Thursday, October 13, 2011

Paul Krugman's Obfuscation About Adam Smith

Stuart K. Hayashi

This particular blog post by Per-Olof Samuelsson alerted me to something quite troubling. Nobel Prize-winning economist Paul Krugman quotes from Adam Smith's The Wealth of Nations to give his readers the impression that Smith is advancing a viewpoint that accords with Krugman's when, in fact, it does not.

In his usual snide tone, Krugman states,
One line I’ve been seeing in various places, including comments here, is the claim that the real way to deal with Wall Street is laissez-faire economics: no more bailouts! On this view, policy makers should raise their right hand in the air, place their left hand on a copy of Atlas Shrugged, and swear in the name of A is A that they will never again step in to rescue failing banks. And all will be well with the world. 
He then says, "First of all, bank regulation is important even in the absence of bailouts. Don’t trust me, trust Adam Smith. Scotland invented modern banking; it also invented modern banking crises; and Smith, having witnessed such a crisis, favored bank regulations..."

As evidence, Krugman quotes this passage from The Wealth of Nations:
Such regulations may, no doubt, be considered as in some respect a violation of natural liberty. But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments; of the most free, as well as or the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty, exactly of the same kind with the regulations of the banking trade which are here proposed. 
From such a quotation, we are led to believe that Smith is making a concession to Krugman's big-government view: to the mercantilist outlook that would eventually develop into Keynesian economics. However, when you read the Wealth of Nation paragraphs around the passage Krugman quoted, you find that the passage is part of a much larger argument that Smith is making. And that argument is actually contrary to Krugman's Keynesian intrusionism. Adam Smith was arguing in favor of a gold standard, wherein all paper money is backed by a hard metal.  The "regulations" Smith was urging were restrictions against the issuance of paper money that is not backed in any way by gold.

However, in the Keynesian economics that Krugman advocates, the federal government has rules in place that require that the quantity of monetary units in circulation can always increase by government fiat. The "stimulus" fiscal policies that Krugman espouses definitely preclude a gold standard.

The passage of Wealth of Nations that Krugman quoted was from Book 2, Chapter 2, Paragraph 93. In the very next paragraph, Smith talks about  this.
A paper money consisting in bank notes, issued by people of undoubted credit, payable upon demand without any condition, and in fact always readily paid as soon as presented, is, in every respect, equal in value to gold and silver money; since gold and silver money can at any time be had for it. Whatever is either bought or sold for such paper, must necessarily be bought or sold as cheap as it could have been for gold and silver.
Then in Paragraph 96, Smith continues,
It would be otherwise, indeed, with a paper money consisting in promissory notes, of which the immediate payment depended, in any respect, either upon the good will of those who issued them; or upon a condition which the holder of the notes might not always have it in his power to fulfil; or of which the payment was not exigible till after a certain number of years, and which in the mean time bore no interest. Such a paper money would, no doubt, fall more or less below the value of gold and silver, according as the difficulty or uncertainty of obtaining immediate payment was supposed to be greater or less; or according to the greater or less distance of time at which payment was exigible.
The "regulations" Smith was advocating were laws forbidding the arbitrary increase in the quantity of monetary units and laws upholding the gold standard.  Yet the ability of the government on increase the quantity of monetary units -- and the preclusion of the gold standard -- is essential to the Keynesian economics that Krugman sides with. And yet Krugman quotes Smith to imply that Smith is making concessions to a viewpoint more aligned with Keynesian governmental interference than with laissez-faireist hard-line gold-standard advocates like Ron Paul and, well, Per-Olof Samuelsson. You can see the Wealth of Nation paragraphs in question yourself over here in Book 2, Chapter 2. You can find the paragraphs in question (93-96) using the search words "payment was exigible".