Thursday, October 28, 2010

Another Krugman Fallacy On Commodities

While Krugman casts others as being "worst economist in the world", he does his best to try to earn that title for himself.

"Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.

What this official is saying is a version of the classic freshman mistake: an increase in demand leads to higher prices, and higher prices make people buy less, so an increase in demand leads to lower sales.

Amazing stuff, and further evidence of the Dark Age of economics now descending."

First of all, while it is true that higher commodity prices won't necessarily derail the recovery, it will to an uncertain (it could be partially, fully or more than fully) extent prevent higher nominal demand caused by quantitative easing from causing an increase in real demand and real output. This goes both for the general increase in prices as well as the terms of trade loss discussed below.

And what he misses is that since commodity prices are a lot more flexible than most consumer and producer prices, it is all but certain that quantitative easing will in the short term raise commodity prices disproportionately, or in other words raise real commodity prices.

And while that will benefit commodity exporters like Australia, Russia and Brazil, that will by creating a terms of trade loss hurt net commodity importers like the United States.