Another thing to note is that even if Y=C+I+G+(M-X) does only fall by $1 billion as predicted by Krugmanomics, it’s only counting raw dollars. Nations trade because they can purchase more with the same number of dollars. Even in the case of a nation like the United States, where we can feasibly produce everything we use in-nation, the calculation would betray real effects. The $99 billion spent on imports could be spent on domestic production, increasing C, but it would fail to tell us how MUCH was purchased with it. If $99 billion purchased 990 million pairs of Chinese-made jeans but were only able to buy 99 million American-made jeans, the United States is clearly out a net 891 million pairs of pants. But that Y wouldn’t have budged an inch.

Y=C+I+G+(X-M) is a completely useless indicator of whether or not human conditions improve. If $10 buys you twice as much next year, the C number would be exactly the same and Paul Krugman would tell us that the economy was stagnant. This is one of the reasons why many economists actually think there was a depression in the 1870s. Y declined, but it didn’t tell us that people could buy more with less.

The alternative to “freed up” trade (if not really free trade!) is autarky.

Prof. Murphy is right to call attention to Krugman’s accounting mistake but since I am involved in trade as a career I would like to add a few comments on the importance of trade in general.

The “free-est” possible trade plays a decisive role in the world economy in efficiently distributing labor, resources, and production across the globe. Arguments against free trade assume resources, labor, and capital are already evenly spread across the world. The thinking goes, if imports are reduced then the formerly imported products can be easily replaced domestically. Reduction in trade then is a simple change in the Keynesian algebra problem. Nothing could be farther from the case.

The island country in Prof Murphy’s example may have brilliant engineers and automotive manufacturing but no sources of energy. Forcing the island country to produce its own energy expensively domestically rather than importing energy cheaply will drive large investments to that end; this action will consume scarce capital and put off other more productive investments in the island nation’s core strength in the automotive industry. Investing to produce energy expensively rather than produce automotives cheaply will thus undermine the island nation’s total production.

Autarky in Prof Murphy’s time, thankfully, finds far fewer supporters than when Prof Mises was writing. However it is worthy to remind the reader of Prof Mises’ certainty that autarky can only lead to the undermining of the global division of labor, social disintegration, and ultimately war.

For a good portrayal of the dangers of autarky and the disintegration of trade, I’d point interested readers to the passage titled: “Observations on the Causes of the Decline of Ancient Civilization” in chapter 30 of Human Action.

It is a true gem of a passage and a good reminder.

The equation assumes a constant money stock, too. With the Fed manipulating money all the time, all bets are off on how the equation will change.

You spilled a lot of ink on a misunderstanding of what Krugman was saying. He said that trade liberalization will do nothing to address the shortfall in aggregate demand. To illustrate it he made exactly your point that if you expect X and M to roughly cancel out when trade is liberalized, you have to have a compelling reason to think that liberalization would cause a notable rise in the other terms of the accounting identity. There’s no reason it would – certainly not in any way that’s big enough to counteract the fall in C and I. And then he goes on to point out how puny a contribution S. Korea and Peru would make anyway.

You’re treating his post as if he’s arguing that the identity proves something. What he’s clearly doing in that first paragraph is pointing out to people who naively just say “well free trade will lead us to export more which will create jobs” that THEY are committing precisely the accounting identity fallacy that you’re accusing him of.

And once again, as in your “Forgotten Recession” article, you’re demonstrating that you have no understanding of the Keynesian argument. Keynesians don’t say that you need to increase G to “fill the gap”, and just assume nothing else lowers. They recognize that I and C will normally lower in response to increasing G, which is PRECISELY why Keynesians only argue that G should increase when conditions in the loanable funds market are such that a rise in G WON’T lower I and C, namely, a liquidity trap. But just as you did in your “Forgotten Depression” article, you bluster along, pretending that Keynesians advocate spending their way out of any recession they come across.

Daniel Kuehn

“You spilled a lot of ink on a misunderstanding of what Krugman was saying. He said that trade liberalization will do nothing to address the shortfall in aggregate demand.”

Don’t take this as an attack, because I genuinely do want to understand the Keynsian viewpoint here. I think that the key phrase here is this: “… it’s a wash, because X and M rise equally.”

Meaning, if my understanding of aggregate demand is accurate, that eliminating trade restrictions will result in a dollar-for-dollar equal change in imports and exports, yes? And, furthermore, that this change in X and M will have absolutely no effect on C or I.

Now, let’s assume that Murphy’s attack was misdirected, which I’ll admit is possible. But it leaves us without any explanation at all, just an assertion by Krugman. Without an argument, there’s nothing to refute. Any chance you could explain his reasoning for why X and M must cancel out and that all other quantities remain the same?

I think Krugman may, in fact, have been meaning just what Daniel said. However, I also think Murphy’s focus in pointing out tautological reasoning is useful apart from what Krugman may or may not have meant in his post. Without reference to equations (which DG didn’t like), to say that increasing government spending will create jobs is tautological reasoning and doesn’t consider secondary effects (for example, the simple fact that every dollar of government spending means a dollar more in taxes, that will reduce spending) now or in the future.

Tautological reasoning is used by many people to justify positions. Here’s a statement from a Father De Sousa, found in an article in the National Post, Dec 17: “The Vatican’s green gambit.”

De Sousa summarizes a discussion about Christian morality, and church teachings of morality by saying: “…something is not wrong because the Church says so, but rather the Church teaches that it is wrong because there is something wrong with it.”

I kid you not.

Another bit of tautological reasoning is:green jobs are good, therefore we need to stimulate green jobs. I guess cost-benefit considerations are for suckers.

Daniel Kuehn,

You wrote:

To illustrate it he made exactly your point that if you expect X and M to roughly cancel out when trade is liberalized, you have to have a compelling reason to think that liberalization would cause a notable rise in the other terms of the accounting identity. There’s no reason it would – certainly not in any way that’s big enough to counteract the fall in C and I.

Paul Krugman wrote:

Even if the proposed trade deals with Korea and Colombia were remotely big enough to bear mentioning in the context of the crisis — which they aren’t — they wouldn’t be job creation measures.

So, we agree that Paul Krugman’s last point is wrong, and we also agree that trade liberalization will lead to increased aggregate demand and will also lead to increased employment.

But, Krugman wasn’t just making a pooint on Colombia and South Korea; he was trying to make a general point:

There are a lot of good things you can say about international trade. But it does not, repeat not, do anything to alleviate a shortage of overall demand. Yes, if you liberalize trade countries will export more. But they will also import more. If you’re worried about C+I+G+X−M, it’s a wash, because X and M rise equally.

So, we agree that within his general framework that Paul Krugman is wrong.

I like WILL WEAVER’S analysis. While not explicitly on the table today, his comment clearly points out the utter futility of the concept of autarky under the more seductive label of “energy independence,” which has bewitched so many politicians and pundits.

In addition to the comments of Mises in Chapter XXX of Human Action to which WILL points us, I would also point to Mises’ comments in Chapter XV of HA (The Market), Section 14 entitled “The ‘Volkswirtschaft,’” in which he mentions “Lebensraum”–the insane concept embraced by Adolph Hitler, which virtually “required” Germany to invade Poland and later Russia to achieve economic independence.

I don’t know if it is just me, but every time I think of J.M. Keynes, as I do when I hear the name Paul Krugman, I think of the close relationship between Keynesian and National-Socialist (NAZI) economic policies aimed like V-1 buzz bombs (extremely inaccurate) at unemployment–and damn the side effects.

Mises called the idea of the Volkswirtschaft “the most radical denial of all the principles of the market economy. It was this idea that guided, more or less, the economic policies of all nations in the last decades. It was the pursuit of this idea that brought about the terrific wars of our century and may kindle still more pernicious wars in the future.” (HA, p. 324) (http://mises.org/Books/humanaction.pdf) (OMG, which I utter reverently, isn’t it great to have Mises’ works so close at hand thanks to LvMI)

Except that G is not part of the equation at all, or if it is, it’s a negative. Government has no money of it’s own. It spends everyone else’s money. As a result there is a net loss through government wastage (it cannot produce more than it consumes because there is no product of government agencies or politicians just as there is no product of lawyers or the military that contributes to the GDP. They are necessary evils that are required in society and thus supported by the net gain of a productive system, however do not, in and of themselves, contribute and in fact suck away resources.

Thus while the government can artificially create jobs, not only does that job creation take away in exactly the opposite amount from real production, it kills investment too because the excess is siphoned off from investment to the government thus lowering everything in the process.

Hence the equation is roughly equal to: Y=C+I-G1+(X-M)

Where G1 = government waste. The G and the lowering of C and I are in equal amounts, but the waste lowers the overall production thus making the country poorer, not richer.

This is the economic argument for libertarianism and blatantly obvious once you understand that the government has no money of it’s own and doesn’t produce anything of value without taking money in equal amounts away from others and then there is waste on top of that because they’re spending someone else’s money in the first place.

Of course you first have to understand that just spending money isn’t a purpose in itself like the Kidiots think.

Robert Murphy,

While you do a great job of pointing out why Keynesian thought is foolish, you have not disporved Krugman within the Keynesian framework. The fallacy you point out was one that Keynes perpetuated and the same fallacy can be read over and over of Keynesian blogs. Krugman is a totally consistent Keynesian – wrong, but Keynesian.

Mr, Murphy
Thank you for your thought provoking work on dissecting Krugman. Its great to get an Austrian viewpoint on these issues. I would like to see more of it along with more liberalization of trade.

By the way, funniest moment of my day, because it says so much and is so Austrian: Krugman would laugh at such medieval, verbal reasoning.”

Makes sense to me. It’s articles like this (and Anderson’s) that have prevented me from going insane this past year.

Go Murphy!!

The economy will not recover this time until the Protectionist agreements against America that are called free trade are amended. Currently the US allows wide open free access to the US market while other countries retain barriers. Free Trade means both nations eradicate all barriers not the US allowing free access while other nations retain barriers. Calling agreements like this as Free Trade is akin to fraud. When there is fraud people get cheated and lose. Currently jobs we are losing. Just for example, the Korean Free Trade Agreement if passed would still have barriers to US exports. So how can you call that a free trade agreement.

Flawed protectionst agreements called free trade and tax policy have to be changed. Currently domestic US producers can pay up to a 35% corporate tax rate, US companies get tax breaks to outsource, foreign imports come in for free which US taxpayers have to pay to secure at ports, US exports are taxed and don’t get access to foreign markets unless technology is shared and foreign competitors that have free access to the US market and don’t allow free access to their markets manipulate their currency by printing money out of thin air faster to depreciate their currency faster to cause production to be cheaper overseas for as long as the faster depreciation continues. The perfect duo to lose every wealth producing manufacturing job in the US is to allow free access to US market while other countries retain barriers to theirs and then foreign competitors print money out of thin air faster to depreciate their currency faster so that production will be cheaper overseas for as long as the faster depreciation continues. This duo of protectionism against the US is a very serious problem in which the future of the economy depends on taking action against. Additionally I could name another 50 barriers to US exports. Believe or not the WTO does allow nations to charge import duties and take action against countries that are protectionist but the US Congress is too afraid to enforce trade policy and wants to continue to spend itself into oblivion in which it depends on these protectionist countries to print more of their domestic money to buy dollars to buy Treasuries. As it stands now, why should Americans pay high taxes to produce and make a living in the US when foreign products from Protectionist countries come in for free?

Addionally, politicians using GDP to guage the economy is entirely flawed. The GDP number only includes the amount of spending on final consumption by consumers, businesses and the government with the difference in trade between imports and exports. GDP leaves out all the intermediate stages of production. Going to the store to buy a product is just one stage of economic activity. Before a product hits the store shelf it may pass through 500 different stages of intermediate production before the product is created. Since money circulates throughout the economy in more than one stage; if production is going on in the US then the money is recirculating more because it would have to flow through all the intermediate stages leading to final consumption, which would mean various engineers and other workers would be employed at various stages thus increasing employment. GDP leaves out all those stages in that the US could no longer manufacture anything and GDP could still show the same GDP number as if the US was manufacturing because GDP just counts the dollar amount of final consumption by going to the store and purchasing a product. With all the outsourcing due to protectionist agreements called free trade that were lobbied by the large multinational corporations, alot of small manufacturers went under or went overseas. So alot of the money we spend to purchase consumption goods made overseas and if reinvested by these companies has that money recirculating to all the hundreds of intermediate stages of production in foreign countries with all the engineers being employed and R&D work happening overseas. The government printing money for stimulus packages can show GDP growth because it just measures final consumption of goods but just because GDP rises it doesn’t mean a thing about the health of the economy. Thats why you keep hearing constantly about the jobless recovery. Money printing to increase consumption is causing GDP to rise but more and more manufacturing jobs in the intermediate stages of production keep being lost because of inflation and very bad trade agreements. The belief that GDP represents all economic acitivity helps contribute to the fallacy that savings is bad. Well if you just guage the health of the economy by a consumption statistic then of course it could confuse the untrained politican or economist that the economy is contracting. If statistics were avaliable that show all the activity in the intermediate stages of production it could show that consumption spending declined but more spending is going on in R&D and in the intermediate stages of production. So savings is not hoarding like somebody taking all the money out of the bank and putting the money in a mattress. If money is saved it stays in the banking system. So savings doesn’t cause a decline in economic activity but changes the amount of relative spending between consumption of goods and investment in captial goods for production. Right now in the US savings appears to be increasing but spending in the intermediate stages of production would still show stagnation because of all the outsourcing. Besides all the malinvestment and bad debts that has to be liquidated the recovery of the economy also depends on very bad trade agreements being amended.

Barbarossa -
RE: “Daniel, I like how you, once essentially proven wrong, switch your point to something like, “well, true, but the countries with whom we would free our trade are so tiny as to have negligible beneficial effects on the economy,” and pretend as if that’s the point you were saying all along. ”

First, I’m not sure where you think I was “proven wrong”. Second, I mentioned the fact that the liberalization in question was negligible in BOTH of my posts. It wasn’t my only point all along, but it was something I said both times I commented!

I’m not sure if this is what you’re refering to when you say “switch your point”, but I also always maintained that free trade would increase aggregate demand. The point is, since it will ROUGHLY increase X and M in the same amount, and since there’s no reason to expect a massive change in C or I, it’s not a jobs silver bullet. That was the only point and that was always the point. The only way not read that is if you read Krugman EXTREMELY literally and assume he’s saying there’s absolutely no change in C or I. I see no reasonable justification for taking him that ridiculously literally.

I think we’re missing the real big picture here and arguing over pointless semantics. In an economy that has a significant inflationary force, Y=C+I+G+(M-X) is 100% useless as an indicator of anything. What many economists, like Krugman, have lost sight of is what an economy is and what money is. Placing value on currency is precisely the failing of Krugman’s entire argument.

Sure, a nation could set up in such a way where Y remains constant when both M and X are set to 0. Yet we forget what money is. Money isn’t used to eat, to build, or produce. It exists simply to avoid trying to set up complex multi-lateral trades to obtain desired resources.

In either a sound money system (ie gold) or a fiat system, the entire formula provides no meaningful data. With sound money and a free market, prices naturally decline, which would tell us that national income, Y, is going down. But it fails to tell us what is being purchased. If prices decline but more can be purchased, then incomes didn’t go down, they increased, but since Y only measures quantity of currency units, we lose this bit of information.

In the fiat system, the existence of new credit money drives up C and I, making Y look higher, but that’s only because more money enters the system, not becuase new productive trade is occurring. Y could increase yet we are able to buy fewer things with the money, so it betrays the reality that real national income has declined.

Measuring the trade of currency units is so useless it has no purpose being in a debate about liberalizing trade. The trade of individual goods and services within and between economic entities have to be measured. But this would go against the Keynesian tendency to try and treat economics, essentially a study of human behavior, into a hard science with predictable formulae and results. Meaningless indicies like aggregate demand can’t be calculated without the existence of a monopoly currency to calculate it against. Keynesians can’t developed their theories around a barter system, for instance, so telling us that last year America traded 10 bushels of corn for 50 pairs of Chinese pants and next year America traded 8 bushels of corn for 36 Chinese tires. It shouldn’t matter that China decides to retain an IOU for goods to be selected at a later date (trade deficit) unless it reaches a point where we cannot produce anything worth trading for, which isn’t something that totally cutting off the international trade market will fix.

This behavior is lost on Keynsians since some kind of aggregate demand can’t be calculated from this. It nullifies the Keynesian attempt to legitimize economics as a hard science akin to physics. This is why Keynesian policies and hypothesis are so ridiculous to those of us who think in terms of human action and behavior and the impacts policies have on real people.

This is why non-Keynesians can tell that liberalizing trade is a good thing and cutting off trade markets is a bad thing. An Austrian can tell that trying to make everything in-house is inefficient. If it was truly better to make a product instead of import it, that action would already be done. Sure, labor and resources that were otherwise used in the export market could be converted to produce goods that used to be imported. However, the efficiency of this production is drastically reduced as well as any exported goods and services that were retained for domestic use due to the loss of economics of scale. Import markets are also used to obtain goods or services that are otherwise not available domestically, like food for the hypothetical island nation.

The vast misery and reduction of wealth suffered by the nation, as well as its trading partner, is completely lost on a Keynsian because he is so focused on that Y=C+I+G+(M-X) formula. This is why Y=C+I+G+(M-X) doesn’t even belong in this sort of discussion, only how people will beneift or be harmed by specific policies and how, in the end, allowing people to make decisions for themselves in regards of where goods and services are obtained without external interference (ie liberalizing trade) is ultimately the best policy choice.

Oooh Henry, of course services provided by the government waste more resources than privately provided services. Even Obama admitted that in a reference to the U.S. Postal Service. That was not the original contention.

The original contention was that legal and protective services were all a waste of resources.

My point is that politicians and lawyers (and insurance and other pure services) are a waste of money specifically because they don’t contribute to production. As pointed out they are a hedge, but they still draw away from the surplus of production. (an accountant isn’t required of any but the largest business if it wasn’t for government making asinine rules as an example because we have software that can do it)

Of course this expense has to be budgeted for in the overall cost of production, however they only are effective if they are minimized to only what is absolutely necessary and costs less than the result of not having them.

There is nothing that Washington does now-a-days that falls into that category. It is essentially ALL waste. The civil courts are quickly approaching this point as well and becoming nothing more than social welfare for those that pretend to be needy and “hurt” in some pathetic way by someone that has money. They do very little to protect freedom and the use of force.

90% of our criminal court system is for drug or drug related crime. I.e. that which has no victim and thus isn’t a crime and shouldn’t be punished. Thus 90% of the criminal legal system is a waste of money and resources.

In a society with a huge profit gap between actual production costs and sale price, it was easy to justify wasting all of this money (and yes, it’s wasted) because it wasn’t a big deal (it was, just being hidden by the fed printing money). But now, there is no justification for this enormous and pathetic waste.

So my point still stands. The government does not produce anything. The steal money and they waste it. When 90+% of everything that the government does is not needed the waste is ridiculous and is clearly beyond the point of even bothering to do a cost benefit analysis.

Yes, we all need insurance, and to pay for police. But these are draws against our production and should be absolutely minimized at all times, otherwise you’re just throwing money away.

Government is just throwing your money away, but doing so by stealing your money. Basically you might as well burn it, you’d get the same value from it. (i.e. a little temporary warmth)

Re: Alex

The point of looking at statistics that would show the intermediate stages of production is not to find the dollar value of output but to guage the health of an economy. Yes technology improvements can shorten the number of stages it takes to make a product but the technology itself to shorten stages would probably add new stages to the economy because that technology would have to be made. For instance, lets say a TV retailer sells the whole stock of their TVs and have a profit. They decide to reinvest that money to buy more TVs and lets say the wholesalers don’t have any more inventory. So the wholesaler puts in more orders from the manufacturer. If production is happening in the US then people involved in the production of TVs which can include engineers, factory workers, machinests, etc who work among the intermediate stages are helped kept in employed. If we fast forward to today where we are heading to an economy with just one or two stages like retail and wholeselling; then even if GDP increases, but no manufacturing is occurring, unemployement will continue to be high because the economy is missing all the intermediate stages that employed people. Whether we have intermediate stages left or not, GDP does not account for these stages. So thats why GDP could show the same number with no intermediate stages in the economy as a GDP number with intermediate stages left in the economy because GDP just measures final consumption at the retail level. An economy can’t survive long when you have a workforce of all sales people that depend on people going into debt with newly created credit to buy products and nobody is producing. Yes technology can reduce the number of people needed in intermediate stages, but to create that technology requires engineers so it may new workers or cause only a small net loss in total employment. So generally the more intermediate stages there are, the more people will be employed then in an economy with just retail and wholeselling stages. Since most of the products bought in the US come increasing from overseas, all that money beyond the retail and wholesale stages gets recirculated into employing all the workers needed for intermediate stage work in foreign countries.

Daniel said: “The point is, since it will ROUGHLY increase X and M in the same amount, and since there’s no reason to expect a massive change in C or I, it’s not a jobs silver bullet.”

You do a lot of talking and never really say anything.

Alex -

The doctor is not a waste if you show up with a disease and are cured. That is a real benefit, you paid for a service and got results. What is a waste is if you go to a doctor and find out nothing is wrong with you. You paid for a service you otherwise had no use for. You didn’t benefit, however, you did make the decision that the waste you’d experience suffering from an illness that wasn’t discovered and cured in a timely manner was worse than the waste of finding out nothing was wrong.

I’m a cost accountant that spent time in the auditing field. Auditing isn’t expensive. My time was billed at $120/hour. I can’t tell you how many times I’ve done months of work just to come back to the client and say, “Well, nothing’s wrong.” The problem in our environment is that none of the companies I dealt with had any choice in the matter. Either hire me or one of my competitors (silly SEC Act of 1934 and SOX).

When engaging in loss services (annual doctor checkup, retaining a lawyer, engaging in auditing services, etc), owners of the resources, or its managers, should be free to weigh the costs of hiring the services against the potential losses. For example, if it’s determined that there’s a 0.05% chance that the company will suffer a $1 billion loss this year due to a combination of fraud, waste, lawsuits, and being the worst case scenario without all those controls in place, it doesn’t make sense to spend more than $500,000 on the varying controls to cover this. But so much as the external, mandated audit will cost more than that to comply with, let alone all the other people involved.

And when it turns out nothing happened, that’s $500,000 (or more) that was just sent down the toilet. The end consumer doesn’t care if you have a great auditing team or incredible lawyers. The market doesn’t care. All they care about is getting the product at the price the market will bear. The customer doesn’t care if you have great accountants, great accountants don’t add to the value of the product they’re purchasing (though a good cost accountant can get the price down). And any function that doesn’t add value to the end product is a waste of resources, but as I said above, some wastes are suffered because the alternate is worse.

Mr. Econ:

Suppose the U.S. produces 100 units of output in a year with a market value of $100 in total. For simplicity just to prove a point, suppose the only input is labor. Suppose the productivity of labor is one unit of output per year. Labor works 100 man-years to produce the 100 units. Total income=Labor income=$100 (in real terms, 100 units of output).

Whether there is 1 stage, 10 stages, or 1000 intermediate stages of production involved in producing the above output, employment will be 100 man-years and labor income will be $100.

Free-trade, as you know, increases our standard of living and has nothing to do with long run employment. If the U.S. produces 100 units of output, it might have a trade deficit (X-M)=30, or a trade surplus of 30. The 100 units of U.S. production still means 100 man-hours of employment.

If a country (private and government sectors) spends more on goods and services than the value of its production, there will be a trade (more accurately, a current account) deficit. For, example, in the above case of a trade deficit of 30, the country above would have an income of 100 but be spending 130 each year. In terms of the Y=C+I+X-M identity, 100=130(C+I+G)-30(X-M).

Here are some 2008 OECD statistics on the current account balance of a few countries and their unemployment rates:
Current account bal (bills $); U %
Australia -45.6; 4.2%
Canada 7.6; 6.1%
U.S. -706; 5.8 %
Germany 242; 7.5%
Ireland -14.7; 5.2%
Japan 158 ; 4.0%