Must-Read: Paul Krugman: It’s Baaack, Twenty Years Later

Must-Read: Very few people have properly read Paul Krugman’s “It’s Back”. As I understand the paper, one of its key messages is this: When the economy is in a liquidity trap—at the zero lower bound—it wants inflation. Inflation is the way a flex-price economy would keep the zero lower bound from causing a deep, persistent depression. A competent central bank that wants to mimic a flex-price economy as closely as possible in a sticky-price world—a competent central bank that wants to make Say’s Law true in practice even though it is not true in theory—will therefore strain every nerve to generate that inflation. Its leader will not say, as Fed Chair Ben Bernanke said repeatedly, that he does not want higher inflation. He will say that he does. But Bernanke never understood that. And few of those advising him understood that. They had not, I believe, understood Krugman: Paul Krugman: It’s Baaack, Twenty Years Later: “In early 1998 I set out to reassure myself… to show that if Japan was having troubles, it was simply because the Bank of Japan wasn’t trying hard enough…

…But as sometimes happens when you try to model your intuitions explicitly (and is one of the main reasons for doing formal analysis), the model ended up telling me something quite different–namely, that when short-term interest rates are near zero it is not, in fact, easy for the central bank to reflate the economy. In fact, even very large increases in the monetary base will have essentially no effect unless the private sector is convinced that there has been a permanent shift in the central bank’s objectives, a new willingness to accept and even promote inflation. As I put it, the central bank needed to “credibly promise to be irresponsible.”…

Ten years later my fears came true…. With the coming of the global financial crisis the whole advanced world basically turned Japanese, experiencing a protracted era of near-zero interest rates. The United States has emerged from that era, barely; Europe and Japan itself have not. What I want to ask in this paper is how good the analytical approach of 1998 looks in the light of subsequent experience. Were its basic predictions correct? Where did it fall down? What new issues have arisen? And how does its policy prescription look after all these years?…