Paul Krugman is right, Paul Krugman is wrong? At least he is inconsistent on accounting identities

When Paul Krugman some time ago criticized the new Nobel Prize winner Eugene Fama he did a great job in clarifying the role of accounting identities for economic analysis. He wrote in response to Fama’s claim that higher savings will lead to higher investment: “The immediate thing Fama should have asked himself, even if completely ignorant of the history of macroeconomics, is why the causation necessarily runs from savings to investment. Why not the other way around?” Alas, this is exactly the question Krugman should have asked himself when treating the other accounting identity, the one that says that foreign savings always equal the domestic current account deficit.

In the case of the domestic deficit, Krugman comes to a reasonable result by stressing the dynamics of overall income in a case where consumers decide to save more. If consumers cut spending in an attempt to save more, investors facing falling utilization of their capacities or involuntary inventories would cut rather than increase investment. Krugman concludes that in this case “consumers may find that they’re not saving as much as they intended to, because their incomes fall. Naturally, these unintended results will lead to further changes in behavior, with firms cutting production and consumers further reducing spending, until we eventually reach a sort of equilibrium in which desired saving and desired investment match up; this new equilibrium need not be one in which investment rises, and could well be one in which investment falls”.