Here’s Paul Krugman:
From the very beginning of the Lesser Depression, the central principle for understanding macroeconomic policy has been that everything is different when you’re in a liquidity trap. In particular, the whole case for fiscal stimulus and against austerity rests on the proposition that with interest rates up against the zero lower bound, the central bank can neither achieve full employment on its own nor offset the contractionary effect of spending cuts or tax hikes.
This isn’t hard, folks; it’s just Macro 101. Yet a large number of economists “” never mind politicians or policy makers “” seems to have a very hard time grasping this basic concept.
. . .
We’re not talking about stupid people here; clearly, there’s something about the notion that the rules for policy depend on the situation that some economists just don’t want to understand.
Don’t you love the way he juxtaposes; “This isn’t hard folks” “it’s just Macro 101” “stupid people” “don’t want to understand” “hard time grasping this basic concept.” Let’s translate this bit of Krugmanese as follows:
“I want to signal to my sophisticated readers that anyone who believes monetary stimulus can restore full employment at the zero bound is stupid, but I also want to be able to deny that I made that charge. So I inject the term ‘stupid’, next to all sorts of other comments that imply I think they are stupid. I’ll say my opponents are not stupid people, even as I imply they are.”
I don’t teach EC101, but I do teach EC391, which is monetary economics. I use the number one textbook. Here’s what it says:
Monetary policy can be effective in reviving a weak economy even if short term rates are already near zero.
So Frederic Mishkin is one of those non-stupid people who we all know (nudge-nudge), must be stupid. Who else is not really stupid, but just acts like it?
Well there’s Ben Bernanke, who always insists that the Fed never runs out of ammunition, just that the costs and risks of buying back debt are uncertain. And how about the costs and risks of issuing trillions in new debt?
Or how about Milton Friedman?
How about Krugman’s colleague Lars Svensson who wrote a paper discussing a “foolproof” plan for reflation when in a liquidity trap?
But as always, my favorite clueless economist is the guy that wrote the 1998 paper that revolutionized the way we think about liquidity trap; the paper that pushed the profession far beyond the simple EC101 model:
The point here is that the end of the Depression – which is the usual, indeed perhaps the sole, motivating example for the view that a one-time fiscal stimulus can produce sustained recovery, does not actually appear to fit the story line too well; much though by no means all of the recovery from that particular liquidity trap seems to have depended on inflation expectations that made real interest rates substantially negative.
If temporary fiscal stimulus does not jolt the economy out of its doldrums on a sustained basis, however, then a recovery strategy based on fiscal expansion would have to continue the stimulus over an extended period of time. The question then becomes how much stimulus is needed, for how long – and whether the consequences of that stimulus for government debt are acceptable.
It may seem strange even to have a subsection mentioning monetary policy, given that everything up to this point has stressed the ineffectuality of such policy in a liquidity trap. However, as we noted at the beginning, only temporary monetary expansions are ineffectual. If a monetary expansion is perceived to be permanent, it will raise prices (in a full-employment model) or output (if current prices are predetermined).
Of course, if one expects interest rates to stay near zero indefinitely, the level of government debt hardly matters. But if one expects that at a sufficiently distant date real rates will become strongly positive again, the eventual size of that debt becomes an important concern.
The political point is that Japan – like, we might note, the United States during the New Deal – appears to have great difficulty working up its political nerve for a fiscal package anywhere close to what would be required to close the output gap. Exactly why is an interesting question, beyond this paper’s scope.
Does this mean that fiscal policy should be ignored as part of the policy mix? Surely not. On the general Brainard principle – when uncertain about the right model, throw a bit of everything at the problem – one would want to apply fiscal stimulus. (Even I wouldn’t trust myself enough to go for a purely “Krugman” solution). However, it seems unlikely that a mainly fiscal solution will be enough.
In 1998 the “purely ‘Krugman’ solution” was monetary stimulus, and now it’s fiscal stimulus, with monetary stimulus added on in a sort of “worth a shot” context.
I can already anticipate commenters telling me that Krugman has a right to “change his mind.” Yes, but the 1998 liquidity trap paper was written after he changed his mind about liquidity traps. This is the paper he frequently cites in his blog as representing his current views. I guess you could argue that he changed his mind again about the relative effectiveness of monetary and fiscal stimulus. People have a right to change their minds as often as they wish. But if they do so frequently, it makes little sense to cite EC101 as if it is some sort of holy writ.
From my perspective nothing can top the following Krugman comment from 1999, one year after his famous liquidity trap article:
What continues to amaze me is this: Japan’s current strategy of massive, unsustainable deficit spending in the hopes that this will somehow generate a self-sustained recovery is currently regarded as the orthodox, sensible thing to do – even though it can be justified only by exotic stories about multiple equilibria, the sort of thing you would imagine only a professor could believe. Meanwhile further steps on monetary policy – the sort of thing you would advocate if you believed in a more conventional, boring model, one in which the problem is simply a question of the savings-investment balance – are rejected as dangerously radical and unbecoming of a dignified economy.
Will somebody please explain this to me?
I’ve been asking the same question for 4 long years, and I have yet to receive an answer that makes any sense. Maybe Krugman and I need to go back and study EC101.
HT: Clark Johnson