. And yet, Krugman is not worried about that, just assumes that he will spend it and everything is fine.
It’s only when B gets the money as the repayment of a debt that suddenly Krugman is worried. Why? First of all, not all loans are taken from banks. So if B is not a bank, there is no reason to assume some strange thing, that if B got the money from selling something, he will spend it, but if he got it because he lent it long ago to A, then he won’t.
Banks will always lend money. How else will they stay in business? It’s like a football team deciding not to play football. How will it generate income?
Now some people may argue that banks have not lent money these past few years, but there is a govt meddling that created that. [Do a search for “banks not lending money”]. Take away the meddling and of course they will lend.
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Yeah. I agree. This is Say’s law. It would have been better if you had given this explanation in your post. Now it is clear! thanks
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Good idea. I’ll put it in.
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Hi Dave. Good blog.
I’ve been thinking about one problem recently. Let’s say we’ve got a poor country (Country A) with autarkic economy. They decide to open their borders and adopt free trade policy. Nonetheless the country has neighbours which are far more developed. Foreign companies come to Country A and start selling their products here. After some time majority of banks and big companies is in hands of foreign owners. The profits go outside the country instead of staying within. Is this advantageous for a Country A?
Thanks for a reply
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Thanks.
Let’ see. We’ll call Country A Mexico, and its currency the Peso.
1. The consumers in Mexico buy all the American product previously unavailable to them. Since the are buying the stuff, it means they want it. So we have a huge gain so far.
2. The American owners take all the accumulated pesos, put them in their wallets, sneak across the border to the US, and… And what exactly? There is nothing they can buy with pesos anywhere in the world but in Mexico. So they take the next bus back, and spend the money the only place they can, Mexico.
3. How has Mexico suffered? How would it be any different if a Mexican owned the bank, business, whatever?
This article taught me what’s what on this subject: https://mises.org/daily/6309/
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Awesome reply Dave. One question though. What if Mexico and US have the same currency? Now the companies can spend the money (earned in Mexico) in their own country.
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The Austrian perspective is that we have that situation right now. You have a company in say, California, that owns businesses in other states. You don’t see anyone complaining. Because what’s there to complain about?
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Yeah, I guess if businesses and entrapreuers are abbadoning one area and flowing to the other one it’s a fault of institutional conditions.
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I found this article enlightening:
https://mises.org/rothbard/protectionism.asp
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It seems your whole point is built on the assumption that bank can choose to lend as much as they legally can: this is just not true, nor observed in real life. Banks only lend to creditworthy borrowers, and that is if they show up ! The whole reason keynesianism exist in the first place is because there is such a thing as a situation in which the effective private sector demand for loans is lower than the total debt repayment mometum, hence triggering a debt deflation movement. (A fast decrease in broad money as opposed to a healthy economy that sees a steady increase in the monetary mass).
Firstly, you cannot compare a debt repayment with a traditional transaction because the former reduces the monetary mass when the latter simply transfer money from one person to another; then most importantly, and correct me if I’m wrong, but you seem to miss a major feature of the banking system: the endogeneity of money. Banks don’t choose to lend money out, they can only lend if, and only if, there are profitable projects and creditworhty borrowers to ask for loans, in other words, it is the demand side for loans that determines the total size of the market. Banks cannot force entire populations to get in debt against their will (they can try to influence them, think revolving credit and the like, but that’s nowhere near deciding to lend out money at will). Banks are never reserve constrained, and there is no such thing as a “money multiplier” that would suppose an increase in reserves or depostis would automatically trigger an increase in loans, even the Fed admitted it.
The whole problem lies in the fact that a sharp decrease in the money supply can have (and recently had) massive spillover effects that artificially reduce money velocity and demand in industry otherwise not particularly malinvested: some keynesians (among others) uses this as a argument to justify deficit spending to compensate this phenomenon: this is debattable, and very much so, but the underlying problem is there, and I see no point in avoiding to expose it.
Cheers.
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This well thought out comment will, God willing, get a reply in the form of article.
Here it is: https://smilingdavesblog.wordpress.com/2013/09/24/reply-to-pedro-al-sombrero-negro/
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“DA: Of course, what do you think? Paying your debts is not destroying the money, just handing it over to someone else to spend.”
Paying debts is destroying the money, which was created through the credit the bank gave in the beginning. But you crazy austrian crazyheads shouldn’t think about the stuff, banks actually do. Like basic accounting.
Nontheless Krugman is also wrong, as usual.
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Glad you are taking an interest in the Austrian view.
To help you reach enlightenment, ask yourself the following question about the stuff banks actually do. Why do banks want to collect the money, if it is destroyed and they can do nothing with it? Are they out to destroy the economy as well? Why not just tell everyone, “Keep the money we give you, spend it and save the economy. It will only be destroyed if we get it. It’s useless to us.”
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Banks are not restirced by how much money are deposited to award loans..
Loans are backed by Capital not that much by Cash-reserves .. i.e. if they are profitable deposited-currency is not a problem of extending more loans, the banks can just buy “capital” on the inter-bank market once they extended the loan.
We do not have Fractianal-reserve banking we have Fractional-capital-banking.
(Check the UK-CB paper and also the Fed-paper on mutliplication ratio)
This does not invalidate your argument, just you are not descibing correctly how current banking system works.
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Thanks for the info.
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