Paul Krugman and the Error of Normalization
August 24, 2009
– Comments (6)
Look, I think the value of the US dollar is going to decline and that we're going to see inflation as a result of current government spending. There's my bias out of the way from the get-go. NY Times persona Paul Krugman somewhat agrees with this stance, but he tried to rationalize a $9 trillion deficit on his blog yesterday, writing:
"What you have to bear in mind is that the economy — and hence the federal tax base — is enormous, too. Right now GDP is around $14 trillion. If economic growth averages 2.5% a year, which has been the norm, and inflation is 2% a year, which is the target (and which the bond market seems to believe), GDP will be around $22 trillion a decade from now. So we’re talking about adding debt that’s equal to around 40% of GDP."
Now, 2.5% annual GDP growth over the next 10 years with just 2% inflation would be a spectacular accomplishment. That's a very optimistic scenario, in my mind. Yet Krugman, just the day before, wrote this on his blog:
"The stimulus has helped, and the conventional recession is over. But the economy is not recovering in the most crucial area, job creation, and the stimulus won’t be enough to restore prosperity."
My thought is that 2.5% GDP growth would mean that prosperity has been restored, which means these posts must each exist in their own little vacuum in order for them to hang together. Yet they were written on the same blog, by the same guy, one day apart. Must be fun to be an economist!
The broader point, however, is in the error of normalization, which people make all of the time. As Nassim Taleb has pointed out time and time again, the world won't grow a steady 2.5% each and every year for the next 10. There will be significant swings, which will cause significant volatility. And we problem don't want to be holding so much federal debt when those swings happen, IMO.
Similarly, when we look back in 50 years long after this housing crisis has passed, we're probably going to annualize out this "blip" and say that housing prices increase 2% a year. And while that's true, that doesn't mean you should lever up expecting 2% returns each and every year. As we've seen, reality is volatile and people who normalize are stupid.
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