By “this” I mean sluggish growth, very low inflation, and especially near-zero interest rates. Paul Krugman has repeatedly said “yes” and mocked people like Martin Feldstein, who expected a more conventional recovery with rising inflation and rising interest rates. But Brad DeLong says he’s too tough on Feldstein:
Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon–that that was the duration of the short run–while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.
I’m somewhere in between, and also a bit off to the side. DeLong has by far the best argument, and if you are only going to read one post, stop reading mine and read his instead. But I’ll put in my 2 cents, FWIW.
I have a very low opinion of the IS-LM model; indeed I blame a lot of our policy failures on that model. I think it led too many economists to write off monetary policy in late 2008, right when we desperately needed monetary stimulus. But I reached the same conclusions as Krugman, for somewhat different reasons.
Since late 2008, I’ve consistently wanted more, more and more, but not for IS-LM reasons. Rather I’m a market monetarist, and in my view the markets have been signaling a need for more, more and more. I’m also a Lars Svensson-style, “target the forecast” guy, which means I always, at every single moment, want the instruments of monetary policy set at a position where expected NGDP growth equals desired NGDP growth. Since 2008 we’ve consistently fallen short.
In contrast, Paul Krugman is much more skeptical of the market view:
But never mind all that: read the comments, specifically this one:
The markets want money for cocaine and prostitutes. I am deadly serious.
Most people don’t realize that “the markets” are in reality 22-27 year old business school graduates, furiously concocting chaotic trading strategies on excel sheets and reporting to bosses perhaps 5 years senior to them. In addition, they generally possess the mentality and probably intelligence of junior cycle secondary school students. Without knowledge of these basic facts, nothing about the markets makes any sense—and with knowledge, everything does.
That’s about as far from my view of markets as it’s possible to get, although I suspect that Krugman himself doesn’t really quite believe it. Maybe it’s just my imagination, but on occasion I think I see him “peeking” at markets, to confirm his (often excellent) intuition about where things are going. And when he fails to do so, as in early 2013, he pays a heavy price in lost prestige.
OK, so Krugman and I were right in 2009, but did we just get lucky? Even now it’s hard to say. DeLong spends a lot of time explaining why in a traditional macro model, even a traditional Keynesian macro model, you would not expect a recession to lead to 7 years of near-zero interest rates. Not even a deep recession like 1982, when unemployment peaked at 10.8%. So what happened this time?
On the other hand Krugman’s right that this isn’t actually unprecedented, we had near-zero rates from 1932 to 1951, and then again in Japan beginning in the late 1990s, and still ongoing. So (he asks) why is anyone surprised?
In my view we had a perfect storm of shocks that just barely added up to zero rates for 7 years in the US, but not enough for Australia, and more than enough for Japan (and perhaps going forward, Europe.) These included:
1. A big negative AD shock. Both a big NGDP drop in 2008-09, and an unprecedentedly slow recovery. DeLong might argue that I am assuming the conclusion, that I need to explain this slow NGDP recovery. I don’t quite agree, but I’ll circle back to this issue later.
2. Bad supply-side factors. In the US we have boomers retiring, fewer young people choosing to work, more people going on disability, and a crackdown on immigration. Then we had a 40% rise in the minimum wage right at the onset of the recession, and an unprecedentedly long extension of unemployment benefits (which DeLong correctly predicted (in 2008) would raise unemployment.) By themselves, these factors weren’t that important, but together they had some impact. For instance, after unemployment compensation returned to the usual 26 weeks in early 2014, job growth accelerated.
3. A 30-year downtrend in the Wicksellian equilibrium real interest rate. And the last step down after 2008 was aided by a structural shift in the US and Europe from investment to consumption, as an after effect of the housing bust and tighter lending standards.
In my view the weak NGDP growth is monetary policy. Period, end of story. But DeLong would want something more:
At that time–or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero–expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base.
So you can’t explain why the massive QE didn’t lead to a big growth in NGDP unless you can explain how interest rates stayed near zero for 6 years after the recession, holding down velocity.
My response is that, yes, back in 2009 it would have been hard to predict near-zero rates in 2015. The markets didn’t expect that and neither did I. We had that perfect storm described above. But that doesn’t matter. You take policy one step at a time. The markets were also telling us that the policies that so many thought “extraordinarily accommodative” were in fact woefully inadequate. That’s all we knew in 2009, but it’s also all that we needed to know in 2009.
Krugman sees traders as drug-crazed yuppies. I see economists and Fed officials as stupid bulls that need a ring in their noses. Then you attach the rings to the markets, and let those 22-27 year old drug-addled traders lead us to a glorious world where expected NGDP growth is always on target and where bailouts and fiscal stimulus aren’t needed. A world where Say’s Law is true even though it’s not really true (I stole that last one from Brad DeLong.)
HT: Marcus Nunes