Krugman and Sumner on fiscal stimulus

Via Mark Thoma (EconomistsView), here is Paul Krugman espousing the Keynesian view that fiscal stimulus is necessary to stimulate an economy caught in a liquidity trap, with low interest rates and low expected inflation.

As I see it, the whole structural/classical/Austrian/supply-side/whatever side of this debate basically believes that the problem lies in the labor market. …. For some reason, they would argue, wages are too high….

As regular readers know, I find this prima facie absurd ….

So what’s the alternative view? It’s basically the notion that the interest rate is wrong — that given the overhang of debt and other factors depressing private demand, real interest rates would have to be deeply negative to match desired saving with desired investment at full employment. And real rates can’t go that negative because expected inflation is low and nominal rates can’t go below zero: we’re in a liquidity trap. ….

There are strong policy implications of these two views. If you think the problem is that wages are too high, your solution is that we need to meaner to workers — cut off their unemployment insurance, make them hungry by cutting off food stamps, so they have no alternative to do whatever it takes to get jobs, and wages fall. If you think the problem is the zero lower bound on interest rates, you think that this kind of solution wouldn’t just be cruel, it would make the economy worse, both because cutting workers’ incomes would reduce demand and because deflation would increase the burden of debt.

What my side of the debate would call for, instead, is a reduction in the real interest rate, if possible, by raising expected inflation; and failing that, more government spending to increase demand and put idle resources to work. …. [emphasis added]

Paul Krugman, “The Price Is Wrong“, The Conscience of a Liberal, New York Times blog, 30 March 2013.

This was standard textbook economics decades ago when I studied macroeconomics. If I had read this yesterday – instead of today – I would have agreed completely with Krugman. Now, I have to confess that I was never a good student of macroeconomics. The theory never made much sense to me. But last night I listened to a podcast of Bentley University economist Scott Sumner, which opened my eyes. This shows that it is never too late for an old economist to learn new tricks. I now realize that, unless a central bank is totally incompetent, Krugman is wrong.

Note that Krugman states that it is optimal to use monetary policy when interest rates are at or near the zero lower bound, because increasing inflationary expectations will cause the real – inflation adjusted – interest rate to fall. Only “failing that”, does he call for “more government spending to increase demand and put idle resources to work”.

Now, suppose the central bank is not incompetent, but only targets inflation, and wants to keep it low. This implies that the central bank will tighten monetary policy to offset any fiscal stimulus. Only if the Central Bank does not know how to change inflationary expectations (and that is not difficult to do!), will fiscal stimulus work.

For a clearer explanation, listen to the Sumner podcast. Here is a portion of the podcast highlights, beginning after minute 49:36:

Guest: [D]uring normal times, when interest rates are positive, almost all mainstream macroeconomists agree that monetary policy is the proper tool for stabilizing the economy, not fiscal policy. …. [T]hat part is not controversial. Here’s where it gets controversial: When interest rates fall to zero, is there once again an argument for using fiscal stimulus? Paul Krugman and others say yes. Now, at zero interest rates there’s a powerful argument for using fiscal stimulus because monetary policy is ineffective. However, Paul Krugman and others also say: Well, monetary policy actually could do a lot more if the Fed were really willing to be more aggressive; but they are just too conservative to do the things they really need to do. Therefore we need fiscal stimulus. And my response to the Keynesians is: Then you are sort of arguing for fiscal stimulus on the basis of incompetent monetary policy. Which is defensible. But if you look more closely at the Fed and ask in what way are they incompetent, they are not incompetent in the right way in my view to make fiscal stimulus work. Let me explain that.

Russ: Fiscal or monetary?

Guest: Fiscal. In other words, what I talk about is what’s called a ‘monetary offset.’ The easiest way to see this is if fiscal stimulus really did boost aggregate demand, it would raise inflation. At least a little bit. Now, if the Fed is targeting inflation it will just tighten monetary policy to offset that. It will prevent inflation from rising and it will thwart the intentions of the fiscal stimulus. So, in order to make fiscal stimulus work, you need an incompetent central bank [emphasis added]. You need one that isn’t effectively targeting inflation. …. And instead just sort of passively lets fiscal stimulus move inflation up and down according to the whim of Congress. But I would argue that this vision the Keynesians have of monetary policy becoming passive at a zero interest rate is simply flat out wrong. Yes, the Fed has been too cautious; they’ve been too conservative to promote recovery that both Krugman and I would have liked to see. But they’ve been passive in a very specific way. …. [T]his year a lot of Keynesians said: Now we’ve had these tax increases; now the economy is really going to slow, because our models say that’s a fiscal austerity. And at the beginning of the year I said no, probably GDP is going to grow just as fast in 2013 as in 2012, even though they’ve raised the payroll tax and they’ve raised taxes on the rich and they’ve cut some spending recently.

Russ: Sort of.

Guest: The spending is debatable. But there’s no question at the end of 2012 they did enough fiscal tightening, according to the Keynesian models, to knock about 1.5 points off GDP. That was at least what I’d been seeing in the Keynesian articles. Now, we’ll see how it plays out. But it wouldn’t surprise me at all if GDP is just as strong this year as last year, because the Fed’s actions, which were taken partly to offset this Fiscal Cliff, will essentially neutralize the effect of it. …. In fact, recently I’ve seen some articles suggesting growth is even picking up a little bit in the last few months. Which is exactly the opposite of what should have happened if the fiscal austerity model was correct. So, no, I don’t think fiscal policy has an effect because I think the Fed neutralizes it. They have their own target.

Sumner on Money, Business Cycles, and Monetary Policy“, hosted by Russ Roberts, EconTalk, 25 March 2013.

The full podcast is about 70 minutes in length. Listen to all of it, and become enlightened.

Tags: ,

Comments are closed.