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Krugman on monetary and fiscal stimulus

Summary:
My recent working paper on the “Princeton School” of macroeconomics discussed two interpretations of Paul Krugman’s 1998 paper, which had suggested that a “liquidity trap” is actually more accurately viewed as a sort of expectations trap. In what I called the old Keynesian interpretation, monetary policy is ineffective at the zero lower bound because central banks cannot credibly “promise to be irresponsible”. In the new Keynesian interpretation of Krugman’s paper, monetary policy is still effective if the central bank promises a future path of inflation that is high enough to generate a robust recovery in aggregate demand. Thus the effectiveness of monetary policy is not a purely technical question, it also depends on the politics of central banking.A “Straussian” reader

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My recent working paper on the “Princeton School” of macroeconomics discussed two interpretations of Paul Krugman’s 1998 paper, which had suggested that a “liquidity trap” is actually more accurately viewed as a sort of expectations trap.

In what I called the old Keynesian interpretation, monetary policy is ineffective at the zero lower bound because central banks cannot credibly “promise to be irresponsible”. In the new Keynesian interpretation of Krugman’s paper, monetary policy is still effective if the central bank promises a future path of inflation that is high enough to generate a robust recovery in aggregate demand. Thus the effectiveness of monetary policy is not a purely technical question, it also depends on the politics of central banking.

A “Straussian” reader might have noticed that I was writing this paper in part to boost my own view of monetary policy, which is closer to the new Keynesian interpretation of Krugman’s 1998 paper. Now Krugman has a new working paper that comes down squarely on the old Keynesian side of the issue; monetary policy cannot be counted on going forward, and aggressive fiscal stimulus is the best option for maintaining full employment when there is insufficient aggregate demand. Here Krugman explains why he is skeptical of a purely monetary approach:

The seemingly natural answer would be to raise the inflation target. But central bankers are firmly opposed, and conventional wisdom among those willing to take any of this seriously seems to have migrated toward the use of persistent fiscal stimulus to raise r* sufficiently that monetary policy can do the job with the existing inflation target.

It’s important to be clear that relying on a fiscal solution rather than a higher inflation target is, in effect, a choice to pursue higher public spending at the expense of lower private investment. As I said, a liquidity-trap economy in effect “wants” inflation; choosing not to accept that inflation is a decision to impose lower private investment than the free-market economy would choose on its own.

The main reason to engage in this de facto policy of crowding out is the suspicion that there are significant costs to inflation, even if it is in the low single digits, combined with the belief that the social costs of crowding out some private investment are low.

Here’s how Krugman concludes his paper:

Nonetheless, at the moment the case for a fiscal response to the threat of a liquidity trap, as opposed to a higher inflation target, is stronger than the “Princeton School” envisaged in the early 2000s. Maybe central bankers don’t need to be credibly irresponsible after all.

As is generally the case, Krugman’s paper is very well written and he’s good at clearly explaining the intuition behind his analysis.

Clearly Krugman doesn’t believe that a 2% average inflation target (AIT) is enough to get the job done in the modern world of very low equilibrium interest rates. While I don’t view a 2% AIT policy as optimal, I’m much more optimistic than Krugman about its effectiveness. I suspect that our differing views are based on differences in how we visualize the role of monetary policy in the business cycle. I’ll try to describe Krugman’s views to the best of my ability, and then explain where I disagree.

Krugman sees the economy being hit by occasional demand shocks, mostly due to instability in the investment sector of the private economy. Events such as the housing boom and bust of 2006 lead to a sharp fall in the equilibrium interest rate, at which point conventional monetary policy is largely ineffective. Even an average inflation targeting policy, which might call for a couple years of 3% inflation after a deep slump, is not enough. You need aggressive fiscal stimulus.

In my view, the private economy is not inherently unstable. Unlike most economists, I view the 2008 slump as being caused by an inappropriately tight monetary policy that allowed NGDP expectations for 2009, 2010 and 2011 to fall well below the previous trend line, and well below the levels expected in 2007. A level targeting policy (P or NGDP) that committed to do whatever it takes to get back to the previous trend line would have allowed the US to largely avoid the post-Lehman banking crisis, and would have prevented the equilibrium interest rate from falling nearly as far as it fell when NGDP expectations collapsed in 2008. I don’t take the fall in the equilibrium interest rate as a given; I see it as mostly reflecting an excessively tight monetary policy.

Krugman sees the private economy as a sort of arsonist, with the Fed playing the role of an ill-equipped fireman, and the fiscal authorities being a better-equipped fireman. I see the Fed as being an (unwitting) arsonist, which carelessly causes fires that are then inappropriately blamed on the private sector. (The ECB was even more careless in 2008-11, almost criminally negligent.) Unlike the ECB, the Fed didn’t raise rates in 2008. But it did not cut them fast enough, and more importantly it failed to credibly promise some sort of level targeting make-up policy.

My view is certainly more counterintuitive, and is clearly the minority view within the economics profession. In 2008, it certainly looked like the private sector was at fault. But that’s why I started this blog. Indeed my recent book was written to persuade people that my view should be taken more seriously.

In the end, I’ll probably fail to persuade the rest of the profession. But I won’t abandon my view unless people can provide good reasons why my analysis is wrong. Thus far, I have not seen a persuasive rebuttal.

PS. Krugman also covers other issues related to fiscal policy, such as the importance of r < g, the role of housing in the business cycle, and the efficiency cost of various approaches to stabilization policy. (The whole paper is well worth reading, even if you don’t agree with Krugman.) Thus I don’t mean to suggest that the issue I raised here is the only factor explaining why Krugman and I differ on the relative merits of monetary and fiscal policy, but I believe our differing views on the cause of recessions is the decisive factor.

PPS. At one point Krugman discusses what he views as the instability of the private sector:

I’ve written this paper largely as if r* were a constant or at least slowly moving number. In reality, however, a low-inflation economy appears to be subject to large fluctuations driven by private-sector overreach and retrenchment: the commercial-real-estate-driven cycle of the late 80s/early 90s, the tech boom and bust of the late 1990s, the monstrous housing bubble of the mid-2000s.

Those familiar with Kevin Erdmann’s research know that there was no “monstrous housing bubble” during the 2000s. Housing construction was not abnormal for an economic expansion, and in most areas house prices were not far out of line with fundamentals.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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