A note on “awesomely destructive” fiscal policies

Here’s Paul Krugman describing the effects of recent fiscal policy in the US:

And to do this when the private sector is still deleveraging and interest rates are at the zero lower bound is just awesomely destructive.

It is true that Krugman suggested the fiscal austerity imposed in the US in 2013 would be awesomely destructive. And it is true that he said 2013 would be a test of market monetarism, and in particular monetary offset. But it’s also true that job growth in 2013 is running ahead of the pace of recent years, despite a big rise in payroll taxes, as well as income tax increases and the budget sequester. And a huge fall in the budget deficit.

It would be more accurate to say that fiscal austerity is awesomely destructive when the austerity involves measures that increase the rate of inflation, and the central bank has a single mandate to keep inflation below 2%, and takes that mandate so seriously that it raised interest rate several times in 2011, and not awesomely destructive if the central bank is at least slightly rational.  The US and eurozone did almost identical amounts of austerity. No surprise, it’s the ECB policy that is awesomely destructive:

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David Henderson notes some other problems with the Krugman post.

PS.  In a more recent post Krugman makes the following observations, in response to a Brad DeLong post:

Consider Brad’s five points:

1. Price stickiness causes business cycle fluctuations: You clearly need price stickiness to make sense of the data. However, there is now widespread acceptance of the point that making prices more flexible can actually worsen a slump, a favorite point of Tobin’s.

2. Monetary policy > fiscal policy: Not when you face the zero lower bound — and that’s no longer an abstract or remote consideration, it’s the world we’ve been living in for five years. And Tobin, who defended the relevance of fiscal policy, is vindicated.

3. Business cycles are fluctuations around a trend, not declines below some level of potential output: This view comes out of the natural rate hypothesis, and the notion of a vertical long-run Phillips curve. At this point, however, there is wide acceptance of the idea that for a variety of reasons, but especially downward nominal wage rigidity, the Phillips curve is not vertical at low inflation. Again, a very Tobinesque notion, as Daly and Hobijn explain.

4. Policy rules: Not so easy when once in a while you face Great Depression-sized shocks.

5. “Low multipliers associated with fiscal policy”: Ahem. Not when you’re in a liquidity trap.

I think Krugman is complete wrong about points 1, 2, 4, and 5 (not wrong that some Keynesians have shifted that way, but wrong in implying this new old Keynesianism is an improvement.)  Is there any European country with more flexible wages than Germany?  Point 3 is complicated.  My hunch is that even at low inflation rates (say 1%) unemployment will generally get back to the same natural rates as at 5% inflation.  But I do think recoveries take longer at 1% inflation, so the average rate of unemployment is higher at low rates.  And there is some possibility that you never get back to the original natural rate at low inflation rates, if money illusion (irrational fear of nominal wage cuts) creates a higher natural rate of unemployment.  So I think Krugman is at least partly right on that point.  Of course this entire discussion should have been done in NGDP growth terms, but I stuck with Krugman’s terminology.

 


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22 Responses to “A note on “awesomely destructive” fiscal policies”

  1. Gravatar of jknarr jknarr
    14. December 2013 at 12:07

    Faster, Scott. An awesome take-down. Keep it up.

  2. Gravatar of Andy Harless Andy Harless
    14. December 2013 at 13:17

    I would say that US fiscal policy, while not, perhaps, awesomely destructive, has at least been awesomely inefficient. The US Treasury can create, at very little cost, assets for which the market is willing to pay a huge premium over physical capital. Even under optimal monetary policy it would be awesomely inefficient not to produce more of these assets. As I put it in my latest blog post, our economy is stochastically dynamically inefficient. (OK, that was a shameless plug. But the main concept in the post — what I call the “natural discounted growth rate” was actually inspired by a reply you made to one of my comments on one of your recent posts.)

  3. Gravatar of Morgan Warstler Morgan Warstler
    14. December 2013 at 13:26

    “Morgan, No, easier money is the easy way. And the right way.”

    I don’t disagree Scott, but:

    “My hunch is that even at low inflation rates (say 1%) unemployment will generally get back to the same natural rates as at 5% inflation. But I do think recoveries take longer at 1% inflation, so the average rate of unemployment is higher at low rates.”

    Confirm what I was saying…

    1. YES sure without hindsight, it was right for left to try and cheer for Greece to fight the forces of reality….. LEAVE THE EURO!! BE ICELAND! !HUZZAH!

    2. But we now KNOW that in 2008-2013, those things do not deliver.

    We now know that political economy being what they are, this crisis did not lead to the hopes of the left occurring.

    Instead the people suffer while we watched Germany win a war of attrition.

    So LOGICALLY, the smarter play, with benefit of hindsight, is to end human misery faster, for the loser to knock down his king, and admit defeat.

    And if we had a time machine, or in the future when this happens again, have all the economists at once in unison scream at the Greece in the situation to BEND.

    The deeper the cultural social economic changes adopted by Greece, the better.

    Whatever the action, prolonged waiting is worse, right?

  4. Gravatar of Geoff Geoff
    14. December 2013 at 13:48

    The quality of these blog posts is declining precipitously.

    “It would be more accurate to say that fiscal austerity is awesomely destructive when the austerity involves measures that increase the rate of inflation, and the central bank has a single mandate to keep inflation below 2%, and takes that mandate so seriously that it raised interest rate several times in 2011, and not awesomely destructive if the central bank is at least slightly rational.”

    So now we’re supposed to believe that “NGDPLT” is the same thing as “rational.”

    This is nothing but a technique to shut down argument.

    Worshipping God is “rational.”

    Nothing but a fake defense.

  5. Gravatar of Daniel J Daniel J
    14. December 2013 at 14:21

    Hey Scott I know that you don’t really play videogames but there is a company out there named Valve. They make videogames but more importantly hired an economist to set up an in game barter economy. This allows them to look at data as a whole without having to go through econometrics and make educated guesses. Long story short I was watching a talk by their head guy, Gabe Newell, and he started talking about how he wants to do prediction markets. He goes on to endorse NGDP level targeting. I’m pretty sure he reads your blog. I know this might not seem like much to you but this guy is doing a lot with the gaming community. It’s a community still in it’s infancy that I see becoming a massive part of the future American economy. Here’s the link: http://www.youtube.com/watch?v=Td_PGkfIdIQ#t=2902

  6. Gravatar of Al Al
    14. December 2013 at 15:03

    Daniel J,

    Wow, very interesting. Thank you for the link. Do you know what games or projects he is referencing, or is he just offering his thoughts on the subject?

  7. Gravatar of Daniel J Daniel J
    14. December 2013 at 15:16

    At first he mentions the TF2 economy and how that gave them an economy in a petri dish. He then goes on to talk about how he wants to move into prediction markets for things ranging from pricing hats in TF2 to the pricing of games themselves. He claims that gamers catch on to prediction markets within 3 months. He hopes that research done within that realm could help research in the real world, i.e. his personal favorite NGDPLT.

  8. Gravatar of benjamin cole benjamin cole
    14. December 2013 at 17:36

    Excellent blogging.
    Krugman’s heart is in the right place, but his brain is letting his emotions do the thinking.
    2013 is best explained by QE3–it just should been designed to ramp up until targets were hit…and we need a national.lottery that pays out more in than it takes in, in small cash payouts (sorry, the last sentiment escaped involuntarily).

  9. Gravatar of ssumner ssumner
    14. December 2013 at 17:50

    Thanks Jknarr,

    Andy, I left a comment at your post. I may do a post in reply, but first want to see what you say.

    Morgan. The Greeks should have made you king. And I’m half serious. Given they decided to stay in the euro, your sort of supply-side approach is exactly right–their only option.

    But only half serious about the king thing.

    Daniel, Thanks, Yes, I’ve seen his video and I’ve talked to his employees on the phone. But they seem to have dropped the idea. I hope they pick it up again.

  10. Gravatar of SG SG
    14. December 2013 at 19:26

    @Geoff

    Can you point out which of Scott’s earlier posts you believe to be of higher quality?

  11. Gravatar of Daniel J Daniel J
    14. December 2013 at 20:18

    Bummer, well I hope Gabe still supports NGDPLT. He seems to have an interesting take on economics.

  12. Gravatar of JohnB JohnB
    14. December 2013 at 22:14

    I just can’t bring myself to believe that the difference between a vigorous recovery for the Eurozone and their current depression would have been 1-2 points of inflation per year. As much as I appreciate much of what Scott has written on this blog, I think that is just going too far. The central bank’s mandate is to keep prices stable. Inflation in the -2-2% range should all allow an economy to operate if the rationale behind inflation targeting is accurate.

  13. Gravatar of Geoff Geoff
    15. December 2013 at 00:18

    SG:

    “Can you point out which of Scott’s earlier posts you believe to be of higher quality?”

    Any one that doesn’t focus on money.

  14. Gravatar of Daniel Daniel
    15. December 2013 at 00:20

    Scott, I think what you’re saying in response to Krugman is:

    (A) “Central banks don’t actually freeze into inactivity just because their policy rate is at or near zero. Therefore Krugman’s points 1,2,4, and 5 are wrong, because his underlying model of how central banks behave is wrong.”

    But you might be saying:

    (B) “Even if Krugman were right about central bank behavior, even if central banks really did freeze into total stasis when their policy rate approached zero, Krugman’s points 1,2,4 and 5 would *still* be wrong.”

    I understand that, in your view, Krugman makes a critical mistake when he assumes central banks inevitably freeze into inactivity as policy rates approach zero.

    I’m just not clear on whether I should take your disagreement on this particular linked article as a natural consequence of your larger disagreement about whether central banks freeze near zero.

    Am I right in thinking that your larger disagreement (about whether central banks freeze near zero) is driving these particular disagreements? Or is there a different source for your disagreement on Krugman’s “1,2,4 and 5″?

  15. Gravatar of ssumner ssumner
    15. December 2013 at 05:56

    JohnB, Inflation doesn’t matter, you are right about that. But NGDP matters a lot in the short run (not at all in the long run) The evidence is overwhelming for anyone who cares to examine it. NGDP growth in the US and eurozone was running around 4% in 2010. Then in 2011 the eurozone adopted a tight money policy and slowed the growth to less than 1%, whereas it kept close to 4% in the US. The only way the eurozone could have maintained robust RGDP growth with tha tlow NGDP growth is with deflation. But how often do you see countries maintain robust RGDP growth EVEN AS THEY ARE FALLING INTO DEFLATION?

    Daniel, In part, but for point one I think he’s relying on a false new Keynesian model of wage/price flexibility. In this model deflation caused by flexible prices is contractionary. In fact, if you focus on NGDP it is expansionary.

  16. Gravatar of Ralph Musgrave Ralph Musgrave
    15. December 2013 at 08:36

    Scott says “fiscal austerity is awesomely destructive when the austerity involves measures that increase the rate of inflation..” I’m puzzled as to how any “austere” package (fiscal or monetary) can cause inflation.

  17. Gravatar of Ralph Musgrave Ralph Musgrave
    15. December 2013 at 08:46

    Scott, What do you mean by fiscal stimulus (or similar phrases)? Do you mean government borrows and spends $X, with the Fed letting interest rates rise as a consequence of that borrowing. Or do you envisage the Fed holding rates constant?

  18. Gravatar of ssumner ssumner
    15. December 2013 at 14:34

    Ralph, Higher VATs and other fees.

    Ralph, I would define fiscal stimulus as an increase in the deficit not caused by a downturn in the economy. I envision the Fed continuing to target whatever it is targeting after the fiscal stimulus. It might be inflation, or NGDP, or something else.

  19. Gravatar of Saturos Saturos
    15. December 2013 at 19:50

    Portal 3: In the year 2100, artificial intelligence running NGDP futures becomes sentient and threatens to destroy world economy. Only one wunderkind nuclear physicist in a leotard can save us… with the power of expectations. (Does the future cause the present? Who knows???)

    Gabe Newell is awesome.

  20. Gravatar of Saturos Saturos
    15. December 2013 at 19:51

    *wunderkind mild mannered economist. In a leotard.*

  21. Gravatar of JohnB JohnB
    16. December 2013 at 19:11

    Scott,

    Countries fall into deflation while maintaining robust RGDP growth at least as often as when they fail to maintain RGDP growth. There is no a priori reason an economy can’t enjoy high real growth with slowly falling prices. In fact, other things equal, robust production growth will tend to drive prices down as the same amount of money chases more goods. The United States and western Europe enjoyed a slow decline in prices accompanied by strong growth from c. 1814-1914. Also, the US economy in the late 1920s (before the crash) or the Chinese economy in the late 1990s are examples of economies that maintained robust RGDP growth even as they fell into deflation.

  22. Gravatar of ssumner ssumner
    17. December 2013 at 06:43

    John, Your history is wrong. Under the gold standard the US experienced recessions during periods where it fell into deflation. Yes, there was growth during this period, but most of it occurred during the years when prices were not falling. When they began falling again the economy usually contracted.

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