More musings on the current episteme of the Federal Reserve…
Paul Krugman’s Respectable Radicalism politely points out (at least) one dimension along which I am a moron.
Let me back up: Here in the United States, the current framework for macroeconomic policy holds that the economy is nearly normalized, that further extraordinary expansionary and fiscal policy moves carry “risks”, and that as a result the right policy is stay-the-course. I was arguing that the Economist Left Opposition demand–for substantially more expansionary monetary and fiscal policies right now until we see the whites of the eyes of rising inflation–was soundly based in orthodox lowbrow Hicks-Patinkin-Tobin macro theory. That is the macro theory that economists like Ben Bernanke, Janet Yellen, and Stan Fischer taught their entire academic careers.
Paul Krugman points out—politely—that I am wrong.
The Economist Left Opposition framework contains at least one claim that is substantially non-orthodox: We claim that worries about the debt accumulation from expansionary fiscal policy right now are profoundly misguided. Under current conditions, the government’s borrowing money or printing money and buying stuff does not raise but lowers the debt-to-annual-GDP ratio. However large you think the influence of an outstanding debt burden on interest rates happens to be, interest rates in the future will be lower, the debt as a multiple of annual GDP will be lower, and thus the debt financing burden and all debt-related risks will be lower in the future with a more expansionary fiscal policy than baseline. This is definitely nonstandard. And it is embarrassing to note that this is my idea–or, rather, Larry Summers and I were the ones who did the arithmetic to show how topsy-turvy the macroeconomic world currently is with respect the fiscal policy. This was a really smart thing for us to do. And it is definitely not part of the standard orthodox policy-theory framework in the way that the rest of the Hicks-Patinkin Economist Left Opposition framework is.
As Paul writes:
: Respectable Radicalism: “Hysteresis [in the context of very low interest rates]… is indeed a departure from standard models…
…But the [rest, the] case that the risks of hiking too soon and too late are deeply asymmetric comes right out of IS-LM with a zero lower bound… the framework I used….
Being an official… can create a conviction that you and your colleagues know more than is in the textbooks…. But… [at the] zero-lower-bound… world nobody not Japanese [had] experienced for three generations, theory and history are much more important than market savvy. I would have expected current Fed management to understand that; but apparently not.
I wrote about Rawls’s reflective equilibrium idea yesterday, so let me just cut and paste: Are models properly idea-generating machines, in which you start from what you think is the case and use the model-building process to generate new insights? Or are models merely filing systems–ways of organizing your beliefs, and whenever you find that your model is leading you to a surprising conclusion that you find distasteful the proper response is to ignore the model, or to tweak it to make the distasteful conclusion go away?
Both can be effectively critiqued. Models-as-discovery-mechanisms suffer from the Polya-Robertson problem: It involves replacing what he calls “plausible reasoning”, where models are there to assist thinking, with what he calls “demonstrative reasoning”. in which the model itself becomes the object of analysis. The box that is the model is well described but, as Dennis Robertson warned,there is no reason to think that the box contains anything real. Models-as-filing-systems are often used like a drunk uses a lamp post: more for support than illumination.
In the real world, it is, of course, the case that models are both: both filing systems and discovery mechanisms. Coherent and productive thought is, as the late John Rawls used to say, always a process of reflective equilibrium–in which the trinity of assumptions, modes of reasoning, and conclusions are all three revised and adjusted under the requirement of coherence until a maximum level of comfort with all three is reached. The question is always one of balance.
What I think Paul Krugman may be missing here is how difficult it is to, as Keynes wrote:
The composition of this book has been for the author a long struggle of escape… from habitual modes of thought and expression. The ideas which are here expressed so laboriously are extremely simple and should be obvious. The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds…
In this case, the old ideas with respect to the budget deficit are those of various versions of fiscal crisis and fiscal price level theory developed largely out of analysis of Latin American and southern European experience, and those of various versions of monetarist theory based upon the experience of the 1970s. How difficult this is is illustrated by one fact I find interesting about Paul Krugman (1999): Back then, his analysis of the liquidity trap and fiscal policy back in 1999 was… very close to Ken Rogoff’s analysis of the liquidity trap and fiscal policy today:
(1999): Thinking About the Liquidity Trap, Journal of the Japanese and International Economies 14:4 (December), pp. 221–237: “The story… [of] self-fulfilling pessimism is… a multiple equilibrium story…
…with the liquidity trap corresponding to the low-level equilibrium…. Over some range spending rises more than one-for-one with income. (Why should the relationship flatten out at high and low levels? At high levels resource constraints begin to bind; at low levels the obvious point is that gross investment hits its own zero constraint. There is a largely forgotten literature on this sort of issue, including Hicks (194?), Goodwin (194?), and Tobin (1947))….
Multiple equilibria… allow for permanent (or anyway long-lived) effects from temporary policies. There may be excess desired savings even at a zero real interest rate given the pessimism that now prevails… but if some policy could push the economy to a high level of output for long enough to change those expectations, the policy would not have to be maintained…. Balance-sheet problems… may involve an element of self-fulfilling slump: a firm that looks insolvent with an output gap of 10 percent might be reasonably healthy at full employment….
‘Pump-priming’ fiscal policy is the conventional answer to a liquidity trap…. In either the IS-LM model or a more sophisticated intertemporal model fiscal expansion will indeed offer short-run relief…. So why not consider the problem solved? The answer hinges on the government’s own budget constraint….
Ricardian equivalence… is not the crucial issue…. Real purchases… will still create employment…. (In a fully Ricardian setup the multiplier on government consumption will be exactly 1)….
The problem instead is that deficit spending does lead to a large government debt, which will if large enough start to raise questions about solvency. One might ask why government debt matters if the interest rate is zero…. But the liquidity trap, at least in the version I take seriously, is not… permanent…. [When] the natural rate of interest… turn[s] positive… the inherited debt will indeed be a problem….
Fiscal policy [is] a temporary expedient that cannot serve as a solution [unless]….
First, if the liquidity trap is short-lived… fiscal policy can serve as a bridge… after [which]… monetary policy will again be able to shoulder the load… a severe but probably short-lived financial crisis in trading partners… breathing space during which firms get their balance sheets in order….
[Second, if] it will jolt the economy into a higher equilibrium…. If this is the underlying model… one must realize that the criterion for success is quite strong…. Fiscal expansion… must lead to… increases in private demand so large that the economy begins a self-sustaining process of recovery….
None of this should be read as a reason to abandon fiscal stimulus…. But fiscal stimulus… [is only] a way of buying time… [absent] assumptions that are at the very least rather speculative…
Since 1999, Paul has changed his mind. He has become an aggressive advocate of expansionary fiscal policy as the preferred solution. Why? And is he right to have done so? Or should he have stuck to his 1999 position, and should he still be lining up with Ken today?
One part of the reason, I think, is–and I say this with whatever modesty I have ever had still intact–that DeLong and Summers (2012) has provided one of the very very few additions of conceptual value-added to Krugman (1999). We pointed out that with a modest degree of “secular stagnation”–a modest fall in safe real interest rates over the long run–and a slight degree of hysteresis, fiscal expansion in a liquidity trap does not worsen but improves the long-run fiscal balance of an economy in a liquidity trap. This was something that Krugman missed in 1999. It is something that people like Rogoff continue to miss today.
This has consequences: The more scared you are of some long-run collapse of the currency from excessive government debt relative to annual GDP, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. The more you think that real interest rates in the long run are coupled to high values of government debt relative to annual GDP, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. The more you worry about debt crowding-out useful and productive government spending in the long run, the stronger you should advocate for more expansionary fiscal policy when the economy is in a liquidity trap. This whole line of thought, however, was absent from Krugman (1999), and is absent from Rogoff and company today.
A second part of the reason is that even modest “secular stagnation” does more than (with even a slight degree of hysteresis) reverse the sign on the relationship between fiscal expansion today and long-run government-debt burdens. It also undermines the effectiveness of monetary policy as an alternative to fiscal policy. Monetary expansion–in the present or the future–needs a post-liquidity trap interest-rate “normalization” environment to have the purchase to raise the future price level that it needs to be effective in stimulating production now. Secular stagnation removes or delays or attenuates that normalization.
Third comes the credibility problem.
Fourth, there is a sense in which Paul has not shifted that much. Look at his analysis of Japan…
Third comes the credibility problem. Back in the days of Krugman (1999), he at least had little doubt that a central bank that understood the situation would want to generate the expected inflation needed. That was the way to create a configuration of relative prices consistent with full employment. That was what a competent central bank would wish to do. And a central bank that wished to create expectations of higher inflation would have a very easy time doing so.
The mixed success of Abenomics, however, has cast doubt on the second of these—on the ability of central banks to easily generate higher expected inflation. Japan today appears to be having a significantly harder time generating expectations of inflation than I had presumed. And
With respect to the first—the desire to create higher expected inflation—Ben Bernanke, while chairman of the Federal Reserve, repeatedly declared that quantitative easing policies were not intended to produce any breach of the 2% per year inflation target upward. These declarations were not something that I expected, and were not something that I understood. They still leave me profoundly puzzled.
Fourth, there is a sense in which Paul has not shifted that much. Look at his analysis of Japan today. In his view, fiscal expansion today is needed to create the actual inflation today that will (i) raise the needle on future expected inflation, and so (ii) allow for a shift to policies that (iii) will amortize rather than grow the national debt. Inflation someday generated by the fiscal theory of the price level and high future interest rates generated by the risks of debt accumulation still have their places in his thought.