Where Krugman was magnificantly right

I feel bad doing 4 negative pieces in a row.  So let’s talk about where Paul Krugman was way ahead of everyone else, and is still ahead of almost everyone else.

During the late 1990s and early 2000s Krugman warned that what happened in Japan could also happen in the US.  He was referring to the zero rate trap, and the long period of economic weakness.  I was skeptical, for two reasons:

1.  The US inflation target (believed to be around 2%) was significantly higher than the Japanese target (closer to zero).  I am pretty sure that (prior to 2008) there are no examples in all of world history of countries stumbling into a liquidity trap with mild inflation (although one could have inflation after getting into the trap.)

2.  I believed Bernanke when he said the Fed had plenty of tools to use once rates hit zero.  Indeed I still believe this, as does Bernanke.  But I also inferred from this claim that the Fed would actually use those tools to keep AD on target.  Big mistake.

Most people see this crisis from the perspective of a single framework, which usually involves debt/bubbles/etc.  Instead we need two completely different frameworks, like two trains running on different tracks.  One framework is the supercycle in nominal interest rates.  They peaked in 1981 at about 15%, and have trended downward ever since.  When they hit 1% in 2003 I thought it was the bottom of the supercycle.  I still thought that in 2007, when they were much higher.  But the supercycle wasn’t over, by 2008 they had fallen close to zero.  Most people think this progressive fall in interest rates (both real and nominal) represents progressively more expansionary monetary policy.  They blame the Fed.  Krugman and I both see it as a fall in the Wicksellian equilibrium interest rate, to unusually low levels.  I attribute it to some combination of savings glut and lack of good investment opportunities.  It certainly wasn’t caused by easy money, as inflation has trended downward since 1981, reaching negative levels in 2009.

The second problem was real, factors such as the US banking/mortgage/GSE/regulation mess, which led to a housing crash in 2008.  And to a lesser extent the energy shock of early 2008, which hit autos hard.  These shocks (combined with an inadequate response from the Fed) put us in a recession in 2008, which drove rates to zero.  The moment the markets realized the Fed had no backup plan, when they realized the Greenspan/Bernanke puts were no longer operative, was the point where NGDP expectations plummeted.  The rest is history.  Asset prices collapsed, and the financial crisis got much worse.

The real factors are really easy to see, and hence 99% of pundits focus on those factors.  The nominal problem is much more subtle.  Indeed it never would have occurred if (like Australia) we’d had a 7% NGDP growth trend—a policy Krugman advocates in the form of a 4% inflation target.  The lack of effective monetary policy changes everything.  That’s one reason Krugman seems so much more Keynesian, so much more left wing, than in the early 1990s.  With a Bernanke put, there’s no need for fiscal stimulus, even in a recession.

And nothing has been solved.  The low interest rate supercycle is likely to last for decades, and indeed may get worse when China becomes another Japan.  The next recession is likely to drive interest rates right back to zero, unless the Fed has learned something from this cycle.  But they are telling us that they haven’t.  They tell us that they oppose higher inflation targets, or price level targeting, or NGDP targeting, or indeed every single policy that would prevent the zero rate trap.  They’ve worked hard in getting inflation expectations down to this level, and dammit they’re not going to give up those gains just because it makes monetary policy ineffective for the next 5 recessions in a row, and leads to so much fiscal stimulus and recessionary deficits that we end up like Greece.

Have a nice day.



12 Responses to “Where Krugman was magnificantly right”

  1. Gravatar of Contemplationist Contemplationist
    8. July 2011 at 13:01

    “Have a nice day.”

    Nice Klingian touch there Scott.

  2. Gravatar of thruth thruth
    8. July 2011 at 13:16

    Hi Scott. Welcome back to blogging.

    “The next recession is likely to drive interest rates right back to zero, unless the Fed has learned something from this cycle.”

    Don’t you think there’s got to be at least a 20% chance that we won’t even get away from zero bound before the next crisis hits? I could easily see a scenario where US long rates drift down to Japan like levels over the next couple of years as more and more investors realize we really are trapped by too many distressed balance sheets and a too orthodox monetary authority.

  3. Gravatar of Liberal Roman Liberal Roman
    8. July 2011 at 13:16

    I too often wonder what happened to Krugman in the 1998-2001 period. If you read some of his papers and articles and writings from the 1990s, you would never guess this guy would become a hero of the liberal movement. There are writings of him criticizing liberals for making raising the minimmum wage the center piece of their economic program. There are writings of him in defense of free trade. Even now, he lets his inner conservative shine through a little bit. He begrudgingly accepts that the FTAs are a good idea. He surprisingly has gone out on a limb and written that pouring money into getting more and more people into college is probably not worth it at this point.

    He has himself said in recent interviews that in the 80s & 90s he thought both sides were just as prone to stupidity on the economic front.

    Perhaps it was the combination of the Japan crisis and the Bush presidency that switched him. I don’t know. But it is weird.

  4. Gravatar of John hall John hall
    8. July 2011 at 13:18

    Borio and Disyatat have a paper (BIS working paper 346) about the global savings glut argument and I found it quite convincing and you may want to check it out. Basically they make two points, 1) The savings glut people are arguing based on net capital flows. There’s a difference between saving and financing. For instance, saving could be zero, but investment still needs to be financed. Alternately, current account could be zero, while all of investment is financed abroad. Hence you have to look on a gross basis to see the actual picture. 2) The determination of the ex ante/equilibrium/Wicksellian interest rate is meant to coordinate savings and investment in the goods market. However, market interest rates at the short-end reflects central bank policy and at the longer range reflects term premium from market expectations of future short-term rates. So basically market interest rates do not necessarily say anything about the Wicksellian interest rate and hence savings/investment imbalances.

    No offense, but I cringe any time anyone says supercycle. On second thought, I should take that back b/c I’m just excited at how much you’ve posted the past few days.

  5. Gravatar of John Thacker John Thacker
    8. July 2011 at 13:22


    Is it fair summary of your views to say:

    1) Krugman is recommending fiscal stimulus because he believes that the current Fed is either unwilling (the view you believe is correct) or unable (a liquidity trap view you believe is wrong, but Krugman has voiced in the passed) to do monetary stimulus;

    2) However, he misses the point that the Fed is so unwilling to allow monetary growth that it actually will cancel out the aggregate demand stimulating effects of any fiscal stimulus, leaving the fiscal stimulus as worse than nothing (since it inevitably involves economic inefficiency);

    3) Therefore, the correct view is not to abandoned hope of changing monetary policy and concentrate on fiscal policy, since that will never work with the current Fed, but to concentrate on changing monetary policy?

  6. Gravatar of W. Peden W. Peden
    8. July 2011 at 13:29

    Just to say that I’m glad you’re back. I’ve just got back from a holiday in the wilderness and I’m rationing myself to three of your new posts a day, to avoid ODing on interesting ideas, especially when I have an interview to prepare for.

  7. Gravatar of Left Outside Left Outside
    8. July 2011 at 14:09

    I do cringe at the phrase supercycle – too teleological for me.

    Supercycle suggests there is something inevitable in the introduction of India’s & China’s workforces to the global division of labour and of Tyler’s “Great Stagnation.” Whereas both are historically contingent events.

    You might think Brown wrecked the UK’s economy, but to what extent have you considered the deficits run where the mirror image of a private sector in surplus due to a dearth of investment decisions?

  8. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2011 at 14:55

    Ouch. Reading Scott Sumner can be brutal sometimes. Feeling a little optimistic? Not now.

    But Sumner is right. We gotta somehow convince the Fed to get aggressive.

    The Nipponistas are the biggest threat to USA security and prosperity right now. The terrorist look like a bunch of sideshow punks compared to what the Nipponistas are going to do to us (and have).

  9. Gravatar of B B
    8. July 2011 at 15:16

    “I feel bad doing 4 negative pieces in a row.”

    Certainly not bad enough to prevent you from writing a fifth.

  10. Gravatar of Scott Sumner Scott Sumner
    8. July 2011 at 18:01

    Contemplationist, Yes, I’m kind of embarrassed to have stolen that from Kling. I also want to steal Mickey Kaus’ “editor” as it would work perfectly for my blogging style.

    thruth, Yes, that’s possible.

    Liberal Roman, It seems to me that conservatism become somewhat anti-intellectual after they won battles on high MTRs, price controls, crime, welfare, and communism. They had the high ground on those issues. They are not as good on health care, war on terror, war on drugs, gay rights, global warming, etc.

    Also, the GOP became lower income, more populist, and more corrupt.

    John Hall, They are wrong; markets determine interest rates, not central banks. If the central bank tried to set the rate below the Walrasian equilibrium, you’d explode into hyperinflation. That’s what almost everyone is missing. That’s why I predict Krugman and I will continue to be right about interest rates and inflation.

    But you are right about supercycles, I’m starting to drink the koolaid of predicting markets. Blogging has gone to my head.

    John Thacker, Yes, that’s about right.

    W. Peden. Thanks.

    Left Outside, See my final comment to John Hall. 🙂

    The big problem with Brown’s policy was that he raised government spending as a share of GDP when Britain was booming. No ammo left for the recession. He should have studied Australia and Singapore.

    Benjamin, Yes, we should explain to new readers that you mean inflation hawks.

    B, Touche. (I meant negative about Krugman.)

  11. Gravatar of Howard Howard
    9. July 2011 at 10:08

    But the clue regarding a likely mistake was available – “opportunistic disinflation.” You’ve commented on this before.

  12. Gravatar of Scott Sumner Scott Sumner
    10. July 2011 at 06:28

    Howard, Good point–but I assumed they’d stop at 2%. Big mistake.

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