Krugman on 2013 vs 1958 macro

At the recent American Economic Association meeting in San Diego, Brad DeLong chaired a panel on ” Stimulus or Stymied?: The Macroeconomics of Recessions“, and has posted a transcript. Paul Krugman was there and picked up my claim that macroeconomics has, on balance, gone backwards since 1958. I’ve extracted his section here. Lots of useful stuff, but I’d stress this:

the whole basis on which we constructed monetary policy during the Great Moderation, which is that stabilizing inflation and stabilizing output are the same thing, is all wrong: you can have a sustained period of low but not negative inflation consistent with an economy operating far below its potential productive capacity. That is what I believe is happening now. If so, we are failing dismally in responding to this economic crisis. This is in contrast to what some central bankers are saying—that we have done well because inflation has stayed relatively stable.

To push this a bit further, I’d argue that there will be no real recovery as long as central banks continue to treat the inflation-targeting polices of the (spurious) Great Moderation as the pre-crisis normal to which we should strive to return

Krugman remarks to panel on The Macroeconomics of Recessions

Let me try to talk about where I think we stand and what the fiscal-policy issues ought to be.

The basic story—at least as many of us see it—is that we had this really, really dramatic shock to private spending. This is the private-sector financial deficit: gross private domestic investment minus gross private domestic saving as a share of potential GDP as estimated by the CBO. This is not the first time in the post-WWII era we have had a big drop, but it is the biggest: 10% of potential GDP. [30:00] The previous ones in the mid-1970s and early-1980s were associated with tight monetary policy, very high interest rates, and collapses in housing investment driven by tight monetary policy—which, of course, sprang back as soon as the Federal Reserve decided that the American economy had suffered enough.

This time is different. This time it came spontaneously. This time it came in spite of drastic cuts in interest rates to essentially zero.

The question is: “What do we do?”

There is an interesting debate: “When did economics go all wrong? When did macroeconomics go all wrong?” Bob Gordon has rather persuasively made the case that it went all wrong about 1978—that we would have done a better job at macro policy if we had met this crisis with the intellectual panoply we had then and had not had the thirty years since. I saw John Quiggin just made the argument that things actually went all wrong about 1958.

If an economist from 1958 had seen what is going on now, he—and back in 1958 it would have been “he”—would have said: “OK. Private sector does not want to spend. The government should spend. This is a powerful case for fiscal stimulus to prevent this from causing a persistent slump.” We have not done that. We had some fiscal stimulus delivered for a brief period of time in 2009. We have had a fair bit of allowing automatic stabilizers to operate. But at the same time we have had quite a lot of policy austerity. We had a worldwide or at least an advanced-world turn to austerity in 2010 inspired to some extent by the lessons that were drawn—I would say mostly wrongly—from the story of Greece but then applied across the board, and also from a reversion to pre-Keynesian modes of thinking about the macroeconomy. Whatever the reasons—and there are a mixture of political-economy reasons and just plain bad-economics reasons—we made a big turn to austerity. Now we debate: “Was that wrong? How wrong was it? Should we really be doing as much fiscal stimulus as the man from 1958 would say?”

Think about the objections to stimulus. I would put them into three categories:

First, perhaps we do not have nearly as much economic slack as people like—well—me say. Perhaps there is something much more structural going on, and we do not have that much room to expand. We have a huge economic failure, but the failure is not for the most part a simple failure of aggregate demand.

Second—you do not hear this story that much, but it is important to set up the third—is that we should not be using fiscal policy but should instead by using monetary policy. That is a more popular argument in the more informal discussion in the econoblogosphere than it is in academia. But there is the question of what you can do.

Third, even though we are at the zero lower bound, fiscal policy is a lot less effective than the man from 1958 would say it is, and that multipliers are quite low even under urgent conditions.

About limited economic slack:

There is a whole literature trying to identify structural issues—what does the shift in the Beveridge Curve mean—that would be an entirely different discussion. I think the most important argument that has the biggest impact is the argument: “If we have all that economic slack, where is the deflation?” When we look at core inflation, it dropped a lot in the crisis, but has been fluctuating in a 1-2%/year range since then and has not been declining. You will see the argument, which is consistent with what most Principles of Economics or Intermediate Macroeconomics textbooks say or would have said before the crisis, that if we really had a large output gap we should be seeing not just low but declining inflation. The stability of the core inflation rate is an indication that there is not a lot of economic slack. The most recent speech by James Bullard makes that case. The San Francisco Fed has a nice updated chart estimating the output gap by backing it out of a linear expectational Phillips Curve and comparing it to the CBO output gap which is a gussied-up trend. The difference is striking. The stability of inflation says that there is hardly any output gap. Comparing us to the pre-crisis trend says that there is still a very large output gap: $900 billion/year of potential non-inflationary production of goods and services is simply not happening.

Brad asked: “What have we changed our views about?” The inflation process is one area in which I have changed my views. It has become much more apparent that downward nominal rigidity—not just stickiness but people don’t like to cut nominal prices and wages—is a very significant factor. When you have a depressed economy in a state of initially low inflation the zero bound not just on interest rates but on wage changes becomes a really big deal. Again, more San Francisco Fed stuff: they have tried to back out how many people are literally getting zero wage change. The answer is: “a lot”. That suggests that we are indeed an economy in its depressed state, and that the reason that average wages continue to rise is that we have truncated the left edge of the distribution, not that we have anything close to full employment.

That is very important, if true. Among other things, it means that the whole basis on which we constructed monetary policy during the Great Moderation, which is that stabilizing inflation and stabilizing output are the same thing, is all wrong: you can have a sustained period of low but not negative inflation consistent with an economy operating far below its potential productive capacity. That is what I believe is happening now. If so, we are failing dismally in responding to this economic crisis. This is in contrast to what some central bankers are saying—that we have done well because inflation has stayed relatively stable.

Monetary policy: When I arrived at Princeton in 2000 there was a group of us—“Japan worriers”. I am the only one still there. Mike Woodford, Lars Svensson, who is now run off to the Riksbank, me, and Ben Bernanke—I wonder what happened to him? All of us were very concerned by what was happening to Japan in the 1990s. Some people looked at it and said: “That just shows how messed up the Japanese are.” Some of us looked at us and said: “Surface differences apart, Japan looks a lot like us: big advanced country, lots of room to maneuver, government officials who might not be the most brilliant but who were not complete idiots, and if they could get trapped in this sort of deflationary stagnation then it could happen to us.” Sure enough, it did.

At the time, all of the discussion was about what you could do by way of monetary policy. Could the central bank by unconventional purchases of non-standard assets move expectations? The simple fact is that dramatic changes in the simplest measures of what central banks are doing—the size of the monetary base—have been invisible in their effect on either inflation or output. I think we have to say that at this point to make the argument that if only the central bank really wanted to we would be doing much better needs to be accompanied by a very clear explanation of how that it is supposed to work and why the effects of monetary policy to date have been so limited. There is in principle the expectations channel. If a central bank can credibly promise that it will allow a higher inflation rate over the medium term then it ought to be able to reduce real interest rates and have a significant expansionary effect on the economy. The problem is how do you in fact make that promise credible. There are multiple hurdles that you have to cross. First, you have to cross the threshold of the political acceptability of the policy of changing the inflation target, which has proved virtually impossible to tackle in part because people do not think that this is a permanent crisis. They may be right. But that means that it is then very very hard to say that we should change the price-level target for five or ten years in the future to deal with a crisis that everybody expects will be over in a year .

Then, how do you make it credible? Why will the people running the central bank five or ten years from now—who are not the people running it now—go through with it? In an unfortunate phrase I used back in 1998 about Japan, they have to credibly promise to be irresponsible. That is the issue. It has turned out, I think, that, as Michael Woodford says, while in principle unorthodox monetary policy can deal with a situation like what we have now, in practice it is really really hard to see how this could work. And that makes you lean on fiscal policy.

Last comes the question about the effectiveness of fiscal policy. Valerie Ramey will present evidence on the size of multipliers. What are multipliers? That is a critical issue. The trouble is that fiscal policy is very hard to assess econometrically from the historical record. The basic rule is that when all is said and done, no matter how much effort we put it and in spite of all the valid work we do, unless you can show clear natural experiments people are not convinced. Even with natural experiments people are often not convinced, but it is your best chance. And convincing natural experiments are hard to come by. The clearly-exogenous changes in government spending are pretty much those associated with wars. This is just the very simple stuff that Bob Hall did just a little while back. They clearly show that expansionary policy is expansionary. They also show that the multiplier is less than one, which is not what an enthusiastic advocate of Keynesian fiscal stimulus would like to see. Again, the IMF tried recently very carefully to tease out the answer, and again found that expansionary policy is expansionary and contractionary policy is contractionary, but once again multipliers are less than one.

The IMF has changed its mind, or at least Oliver has changed his mind. But that’s where we are.

The question then becomes: is this historical evidence relevant for what we face now? The historical evidence incorporates a lot of crowding-out. The question is then: where is this crowding-out coming from? One answer is the old textbook crowding-out: crowding-out via rising interest rates. That is clearly relevant to the historical cases but not relevant now. A second answer is that in wartime other things are happening. I believe that a lot of the literature on this understates the seriousness of this issue. It’s not just that the multiplier is lower at full employment. During World War II there was severe rationing of consumer goods. During World War II—I have not seen this mentioned at all—there was essentially a prohibition on private construction. You look at World War II and say “private spending fell”. What relevance does that have? We are not about to have such controls on private investment. [45:00]

We can look at periods that do not have war complicating the picture, and the problem is that there is not a lot of that. For the U.S., the World War II period before wartime controls come in is about a year and a half, six quarters. If you are going to use VAR time-series methods, you can look at quarters that have both high unemployment and large changes or news of large changes in military spending, the problem is that the impulse response period extends well into the period of wartime controls. It is not at all easy to get past that.

Finally, Ricardian effects. It is really important to understand how many people misunderstand that. There are many people who believe that higher government spending now means higher taxes later and this will crowd-out private spending now. But higher spending now means higher incomes now as well. In the simplest Ricardian setup, if you believe that resources are unemployed and if interest rates are zero, the multiplier is not zero but one. It is very difficult to come up with a story in which the current multiplier would be less than one. Invoking the expectation of future tax increases as a reason for a multiplier less than one is a much more difficult story to tell than people seem to imagine.

Our evidence is not great. The closest thing to a really good natural experiment is what is happening now—the scary policies of recent years. It is not perfect. But look at the euro area countries—we talk about the great mistake of 1937, Roosevelt’s turn to austerity, but his turn to austerity was less than 3% of GDP. Compare that to what is happening to Greece or Ireland now, that is nothing. In Greece, if the whole program is implemented, we are talking about austerity on the order of 16% of GDP. These are enormous shocks. And if you do a simple regression it looks like a multiplier of 1.3.

The immediate objection is that causation is not reversed? This is where the Blanchard-Leigh stuff comes in: They look at forecast errors in output growth and forecast errors in future policy, and find that their forecasts of output growth which assumed a multiplier of 0.5 underestimated the true multiplier by about 1.0, systematically understating economic contraction in countries with larger-than-expected degrees of austerity.

I think their work is good. Of course, it fits what I wanted to believe, so you have to be careful. But very important stuff, if true.

The final point is policy: Are we sure that expansionary fiscal policy is the right thing to be doing and that austerity is a terrible, terrible mistake? No. We are absolutely sure of nothing. But the consequences, if that is the truth, and I think the evidence tilts that way, is that what we are doing right now is absolutely disastrous. And that is where we are right now.

44 thoughts on “Krugman on 2013 vs 1958 macro

  1. Ikonoclast #7
    Another one of your brilliant writing.
    On the first part i would just say; When all you have is a hamer then every problem looks like a nail sticking out.

    Fetishizing the money as real value is the mistake neoclassical make all the time.
    For exsample; Everybody knows that taxes take away from private sector, but most of them forget implications of that.
    If taxes take away from private and give it to public sector, that implys that government (public) surplus means that public sector took more in then gave back to private sector.
    If taxes take away from private sector then that automaticly implys that government deficit gives more to private sector then it takes away in taxes.

    Hence gov surplus is bad for private sector and gov deficits are good for private sector.

    Deficit or surplus is not either bad or good for a sovereign government.

    For sovereign issuer of the currency it is visible that accumulated defficit does not present a problem to the government ability to keep accumulating it and by doing so benefiting the private sector. Neither as problem for servicing that debt nor as a problem for private sector trough interest rates.
    For great example is Japan, even tough USA is not a bad example of a deficit not giving any problems.

  2. Are you suggesting that the nations of the world include in their constitutions a commitment to abide by the gold standard?

  3. I think the onus is on TerjeP to explain why a return to Gold Money or the Gold Standard, as in the variant of 1958 or some other epoch, will cure all, or some significant ills, of the modern economy, if that is his claim.

    This is interesting;

    “According to Keynesian analysis, the earliness with which a country left the gold standard reliably predicted its economic recovery from the great depression. For example, Great Britain and Scandinavia, which left the gold standard in 1931, recovered much earlier than France and Belgium, which remained on gold much longer. Countries such as China, which had a silver standard, almost avoided the depression entirely. The connection between leaving the gold standard as a strong predictor of that country’s severity of its depression and the length of time in its recovery has been shown to be consistent for dozens of countries, predominantly in developing countries. This may explain why the experience and length of the depression differed between national economies.” – Wikipedia.

    Now even I do not say that correlation equals causation. The length of a person’s hair can predict their gender with a fair degree of accurracy.

    Saying that leaving the gold standard is responsible for part or all of economic ills now is like me saying, “You know I only started to age once I started drinking coffee. Therefore coffee causes ageing.”

  4. As a footnote, let me say, I am always sceptical about proposals for simple solutions to complex problems. In the face of complex or “wicked problem”, a great many people tend to fixate on the possibility of a single fix-all or silver bullet (or even gold bullet) for the problem. Here’s a short list of wicked problems followed by the simple “solutions” commonly proposed;

    1. Crime -> Increase punishment
    2. Drugs – > Prohibition
    3. Refugees -> “Stop the boats”
    4. Climate change -> Deny it.

  5. What i think that hugely afects the fiscal multiplyer are multitude of conditions in today’s advanced economy.
    First is the high productivity, when government orders more spending in an environment with a lot of spare capacity it doesn’t take a lot of additonal spending on the side of a corporation to fill new orders and a lot of stimulus goes to profits which are not spent but saved. A corporation can add only few employees and extend hours of present ones or hire temp jobs, all on very low wage which contributes little to total buying power.

    Another condition is the borrowers on the edge of a default that were unemployed but with government stimulus get employed and decide to keep paying off the debt instead of defaulting.

    These can lower fiscal multiplyers significantly when it is considered to do fiscal stimulus.
    To make them more effective, the governments have to raise minimum wage and limit working hours.
    With rising productivity and automatisation of workplace there has to be implemented higher wages and reduced workhours or there will be need for very small workforce and rest of them will be out of job while government will be presed for finances to provide for safety nets.

    Todays advanced economies require about 15% of workforce for esential provision to 100% of population, with more and more robotization and computer use the percentage of necessary workforce will keep shrinking. Aging of population can not keep up with rise in productivity to have a work force fully employed, even with more and more people employed in entertainment sector or archeology does not cover for it.
    Work hours have to be reduced and minimum wage raised to cover for rise in productivity in order to have full employment.
    Recent debt collapse in USA and EU shows that even debt as a mean to continue Nominal Surplus Circulation has its limits. A debt jubilee could restart that cycle again without waiting for deleverage which could last another 20 years.

    Combination of debt jubilee and reduced workhours with dramatic rise in minimum wage would stop this Great recession right away.
    To accomodate for natural resource limit we have to equalize the income distribution by high marginal tax or with worker cooperatives, maybe both.

  6. now you come and say that “limited government” in the Constitution means how much government can spend and how many to employ.

    Another Turkey that wants to put words in my mouth. Jordan, where have I ever said what you just claim I said? I may like such limits to be added to the constitution but I certainly never claimed that they were already there. However the condition does define other limits. For instance the just compensation clause limits the federal governments capacity to appropriate land.

  7. Come on Terje, stop being disingenuous: “I may like such limits.”…yay or nay – say what you mean and mean what you say! We are entitled to apply “bounded rationality” when you disguise your views.

  8. You asked for it:

    a gold-based system lasts only as long as the governments of financially important nations agree to play by the rules.

    onto which you replied

    Katz – national constitutions only work so long as governments agree to be limited by them.

    Gold standard is not in almost no state constitution so it is totaly unto a governing body to decide to get on or off a gold standard. Under gold standard it is not a democracy that can decide how much government can spend it is only a convention of Gold standard that decides and with that GS limits democracy and the will of the people.

    It is obvious that you meant GS as a limitation on govermnet, with that it means limitation on democracy deciding how much government can spend. Your sentence clearly means that “National constitutions only work so long as they agree to be limited by GS” hence it says that GS is in national constitutions.

    Under GS, only banks are allowed money printing which over time accumulates a lot of new money which when deleverage comes start destroying that same money by paying off the loans without making new ones. Total Debt service is conditioned on ever growing debt. if total debt in an economy start to shrink then total money in economy also shrinks.
    With total money shrinking but total products do not, then it comes to deflation in order to cover ammount of exchanges in economy. Prices and wages shrink but debt does not, which produces economy wide illiquidity with a lot of spare capacity which can not be used only because of illiquidity.

    GS prevents government from supplying enough liquidity needed for employing spare capacity since it is the only entity willing to do it and banks can not provide more loans due to deflation or bad liquidity.
    To provide last resort liquidity government have to get off the GS and employ spare capacity.
    GS does not prevent printing money by banks and with that can not prevent inflation.
    GS only prevents fighting deflation.

  9. Jordan – a gold standard does not stop a government having a whopping load of tax and spending like drunken sailors. And your contortions to put words in my mouth are fascinating but I’ll pass up trying to defend things I never actually said. Stop being a pain.

  10. Kevin1 – my apology for being unclear. I would like such limits to be in our constitution. However clearly they are not, and clearly I never claimed that they were.

  11. So I don’t understand economics. But aren’t there enough accidental small experiments to be able to estimate these economic parameters from?

    For example, we just did an experiment in Australia with the carbon tax and coincident adjustment of income tax rates. We can look at the result of this experiment. Of course it may be that other factors hide the effect of this experiment, but if we find enough experiments, then the actual effect will emerge through the statistics. Another such experiment has just started with the benefit cut to single parents whose youngest is over 8 years old…

  12. Oh feck off, Terje. Your gold bug nonsense was boring and unconvincing 5 years ago and it hasn’t improved since then. Take it somewhere else.

  13. This discussion is getting horribly off-topic, but if you want to find a subject on which more economists agree than any other, it would be hard to find one beyond “the benefits of an independent central bank over a metals standard”. This is a horribly large topic, but to sum up in a few words the gold standard is wasteful, inefficient, and leads to increased economic instability. I’m sorry, but I can’t cover on the economic side the theories of money, benefits of inflation, severe issues with deflation, problems with supply and demand of gold, fractional reserve banking etc etc. I also can’t cover on the historical side the exogenous factors that caused hyperinflation where it came about – hyperinflation occurred because there was literally no other option amidst war and chaos and ruin, and not because functional democratic governments want a “free lunch”.

  14. Floating exchange rates are theoretically more efficient than a fixed currency standard, in maintaining the external balance the trouble is some countries cheat . It’s interesting that Terje the free market champion thinks that the government should have a policy of maintaining an often incorrect price of the currency over free market pricing.

  15. The New Keynesians are almost as clueless as the neoclassicals as to the dynamics of money creation. Krugman is no different to the rest in that respect, as demonstrated by Steve Keen.

  16. TerjeP :
    Mel – love it or loath it the gold standard was used across the world in 1958.

    That point is irrelevant when discussing the efficacy of the gold standard. To use the point above, why not mercantilism?

    Look amigo, from what you have posted I assume you follow the Austrian school? Why on Earth would anyone do that? Austrian economists are batting at a strike rate of 0.00. Literally everything they said is wrong. Historically, the only thing they do is predict fire and brimstone and economic despair, and they have successfully predicted 23 of the last 3 major financial events. Continually calling for bust periods may provide the veneer to fool the ignorant but their kind of prognostications are on the same level as me saying there will be a war in the future. True, but utterly useless.

    There has been no hyperinflation or interest rate increases or massive increases in the gold price (the highest point was $1800/oz in about August last year attributable to the Republicans holding the economy hostage) while Krugman, working with simple bog-standard macroeconomic tools, has been right more often than not. You also mention malinvestment. Malinvestment in what market? The marketplace consists of the exchange between buyers and sellers of millions of commodities, and there is simply no single natural rate of interest (this is one of the arguments used by Sraffa in the ’70s to debunk Austrian economics).

    I know why the Austrian school is more popular than not. Unfortunately it comes down to the conspiracy theory mindset. Unscrupulous folk appeal to people’s desire for secret knowledge and the feeling of being oppressed. The ego boost from knowing that you are right and everyone else is a mindless sheep is profoundly gratifying. You could critically examine the evidence, and most likely come to the conclusion that the Austrian school is more heat than light and hence begin a long, painful process of learning; or you could dismiss it all with a sneer and retreat to Cafe Mises, Drudge Report and Zero Hedge.

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