Paul Krugman Looks Back at the Last Twenty Years of the Macroeconomic Policy Debate

Preview of Paul Krugman Looks Back at the Last Twenty Years of the Macroeconomic Policy Debate

Everybody interested in macroeconomics or macroeconomic policy should know this topic backwards and forwards by heart. My problem is that I do not see how I can add value to it. The only thing I can think of to do is to propose two rules:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to rule #1.

I do wish that those who were not bad actors who made mistakes would ‘fess up to them. Those who don’t will get moved to the “bad actor” category: and, yes, I am looking at you, Marvin Goodfriend.

The only remaining question, I think, is whether these should all be read in chronological or reverse chronological order. I find myself torn, with arguments on both sides having force:

Ben Bernanke (1999): Japanese Monetary Policy: A Case of Self-Induced Paralysis? https://www.princeton.edu/~pkrugman/bernanke_paralysis.pdf

What Can Be Done to Improve the Episteme of Economics?

I think this is needed:

INET: Education Initiative: “We are thrilled that you are joining us at the Berkeley Spring 2017 Education Convening, Friday, April 28th 9am-5pm Blum Hall, B100 #5570, Berkeley, CA 94720-5570… https://www.ineteconomics.org/education/curricula-modules/education-initiative

…Sign up here: https://fs24.formsite.com/inet/form97/index.html or email aoe@ineteconomics.org…

I strongly share INET’s view that things have gone horribly wrong, and that it is important to listen, learn, and brainstorm about how to improve economics education.

Let me just not six straws in the wind:

  1. The macro-modeling discussion is wrong: The brilliant Olivier Blanchard https://piie.com/blogs/realtime-economic-issues-watch/need-least-five-classes-macro-models: “The current core… RBC (real business cycle) structure [model] with one main distortion, nominal rigidities, seems too much at odds with reality…. Both the Euler equation for consumers and the pricing equation for price-setters seem to imply, in combination with rational expectations, much too forward-lookingness…. The core model must have nominal rigidities, bounded rationality and limited horizons, incomplete markets and the role of debt…”

  2. The macro-finance discussion is wrong: The efficient market hypothesis (EMH) claimed that movements in stock indexes were driven either by (a) changing rational expectations of future cash flows or by (b) changing rational expectations of interest rates on investment-grade bonds, so that expected returns were either (a) unchanged or (b) moved roughly one-for-one with returns on investment grade bonds. That claim lies in total shreds. Movements in stock indexes have either no utility-theoretic rationale at all or must be ascribed to huge and rapid changes in the curvature of investors’ utility functions. Yet Robert Lucas claims that the EMH is perfect, perfect he tells us http://www.economist.com/node/14165405: “Fama tested the predictions of the EMH…. These tests could have come out either way, but they came out very favourably…. A flood of criticism which has served mainly to confirm the accuracy of the hypothesis…. Exceptions and ‘anomalies’ [are]… for the purposes of macroeconomic analysis and forecasting… too small to matter…”

  3. The challenge posed by the 2007-9 financial crisis is too-often ignored: Tom Sargent https://www.minneapolisfed.org/publications/the-region/interview-with-thomas-sargent: “I was at Princeton then…. There were interesting discussions of many aspects of the financial crisis. But the sense was surely not that modern macro needed to be reconstructed…. Seminar participants were in the business of using the tools of modern macro, especially rational expectations theorizing, to shed light on the financial crisis…”

  4. What smart economists have to say about policy is too-oftendismissed: Then-Treasury Secretary Tim Geithner, according to Zach Goldfarb https://www.washingtonpost.com/blogs/wonkblog/post/geithner-stimulus-is-sugar-for-the-economy/2011/05/19/AGz9JvLH_blog.html: “The economic team went round and round. Geithner would hold his views close, but occasionally he would get frustrated. Once, as [Christina] Romer pressed for more stimulus spending, Geithner snapped. Stimulus, he told Romer, was ‘sugar’, and its effect was fleeting. The administration, he urged, needed to focus on long-term economic growth, and the first step was reining in the debt…. In the end, Obama signed into law only a relatively modest $13 billion jobs program, much less than what was favored by Romer and many other economists in the administration…”

  5. The competitive model has too great a hold: “Brad, you’re the only person I’ve ever heard say that Card-Krueger changed their mind on how much market power there is in the labor market…”

  6. The problem is of very long standing indeed: John Maynard Keynes (1926) https://www.panarchy.org/keynes/laissezfaire.1926.html: “Some of the most important work of Alfred Marshall-to take one instance-was directed to the elucidation of the leading cases in which private interest and social interest are not harmonious. Nevertheless, the guarded and undogmatic attitude of the best economists has not prevailed against the general opinion that an individualistic laissez-faire is both what they ought to teach and what in fact they do teach…”


So:

INET: Education Initiative: “We are thrilled that you are joining us at the Berkeley Spring 2017 Education Convening, Friday, April 28th 9am-5pm Blum Hall, B100 #5570, Berkeley, CA 94720-5570… https://www.ineteconomics.org/education/curricula-modules/education-initiative

…Sign up here: https://fs24.formsite.com/inet/form97/index.html or email aoe@ineteconomics.org…

We are convening students and professors who are interested in broadening economics education…. Our goals are to learn more about prevailing needs, pool and share existing pluralist curriculums, and brainstorm the architecture and direction of concrete future endeavors in post-secondary economics education. The economics discipline is in disrepair: publicly discredited, theoretically narrow, and academically constrained. Economics education reflects these flaws…. INET is gathering people in the academic economics community in convenings across the U.S. to better understand the challenges and resources faced by those working to reinvigorate the economics discipline.

Invitations are extended to: pre- and non-tenure faculty, including adjuncts; undergraduate and graduate students; experienced faculty actively engaged in pluralist education…. The convenings will be group-led, facilitated, full-day workshops…. These convenings are an exploratory process for INET. We have not made any funding commitments in this field beyond this series of convenings…. We do not view these meetings primarily as places to present funding proposals, but… to share experiences and ideas.

Next steps for INET in education will be announced following these convenings in May 2017….

As the day is long and the goal is ambitious, we will devote part of our morning to building a community agreement together. In anticipation of this, we invite you all to consider what makes a conversation comfortable and supportive for you (bonus points if you can frame it affirmatively…. This is not a suitable gathering for funding proposals. Chatham House Rules….

  • 9–10am: Breakfast & Coming Together
  • 10–11am: Constraints: Barriers to Economic Education
  • 11am–12pm: Resources: Existing Tools for Economics Education
  • 12–1pm: Lunch
  • 1–2pm: Matching: Fitting Resources to Constraints
  • 2–3pm: Gaps: Identifying Remaining Needs
  • 3-3:30pm: Coffee Break
  • 3:30–5pm: Future: Identifying Avenues of Change
  • 5-6pm: Dinner

Why Were Economists as a Group as Useless Over 2010-2014 as Over 1929-1935?

Let us start with two texts this morning:

Paul Krugman: Don’t Blame Macroeconomics (Wonkish And Petty): “Robert Skidelsky… argues, quite correctly in my view, that economists have become far too inward-looking…

…But his prime examples of economics malfeasance are, well, terrible…. [The] more or less standard model of macroeconomics when interest rates are near zero [is] IS-LM in some form…. [And] policy had exactly the effects it was “supposed to.” Now, policymakers chose not to believe this…. And yes, some economists gave them cover. But that’s a very different story from the claim that economics failed to offer useful guidance…

Simon Wren-Lewis: Misrepresenting Academic Economists: “The majority of academic macroeconomists were always against austerity…

…Part of the problem is a certain disregard for consensus among economists. If you ask most scientists how a particular theory is regarded within their discipline, you will generally get a honest and fairly accurate answer…. Economists are less likely to preface a presentation of their work in the media with phrases like ‘untested idea’ or ‘minority view’…. Part of Brad’s post it seems to me is simply a lament that Reinhart and Rogoff are not even better economists than they already are. But there is also a very basic information problem: how does any economist, let alone someone who is not an economist, know what the consensus among economists is? How do we know that the people we meet at the conferences we go to are representative or not?…

“Mainstream”, “academic”, and “majority” are doing an awful lot of work here for both Paul and Simon. So let me repeat something I wrote last December, in response to Paul’s liking to say that macroeconomics has done fine since 2007. Certainly Jim Tobin’s macroeconomics has. John Maynard Keynes’s macroeconomics has. Walter Bagehot, Hyman Minsky, and Charlie Kindleberger’s macroeconomics has done fine.

But Bagehot and Minsky influenced the then top-five American economics departments–Chicago, MIT, Harvard, Princeton, Yale–only through Kindleberger. Charlie went emeritus from MIT in 1976 and died in 1991, and MIT made a decision–a long series of repeated decisions, in fact–that there was no space on its faculty for anybody like Charlie.

When Robert Skidelsky says “macroeconomics”, he means the macroeconomics of RBC and DSGE and ratex and the Great Moderation.

And he is right: Alesina and Ardagna and Reinhart and Rogoff each had more influence on what policymakers and journalists thought about the effects of fiscal policy than did Paul Krugman and company, (including me). While the Federal Reserve went full-tilt into quantitative easing (but not stamped money or helicopter money), it did so in the face of considerable know-nothing opposition. And the ECB lagged far behind in terms of even understanding its mission. Why? Because economists Taylor, Boskin, Calomiris, Lucas, Fama, and company had almost as much or even more impact as did Paul Krugman and company.

“Basic macro” did fine. But basic macro was not the really-existing macro that mattered.

And let me repeat part of my public intellectuals paper: In the last days before the coming of the Roman Empire, Marcus Tullius Cicero in Rome wrote to his BFF correspondent Titus Pomponius Atticus in Athens:

You cannot love our dear [Marcus Porcius] Cato any more than I do; but the man–although employing the finest mind and possessing the greatest trustworthiness–sometimes harms the Republic. He speaks as if we were in the Πολιτεια of Plato, and not in the sewer of Romulus…

Whatever you may think about economists’ desires to use their technical and technocratic expertise to reduce the influence of both the Trotskys and the St. Benedicts in the public square, there is the prior question of whether here and now–in this fallen sublunary sphere, among the filth of Romulus–they have and deploy any proper technical and technocratic expertise at all. And we seem to gain a new example of this every week. The most salient relatively-recent example was provided by Carmen Reinhart and Kenneth Rogoff–brilliant, hard-working economists both, from whom I have learned immense amounts….

They believed that the best path forward for… the U.S., Germany, Britain, and Japan was… to shrink their government deficits quickly and quickly halt the accumulation of and begin to pay down government debt. My faction, by contrast, believed that the best path forward for these economies was for them to expand their government deficits now and let the debt grow until either economies recover to normal levels of employment or until interest rates begin to rise significantly…. [For example:]

[Carmen] Reinhart echoed [Senator] Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent [debt-to-GDP] threshold, we would expect a higher incidence…”

I think we have by far the better of the argument. There is no tipping point. Indeed, there is barely a correlation, and it is very hard to argue that that correlation reflects causation from high initial debt to slower subsequent growth:

NewImage

Yet it is very clear that even today Reinhart and Rogoff–and allied points by economists like Alberto Alesina, Francesco Giavazzi, et al., where I also think we have the better of the argument by far–have had a much greater impact on the public debate than my side has.

Thus, the key problem of knowledge: Since technical details matter, conclusions must be taken by non-economists on faith in economists’ expertise, by watching the development of a near-consensus of economists, and by consonance with observers’ overall world-view. But because political and moral commitments shape how we economists view the evidence, we economists will never reach conclusions with a near-consensus – even putting to one side those economists who trim their sails out of an unwarranted and excessive lust for high federal office. And note that neither Carmen Reinhart nor Kenneth Rogoff have such a lust.

We do not live in the Republic of Plato. We live in the Sewer of Romulus. In this fallen sublunary sphere, the gap between what economists should do and be and what they actually are and do is distressingly large, and uncloseable.

And this leaves you–those of you who must listen to we economists when we speak as public intellectuals in the public square–with a substantial problem.

V. Should You Pay Attention to Economists as Public Intellectuals in the Public Square?

You have to.

You have no choice.

You all have to listen.

But you have nearly no ability to evaluate what you hear. When we don’t reach a near-consensus, then Heaven help you. Unless you are willing make me intellectual dictator and philosopher-king, I cannot.

The Need for a Reformation of Authority and Hierarchy Among Economists in the Public Sphere

I find that I have much more to say (or, rather, largely, republish), relevant to the current debate between Simon Wren-Lewis and Unlearning Economics.

Let me start by saying that I think Unlearning Economics is almost entirely wrong in his proposed solutions.

Indeed, they does not seem especially knowledgeable about their cases. For example:

  1. the trashing of the Grameen Bank is undeserved;

  2. the blanket denunciation of RCTs as having “benefited global and local elites at the expensive of the poorest” is just bonkers;

  3. Merton and Scholes’s financial math was correct, and the crash of their hedge fund did not require any public-money bailout;

  4. Janine Wedel is not a reliable source on Russian privatization, which I saw and see as the only practical chance to try to head off the oligarchic plutocracy that has grown up in Russia under Yeltsin and Putin (and, no, my freshman roommate Andrei was not prosecuted for “fraud in Russia”, but rather the Boston U.S. Attorney’s office overreached and was unwilling to admit it);

  5. Unlearning Economics confuses the more-sinister Friedrich von Hayek (who welcomed Pinochet’s political “excesses” as a necessary Lykurgan moment) with the truly-libertarian Milton Friedman, who throughout his whole life was dedicated to not telling people what to do, and who saw Pinochet as another oppressive authoritarian who might be induced to choose better rather than worse economic policies;

  6. and then there is Reinhart and Rogoff, where I think Unlearning Economics is right.

So Unlearning Economics is batting 0.170 in their examples of “mainstream economics considered harmful”. But there is that one case. And I do not think that Simon Wren-Lewis handles that one case well. And he needs to–I need to. And, since neither he nor I have, this is a big problem.

Let me put it this way: Carmen Reinhart and Ken Rogoff are mainstream economists.

The fact is that Carmen Reinhart and Ken Rogoff were wrong in 2009-2013. Yet they had much more influence on economic policy in 2009-2013 than did Simon Wren-Lewis and me. They had influence. And their influence was aggressively pro-austerity. And their influence almost entirely destructive.

Simon needs to face that fact squarely, rather than to dodge it. The fact is that the “mainstream economists, and most mainstream economists” who were heard in the public sphere were not against austerity, but rather split, with, if anything, louder and larger voices on the pro-austerity side. (IMHO, Simon Wren-Lewis half admits this with his denunciations of “City economists”.) When Unlearning Economics seeks the destruction of “mainstream economics”, he seeks the end of an intellectual hegemony that gives Reinhart and Rogoff’s very shaky arguments a much more powerful institutional intellectual voice by virtue of their authors’ tenured posts at Harvard than the arguments in fact deserve. Simon Wren-Lewis, in response, wants to claim that strengthening the “mainstream” would somehow diminish the influence of future Reinharts and Rogoffs in analogous situations. But the arguments for austerity that turned out to be powerful and persuasive in the public sphere came from inside the house!

Simon Wren-Lewis: On Criticising the Existence of Mainstream Economics: “I’m very grateful to Unlearning Economics (UE) for writing in a clear and forceful way a defence of the idea that attacking mainstream economics is a progressive endeavor…

…I think such attacks are far from progressive…. Devoting a lot of time to exposing students to contrasting economic frameworks (feminist, Austrian, post-Keynesian)… means cutting time spent on learning the essential tools that any economist needs…. Let me start at the end of the UE piece:

The case against austerity does not depend on whether it is ‘good economics’, but on its human impact. Nor does the case for combating climate change depend on the present discounted value of future costs to GDP. Reclaiming political debate from the grip of economics will make the human side of politics more central, and so can only serve a progressive purpose…

Austerity did not arise because people forgot about its human impact. It arose because politicians, with help from City economists, started scare mongering about the deficit…. Every UK household knew that your income largely dictates what you can spend, and as long as the analogy between that and austerity remained unchallenged, talk about human impact would have little effect…. The only way to beat austerity is to question the economics on which it is based…. Having mainstream economics, and most mainstream economists, on your side in the debate on austerity is surely a big advantage….

Where UE is on stronger ground is where they question the responsibility of economists…. Politicians grabbed hold of the Rogoff and Reinhart argument about a 90% threshold for government debt:

Where was the formal, institutional denunciation of such a glaring error from the economics profession, and of the politicians who used it to justify their regressive policies? Why are R & R still allowed to comment on the matter with even an ounce of credibility? The case for austerity undoubtedly didn’t hinge on this research alone, but imagine if a politician cited faulty medical research to approve their policies—would institutions like the BMA not feel a responsibility to condemn it?”

I want to avoid getting bogged down in the specifics of this example, but instead just talk about generalities…. If some professional body started ruling on what the consensus among economists was… [that] would go in completely the opposite direction from what most heterodox economists wish…. There is plenty wrong with mainstream economics, but replacing it with schools of thought is not the progressive endeavor that some believe. It would just give you more idiotic policies like Brexit.

What did Reinhart and Rogoff say? What Let me turn the mike over to Tom Cotton:

Reinhart and Rogoff had… dismantl[ed] the mistaken belief… that this particular group of [Democratic] policymakers in this moment in history was somehow smarter than all the others and could run up debt forever without catastrophic consequences…. They wrote:

We have been here before. No matter how different the latest financial frenzy or crisis always appears, there are usually remarkable similarities with past experience from other countries and from history. Recognizing these analogies and precedents is an essential step toward improving our global financial system, both to reduce the risk of future crisis and to better handle catastrophes when they happen…

The student senators began asking questions with a sincere curiosity cynics would find disarming. Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: “Do we need to act this year? Is it better to act quickly?” “Absolutely,” Rogoff said: “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point….” Neither Reinhart nor Rogoff said we could fix our debt problem with just tax increases. Both emphasized the need for comprehensive tax reform and tax code simplification…. “I don’t want to be fire and brimstone,” Rogoff said. “No one knows when this will happen.” Yet, he added, “It takes more than two years to turn the ship around…. Once you’ve waited too long, it’s too hard to take radical steps”…

Plus there are things like Rogoff’s:

Debt levels of 90% of GDP are a long-term secular drag on economic growth that often lasts for two decades or more…. There is two-way feedback between debt and growth, but normal recessions last only a year and cannot explain a two-decade period of malaise. The drag on growth is more likely to come from the eventual need for the government to raise taxes, as well as from lower investment spending. So, yes, government spending provides a short-term boost, but there is a trade-off with long-run secular decline…

Simon Wren-Lewis wants to say:

  • mainstream economists good
  • City economists bad
  • Feminist, Austrian, post-Keynesian economists unhelpful because they distract focus from the powerful mainstream arguments that austerity is bad.

And the problem is that Carmen Reinhart and Ken Rogoff are not “City” but mainstream economists—as are Martin Feldstein, John Taylor, Greg Mankiw, Glenn Hubbard, Eugene Fame, Robert Lucas, Robert Barro, and a huge host of others pro-austerity throughout 2008-2017. That is the elephant in the room that Simon needs to face. And when he writes that he wants to “avoid getting bogged down in the specifics of this example”, he evades UE’s big question and fails to make the argument he needs to make.


Background:

Why Are Reinhart and Rogoff—and Other Mainstream Economists—so Wrong?

On a psychological level—for an explanation of why they said and wrote what they said and wrote—I have no explanation. On the technocratic level, there is a lot to say:

When Carmen Reinhart and Kenneth Rogoff wrote their “Growth in a Time of Debt”, they asked the question:

Outsized deficits and epic bank bailouts may be useful in fighting a downturn, but what is the long run macroeconomic impact or higher levels of government debt, especially against the backdrop of graying populations and rising social insurance costs?

They concluded that over the past 200 years:

[T]he relationship between government debt and real GDP growth is weak for debt/GDP ratios below a threshold of 90 percent of [annual] GDP. Above 90 percent, median growth rates fall by one percent, and average growth… more… in [both] advanced and emerging economies…. [In] emerging markets… [w]hen external debt reaches 60 percent of GDP, annual growth declines by about two percent…. [T]here is no apparent contemporaneous link between inflation and public debt levels for the advanced countries…. The story is entirely different for emerging markets, where inflation rises sharply as debt increases.

And the graph that caught the world’s imagination was:

NewImage

The principal mistake Reinhart and Rogoff committed in their analysis and paper–indeed, the only significant mistake in the paper itself–was their use of the word “threshold”.

It and the graph led very many astray.

For example, it led the almost-always-unreliable Washington Post editorial board to condemn the:

new school of thought about the deficit…. ‘Don’t worry, be happy. We’ve made a lot of progress’, says an array of liberal pundits… [including] Martin Wolf of the Financial Times… their analysis assumes steady economic growth and no war. If that’s even slightly off, debt-to-GDP could… stick dangerously near the 90 percent mark that economists regard as a threat to sustainable economic growth…

(Admittedly, experience since the start of the millennium gives abundant evidence that the Washington Post needs no empirical backup from anybody in order to lie and mislead in whatever way the wind blows.)

It misled European Commissioner Olli Rehn to claim that:

When [government] debt reaches 80-90% of GDP, it starts to crowd out activity in the private sector and other parts of the economy…

Both of these–and a host of others–think that if debt-to-annual-GDP is less than 90% (or, in Rehn’s case, 80%, and I have no idea where the 80% comes from) an economy is safe, and that only if it is above 90% is the economy’s growth in danger. And in their enthusiasm when they entered congressional briefing mode it led Reinhart and Rogoff themselves astray.

Yet the threshold at 90% is not there. In no sense is there empirical evidence that a 90% ratio of debt-to-annual-GDP is in any sense an “important marker”, a red line. That it appears to be in Reinhart and Rogoff’s paper is an artifact of Reinhart and Rogoff’s non-parametric method: throw the data into four bins, with 90% the bottom of the top bin. There is, instead, a gradual and smooth decline in growth rates as debt-to-annual-GDP increases. 80% looks only trivially different than 100%.
Owen Zidar provides what seems to me at least to be a much more informative cut at the data:

NewImage

and he writes:

I took all countries with Public Debt to GDP ratios above 50… evenly divided them into 50 equalized sized bins of Debt to GDP… plot the mean of the outcome of interest for each bin…. [This] would show clean breaks at a Debt to GDP ratio of 90 if they actually exist…

There is no 90% threshold. Making policy under the belief that risks at 100% are very different than risks at 80% is in no way supported by any of the data.

Moreover, there is the big question of how much of this decline in growth as debt rises is cause for fear? Correlation, after all, is only sometimes causation. Ken Rogoff claims that this is one of those cases. Is he write?

First, a good deal of this high-debt-to-GDP growth-decline correlation comes from countries where interest rates tend to be higher and the stock market tends to be lower where government debt is higher. That is simply not relevant to the U.S. today.

Second, a good deal of this correlation comes from countries where inflation rates are higher when government debt is higher. That is not relevant to the U.S. today.

Third, a good deal more of this correlation comes from countries where growth was already slow, and high government debt relative to GDP is, as Larry Summers constantly says, a result not of the numerator but of previous trends in the denominator. That is not relevant to the U.S. today.

How much of this correlation is left for a country with low interest rates, low inflation rates, buoyant stock prices, and healthy prior growth? We need to know that before we can even begin to analyze causation.

And the answer is: not much, if any. Until interest and inflation rates begin to rise above normal levels or the stock market tanks, there is little risk to accumulating more government debt here in the United States. And there are large potential benefits from solving our real low employment and slack capacity problems right now

What did I mean by “not much”? Let me highlight a passage from the “Understanding Our Adversaries” evolution-of-economists’-views talk that I have been giving for several months now, a passage based on work by Owen Zidar summarized by the graph above:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart, Reinhart, and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow. This is the most live argument today. So let me nibble away at it:

  1. Note well: no cliff at 90%.

  2. RRR present a correlation–not a causal mechanism, and not a properly-instrumented regression. There argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question. And the answer is that the bulk of causation is not there, and provides no reason for the U.S. to fear.

  3. Note is how small the correlation is.

Suppose that all of the correlation is causation from higher debt to slower growth. Let us then consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. And suppose that we boost government spending by 2% of GDP.

Let us boost government spending for this year only in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by… wait for it… 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend an extra 2% of GDP over each of the next three years. Collect 15% of a year’s extra output as a plus in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP, and we have the same ten-year depressing effect of 0.06% of GDP.

15% now. -0.06% in a decade.

The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year’s GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP?

That does not seem to me to compute.

As a very smart old Washington hand wrote me:

True, but the 90% red line seemed to say there is nothing more important than moving debt down relative to GDP (though Ken and Carmen would probably acknowledge that faster growth, say through some even more forceful unconventional monetary policy, was a legitimate means to do that).


And why not add more? From my Notre Dame Paper:

IV. We Dwell Not in the Republic of Plato But in the Sewer of Romulus

In the last days before the coming of the Roman Empire, Marcus Tullius Cicero in Rome wrote to his best correspondent Titus Pomponius Atticus in Athens:

You cannot love our dear [Marcus Porcius] Cato any more than I do; but the man – although employing the finest mind and possessing the greatest trustworthiness – sometimes harms the Republic. He speaks as if we were in the Republic of Plato, and not in the sewer of Romulus…

Whatever you may think about economists’ desires to use their technical and technocratic expertise to reduce the influence of both the Trotskys and the St. Benedicts in the public square, there is the prior question of whether here and now – in this fallen sublunary sphere, among the filth of Romulus – they have and deploy any proper technical and technocratic expertise at all. And we seem to gain a new example of this every week.

The most salient relatively-recent example was provided by Carmen Reinhart and Kenneth Rogoff[39][39] – brilliant, hard-working economists both, from whom I have learned immense amounts. Rogoff’s depth of thought and breadth of knowledge about how countries act and how economies respond in the arena of the international monetary system is a global treasure. Reinhart’s breadth and depth of knowledge about how governments have issued, financed, amortized, paid off, or not paid off their debts over the past two centuries is the greatest in the world.

Debt to GDP Ratio and Future Economic Growth pdf page 5 of 6

However, they believed that the best path forward for the developed economies – the U.S., Germany, Britain, and Japan – was for them to shrink their government deficits quickly and quickly halt the accumulation of and begin to pay down government debt. My faction, by contrast, believed that the best path forward for these economies was for them to expand their government deficits now and let the debt grow until either economies recover to normal levels of employment or until interest rates begin to rise significantly.

Why does my faction disagree with them? Let me, first, rely on the graph above that is the product of work by Berkeley graduate student Owen Zidar, plotting how economic growth in different industrialized countries in different eras has varied along with the amount of government debt that they had previously accumulated. And let me give the explanation of why I disagree with Reinhart and Rogoff that I was giving at seminars around the country in the early 2010s:

The argument [for fiscal contraction and against fiscal expansion in the short run] is now: never mind why, the costs of debt accumulation are very high. This is the argument made by Reinhart and Rogoff: when your debt to annual GDP ratio rises above 90%, your growth tends to be slow.

This is the most live argument today. So let me nibble away at it. And let me start by presenting the RRR case in the form of Owen Zidar’s graph.

First: note well: no cliff at 90%.

Second, RRR present a correlation – not a causal mechanism, and not a properly-instrumented regression. Their argument is a claim that high debt-to-GDP and slow subsequent growth go together, without answering the question of which way causation runs. Let us answer that question.

The third thing to note is how small the correlation is. Suppose that we consider two cases: a multiplier of 1.5 and a multiplier of 2.5, both with a marginal tax share of 1/3. Suppose the growth-depressing effect lasts for 10 years. Suppose that all of the correlation is causation running from high debt to slower future growth. And suppose that we boost government spending by 2% of GDP this year in the first case. Output this year then goes up by 3% of GDP. Debt goes up by 1% of GDP taking account of higher tax collections. This higher debt then reduces growth by… wait for it… 0.006% points per year. After 10 years GDP is lower than it would otherwise have been by 0.06%. 3% higher GDP this year and slower growth that leads to GDP lower by 0.06% in a decade. And this is supposed to be an argument against expansionary fiscal policy right now?

The 2.5 multiplier case is more so. Spend 2% of GDP over each of the next three years. Collect 15% of a year’s extra output in the short run. Taking account of higher tax revenues, debt goes up by 1% of GDP and we have the same ten-year depressing effect of 0.06% of GDP. 15% now. -0.06% in a decade. The first would be temporary, the second is permanent, but even so the costs are much less than the benefits as long as the economy is still at the zero lower bound.

And this isn’t the graph that you were looking for. You want the causal graph. That, worldwide, growth is slow for other reasons when debt is high for other reasons or where debt is high for other reasons is in this graph, and should not be. Control for country and era effects and Owen reports that the -0.06% becomes -0.03%. As Larry Summers never tires of pointing out, (a) debt-to-annual-GDP ratio has a numerator and a denominator, and (b) sometimes high-debt comes with high interest rates and we expect that to slow growth but that is not relevant to the North Atlantic right now. If the ratio is high because of the denominator, causation is already running the other way. We want to focus on cases of high debt and low interest rates. Do those two things and we are down to a -0.01% coefficient.

We are supposed to be scared of a government-spending program of between 2% and 6% of a year’s GDP because we see a causal mechanism at work that would also lower GDP in a decade by 0.01% of GDP? That does not seem to me to compute.

Now I have been nibbling the RRR result down. Presumably they are trying to see if it can legitimately be pushed up. This will be interesting to watch over the next several years, because RRR is the heart of the pro-austerity case right now.

That ends what I would typically try to say.

And that is as concise and simple an explanation of why I disagree with Reinhart and Rogoff as I can give.

If you are not a professional economist and have managed to understand that, I salute you.

They disagree with me, first, they started with different prior beliefs – different assumptions about the relative weight to be given to different scenarios and the relative risks of different courses of action that lead them to read the evidence differently. Second, they made some data processing errors – although those are a relatively minor component of our differences – and are now dug in, anchored to the positions they originally took, and rationalizing that the data processing errors do not change the qualitative shape of the picture. Third, they have made different weighting decisions as to how to handle the data. Is Owen Zidar putting his thumb on the scales, and weighting the data because he knows that the effects of high debt in reducing growth are small? I don’t think so: his weighting scheme is simple, and he is too young to be dug in and have a dog in this fight. But I am, perhaps, not the best judge.

But when we venture out of data collection and statistics and the academy into policy advocacy in the public square the differences become very large indeed. Matthew O’Brien quotes Senator Tom Coburn’s report on Reinhart and Rogoff’s briefing of the Republican Congressional Caucus in April 2011:

Johnny Isakson, a Republican from Georgia and always a gentleman, stood up to ask his question: “Do we need to act this year? Is it better to act quickly?”

“Absolutely,” Rogoff said. “Not acting moves the risk closer,” he explained, because every year of not acting adds another year of debt accumulation. “You have very few levers at this point,” he warned us.

Reinhart echoed Conrad’s point and explained that countries rarely pass the 90 percent debt-to-GDP tipping point precisely because it is dangerous to let that much debt accumulate. She said, “If it is not risky to hit the 90 percent threshold, we would expect a higher incidence.”

I think we have by far the better of the argument. Yet it is very clear that even today Reinhart and Rogoff – and allied points by economists like Alberto Alesina, Francesco Giavazzi, et al., where I also think we have the better of the argument by far – have had a much greater impact on the public debate than my side has.

Thus, the key problem of knowledge: Since technical details matter, conclusions must be taken by non-economists on faith in economists’ expertise, by watching the development of a near-consensus of economists, and by consonance with observers’ overall world-view. But because political and moral commitments shape how we economists view the evidence, we economists will never reach conclusions with a near-consensus – even putting to one side those economists who trim their sails out of an unwarranted and excessive lust for high federal office. And note that neither Carmen Reinhart nor Kenneth Rogoff have such a lust.

We do not live in the Republic of Plato. We live in the Sewer of Romulus. In this fallen sublunary sphere, the gap between what economists should do and be and what they actually are and do is distressingly large, and uncloseable.

And this leaves you – those of you who must listen to we economists when we speak as public intellectuals in the public square – with a substantial problem.


V. Should You Pay Attention to Economists as Public Intellectuals in the Public Square?

You have to.

You have no choice.

You all have to listen.

But you have nearly no ability to evaluate what you hear. When we don’t reach a near-consensus, then Heaven help you. Unless you are willing make me intellectual dictator and philosopher-king, I cannot.

Was This the Greatest Failure of the Obama Administration?

Preview of Was This the Greatest Failure of the Obama Administration

Not running the table in January 2009 to make a V-shaped recovery all but inevitable, but instead trusting to good luck and the accuracy of the forecast. An obvious mistake then. An obvious mistake now. And I have never heard a good account of why it was made–other than that Obama, Emmanuel, Plouffe, and Axelrod bonded with Geithner, and that Geithner is always “let’s do less”, no matter how strong the arguments to do more are:


Paul Krugman (2010-07-09): What Went Wrong?: “It’s now obvious that the stimulus was much too small…

…The administration has chosen to deal with this by… condemning Republicans, rightly, for obstructionism, while at the same time claiming, falsely, that we’re still on the right track. How did things end up this way? We’ll never know whether the administration could have passed a bigger plan; we do know that it didn’t try…. It looks as if top advisers convinced themselves that even in the absence of stimulus the slump would be nasty, brutish, but not too long…. [But] even before the severity of the financial crisis was fully apparent, the recent history of recessions suggested that the jobs picture would continue to worsen long after the recession was technically over. And by the winter of 2008-2009, it was obvious that this was the Big One…. Those concerns were what had me fairly frantic….

And here we are. From a strictly economic point of view, we could still fix this: a second big stimulus, plus much more aggressive Fed policy. But politically, we’re stuck: even if the Democrats hold the House in November, they won’t have the votes to do anything major. I’d like to say something uplifting here; but right now I’m feeling pretty bleak.


Paul Krugman (2013-01-06): The Big Fail: “If you had polled… economists… meeting three years ago…

…most of them would surely have predicted that by now we’d be talking about how the great slump ended, not why it still continues. So what went wrong?… Mainly, is the triumph of bad ideas…. Standard [textbook] economics offered good answers, but political leaders—and all too many economists—chose to forget or ignore what they should have known…. A smaller financial shock, like the dot-com bust at the end of the 1990s, can be met by cutting interest rates. But the crisis of 2008 was far bigger, and even cutting rates all the way to zero wasn’t nearly enough. At that point governments needed to step in, spending to support their economies while the private sector regained its balance. And to some extent that did happen: revenue dropped sharply in the slump, but spending actually rose as programs like unemployment insurance expanded and temporary economic stimulus went into effect. Budget deficits rose, but this was actually a good thing, probably the most important reason we didn’t have a full replay of the Great Depression.

But it all went wrong in 2010…. Greece was taken, wrongly, as a sign that all governments had better slash spending and deficits right away…. The warnings of some (but not enough) economists that austerity would derail recovery were ignored. For example, the president of the European Central Bank confidently asserted that “the idea that austerity measures could trigger stagnation is incorrect.” Well, someone was incorrect, all right…. Blanchard and… Leigh… not just that austerity has a depressing effect on weak economies, but that the adverse effect is much stronger than previously believed. The premature turn to austerity, it turns out, was a terrible mistake…. The fund was actually less enthusiastic about austerity than other major players. To the extent that it says it was wrong, it’s also saying that everyone else (except those skeptical economists) was even more wrong. And it deserves credit for being willing to rethink its position in the light of evidence. The really bad news is how few other players are doing the same…. The truth is that we’ve just experienced a colossal failure of economic policy—and far too many of those responsible for that failure both retain power and refuse to learn from experience.

Musings: Donald Trump Ought Not to Be a Hard-Money Gold-Standard Austerian Pain-Caucus President

3 Month Treasury Bill Secondary Market Rate FRED St Louis Fed

When I was working in the Treasury in 1993, I was struck by how much it was the case that President Bill Clinton was still the ex-Governor of Arkansas, and that arguments that would have been powerful and important when directed at a Governor of Arkansas still resonated in his mind much more strongly than they perhaps should have if they were evaluated purely on technocratic grounds.

Arkansas, remember, was a small, poor state, heavily dependent on coupon-clipping from the Walton family and on the ability of Tyson Chicken to export to other states as its engines of economic growth. Those put constraints on Arkansas and make certain factors salient for Arkansas in ways that do not apply to the country as a whole.

Donald Trump has been a real estate developer–and a failed casino manager. The same where-he-comes-from-determine-which-arguments-resonate should apply here.

There thus ought to be an elective affinity between Donald Trump and proper technocratic fiscal policy: he ought to be very responsive to the very strong case for a real and substantial infrastructure construction-led fiscal expansion–and remember that investing in the human capital of twelve year olds is a very durable piece of infrastructure indeed. The math that shows that at current interest rates borrow-and-build is indeed a no-brainer for the economy is math that ought to be very familiar to Donald Trump.

And he ought to be very responsive to the Yellen caucus in the Federal Reserve. Very much like Reagan in 1980, Donald Trump has been told and from personal experience knows very different things about the Federal Reserve. by some that we need rigid Taylor Rules and has been told by others that we need a Gold Standard, but he also knows that high interest rates kill real estate values, real estate deals, and the solvency of real estate developers. Reagan’s goldbug and loose-money staffers fought each other to a standstill, and Volcker was left alone to manage the economy as best he could. There is a potential fight between the Donald Trump who develops real estate and the Donald Trump who wants to be a good Republican fighting for Republican causes he doesn’t really resonate with. My bet is that, if the issue can be properly framed, the valid technocratic arguments for loose money will prevail inside Donald Trump’s head, given the natural elective affinity with his past career.

And there is much to be done here…

One of my proudest moments was when, back in 1992, Larry Summers and I egged each other on to tell the Federal Reserve at Jackson Hole that, given the magnitude of recessionary shocks and the vulnerability of an economy to the zero lower bound, it was too hazardous to try to push the average inflation rate much below 5%/year. Great call. Completely correct. Totally ignored. One that I am very proud of.

But a 2%/year inflation target was set in stone for the U.S. by Alan Greenspan in the 1990s. Thereafter the Federal Reserve system fell in line and coalesced around finding reasons why that target was a good thing–not analyzing whether it was in fact a good thing.

It is now clear that it is not a good thing: shocks are too large. Perhaps the 2%/year target was appropriate if the Great Moderation was permanent. It wasn’t. We have radical uncertainty of many kinds, and a 2%/year target will have us slam into the zero lower bound appallingly often. The target inflation rate should be raised to 4%/year.

The only argument for keeping the 2%/year inflation target is that it helps build the Federal Reserve’s credibility. But the credibility that comes from doing stupid things consistently and persistently is not the kind of credibility you want to build or have, is it? It is important that people trust your promises. But the promises that you want to make and that you want credibility for are promises that you will do the right and smart thing–not the wrong and dumb thing–and thus that you will correct policies that turn out to have been clearly mistaken.

European Fiscal Policy: And All Does Not Go Merry as a Marriage Bell

I find myself thinking of Ludger Schuknecht’s very powerful and apposite comments about just what, even if you believe–as I do–that there are substantial spillovers for Germany and for the world for Germany to use its fiscal space for expansionary policies right now, it is supposed to use its fiscal space for…

The fiscal space is in Germany. The infrastructure needs are in Sicily. This is in the end the political and also the political-economic dealbreaker. It does speak to necessary reforms of the European Union so that things like this do not happen again.

I remember Maury Obstfeld saying once that at the start of the 1990s California and New York had no problem using the United States’s fiscal space to transfer 25% of a year’s Texas GDP to Texas to clean up the Savings and Loan financial crisis mess. This just was not an issue in American politics or political economy. Texas had bet wrongly on the real estate sector via lax regulation–both at the federal and state level–and financial engineering. It was regarded as a proper use of America’s fiscal space to spend money on this and pull Texas out of what was a shallow national but would have been a very deep regional recession.

The fact that the Chair of the Senate Finance Committee at the time was from Texas may, however, have had something to do with it.

The American institutions then were, somehow, a better set of institutions for dealing with this kind of crisis. That there was an alignment of interests, and that the prosperity of each would redound to the prosperity of all in the long even if not always in the short run was taken for granted.

In fact, perhaps, Europe’s institutions today are inferior along some aspects of this dimension than Europe’s institutions in the past. Back in 1200, say, the question of how Germany should use its fiscal space, if in fact the desired location of spending was in Sicily, was finessed. A Germany Hohenstaufen princeling would be married to a Viking-Sicilian princess, and she would then bring Sicily along with her into the Holy Roman Empire as her dowry, and Germany–at least Germany’s rulers–would have an obvious interest in upgrading Sicily’s infrastructure.

Admittedly, the German Emperor might then decide that he would rather spend time in his palace in Palermo than in Burg Hohenstaufen twenty miles east of Stuttgart.

Somehow, national borders and national communities constrain us in Europe in ways that are not the wisest today…

Fiscal Policy in the New Normal: IMF Panel

Ken Rogoff’s Hooverismo…: Hoisted from the Archives from Three Years Ago

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Just what is Ken Rogoff’s argument that the Cameron-Osborne-Clegg government in Great Britain was correct to hit the British economy over the head with the austerity hammer in the spring of 2010, anyway?

Simon Wren-Lewis opens: Ken Rogoff on UK austerity: “Ken Rogoff’s article… is a welcome return to sanity…

…Rogoff focuses on what was always the critical debate: was austerity necessary because financial markets might have stopped buying government debt…. As critical pieces go, you couldn’t have a friendlier one than this…. Rogoff agrees that it was a mistake to cut back on public sector investment…. He says that austerity critics “have some very solid points”…. His comment after putting the austerity critics’ case is “perhaps” or “maybe”…

But… But… But…

About the Rogoff argument: If markets stop buying government debt, then they are buying something else: by Walras’s Law, excess supply of government debt is excess demand for currently-produced goods and services and labor. That is not continued deflation and depression, that is a boom–it may well be a destructive inflationary boom, and it may be a costly boom, but it is the opposite problem of an deflationary depression

So, by continuity, somewhere between policies of austerity that that produce deflationary depression due to an excess demand for safe assets and policies of fiscal license that produce inflationary boom caused by an excess supply of government debt, there must be a sweet spot: enough new issues of government debt to eliminate the excess demand for safe assets and so cure the depression, but not so much in the way of new issues of government debt to produce destructive inflation, right? Why not aim for that sweet spot? Certainly Cameron-Osborne-Clegg were not aiming for that sweet spot, and the John Stuart Millian using the government’s powers to issue money and debt to balance supply and demand for financial assets and so make Say’s Law true in practice even though it is not true and theory?

More urgent and important: In the spring of 2010 there was no sign of an inflationary boom with rising interest rates. There was no sign that there was going to be an inflationary boom soon. There was no sign that anybody in financial markets whose money moved market prices at the margin placed a weight greater than zero on any prospect of an inflationary boom at any time horizon out to thirty years.

Thus the question is: what do you do if there is no boom, are no signs of a boom, is no expectation that there will be a boom, is no excess supply of government debt right now, is no sign in the term structure of interest rates that people expect an excess supply of government debt in the near-future–if in fact looking out thirty years into the future via the term structure there is no sign that there will ever be any significant chance of an excess supply of government debt?

Ken Rogoff thinks that the answer is obvious: that you must then hit the economy on the head with the hammer of austerity to raise unemployment in order to guard against the threat of the invisible bond-market vigilantes, even though there is no sign of them–for, he says, they are invisible and silent as well. We must not try to infer expectations, probabilities, scenarios, and risks from market prices, but rather have St. Paul’s faith that austerity is necessary because of “the evidence of things not seen”.

The argument seems to be:

  1. We can’t trust financial markets that price the scenario in which people lose confidence in government finances at zero because financial markets are irrational–we cannot look at prices as indicators of when austerity might be appropriate, but must hit the economy on the head with the austerity brick and raise unemployment.

  2. Once interest rates rise as people lose confidence in government finances, it is then politically impossible for the government to run the primary surpluses needed–to cut spending and raise taxes–in order to service the debt without the implicit national bankruptcy of inflation

  3. Once interest rates rise as people lose confidence in government finances, it is not possible for the Bank of England to reduce the pound far enough to bring foreign-currency speculators who then expect the next bounce of the pound will be up into the market to reduce interest rates–or, at least, not possible without setting off an import price-driven inflationary spiral, and thus produce the implicit national bankruptcy of inflation.

  4. Greece! Argentina! You don’t want Britain to suffer the fate of Greece or Argentina, do you

Therefore, Rogoff argues, in order to guard against the possibility of a destructive fiscal dominance-inflation in the future, the Cameron-Osborne-Clegg government was wise to hit the British economy on the head with the austerity hammer and produce a longer, deeper, more destructive depression now.

Maybe the argument is really that the big policy mistake was made by Governor of the Bank of England–that Britain was in conditions of fiscal dominance, in which the Exchequer needed to balance the budget to preserve price stability and the Bank of England should have engaged in massive quantitative easing, aggressive forward interest- and exchange-rate guidance, and explicit raising of the inflation target in order to balance aggregate demand and potential supply, and that the unforgivable policy blunders were not Cameron-Osborne-Cleggs’ but King’s. But if that is what Rogoff means, it is not what he says.

So I am still left puzzled.

And so is Simon Wren-Lewis, who continues:

The argument here is all about insurance. The financial markets are unpredictable…. [What if] the Euro had collapsed[?] As Rogoff acknowledges, they might have run for cover into UK government debt, but… might have done the opposite…. The UK is not immune from the possibility of a debt crisis, so we needed to take out insurance against that possibility, and that insurance was austerity…. So let us agree that it was possible to imagine, particularly in 2010, that the markets might stop buying UK government debt. What does not follow is that austerity was an appropriate insurance policy….

Government needed to have a credible long term plan for debt sustainability…. I hope Rogoff would agree that in the absence of any risk coming from the financial markets, it is optimal to delay fiscal tightening until the recovery is almost complete. The academic literature is clear that, in the absence of default risk, debt adjustment should be very gradual, and that fiscal policy should not be pro-cyclical. So the insurance policy involves departing from this wisdom. This has a clear cost in terms of lost output, but an alleged potential benefit in reducing the chances of a debt crisis…. What the Rogoff piece does not address at all is that the UK already has an insurance policy, and it is called Quantitative Easing…. Rogoff says that, if the markets suddenly forsook UK government debt “UK leaders would have been forced to close massive budget deficits almost overnight.” With your own central bank this is not the case–you can print money instead…. We are talking about a government with a long-term feasible plan for debt sustainability, faced with an irrational market panic…. We never needed the much more costly, far inferior and potentially dubious additional insurance policy of austerity.

And so is Paul Krugman: Phantom Crises:

Simon Wren-Lewis is puzzled by a Ken Rogoff column that sorta-kinda defends Cameron’s austerity policies. His puzzlement, which I share, comes at several levels. But I want to focus on… Rogoff’s assertion that Britain could have faced a southern Europe-style crisis, with a loss of investor confidence driving up interest rates and plunging the economy into a deep slump. As I’ve written before, I just don’t see how this is supposed to happen in a country with its own currency that doesn’t have a lot of foreign currency debt–especially if the country is currently in a liquidity trap, with monetary policy constrained by the zero lower bound on interest rates. You would think, given how many warnings have been issued about this possibility, that someone would have written down a simple model of the mechanics, but I have yet to see anything of the sort…. Suppose that investors turn on your country for some reason… a decline in capital inflows at any given interest rate, so that the currency depreciates. If you have a lot of foreign-currency-denominated debt, this could actually shift IS left through balance-sheet effects, as we learned in the Asian crisis. But that’s not the case for Britain; clearly, IS shifts right. If LM doesn’t shift, the interest rate will rise, but only because the loss of investor confidence is actually, through depreciation, having an expansionary effect….

My point is that… [the] claim that loss of foreign confidence causes a contractionary rise in interest rates just doesn’t come out of anything like a standard model. If you want to claim that it will happen nonetheless, show me the model!…

Furthermore, as Wren-Lewis says, even if there is somehow a squeeze on long-term bonds, why can’t the central bank just buy them up? Yes, this is “printing money”–but when you’re in a liquidity trap, that doesn’t matter. (Alternatively, you can take a consolidated view of the government and central bank balance sheets, in which case what we’re effectively doing is refinancing at the zero short-term rate.)…

And Matthew C. Klein: Ken Rogoff’s Latest Bad Argument for Austerity:

It’s been more than three years since the U.K.’s coalition government began aggressively raising taxes and cutting spending in an effort to reduce its deficit. Many economists now agree that this program retarded the recovery, producing a slump worse than the Great Depression. Yet Harvard economist Kenneth Rogoff, in a column in the Financial Times, argues that those measures made sense as a form of insurance against the sort of crisis that has afflicted countries in the euro area such as Spain and Italy. His case has two parts, neither of which is convincing.

First, Rogoff implies that the U.K. was vulnerable to the same sorts of shocks that battered Spain and Italy…. The comparison is misleading, however. Unlike the 17 countries of the euro area, which share a single currency, the U.K. uses its own… totally different from the euro area….

Rogoff’s second point is that previous episodes of high indebtedness in the U.K. were special cases that should not inform today’s policy makers…. Rogoff dismisses the gradual repayment of the U.K.’s World War II-era debts because it was only made possible by persistent rapid inflation. That’s true, but Rogoff himself has repeatedly argued that the rich world needs more inflation, rather than less. In fact, at the bottom of his most recent column, Rogoff says that it was a mistake not to have pursued “even more aggressive monetary policy.”

IMF Panel: Fiscal Policy in the New Normal: (Partial) Transcript

I am (slowly) getting a cleaned-up transcript of this Bank-Fund Meeting cycle’s panel on “Fiscal Policy in the New Normal”:

Moderator: Vitor Gaspar. Panelists: Mitsuhiro Furusawa, Brad DeLong, Bill Morneau, Ludger Schuknecht, Arvind Subramanian

OVERVIEW: The global recovery has been anemic and future prospects have dimmed. Monetary policy has been stretched to extremes with quantitative easing and zero interest rates, yet investment remains subdued and deflationary pressures linger. Waning productivity, growing income inequality, and the longer-term implications of shifting demographics have led to repeated markdowns of medium-term growth potential. Should there be a pivot toward new ways of thinking about fiscal policy in a “new normal” of prolonged slow growth, in terms of both its countercyclical role and its effectiveness in boosting productivity and catalyzing longer-term inclusive growth?


VITOR GASPAR: Please take your seats. Good morning. Welcome to this panel discussion on fiscal policy in the “new normal”. I invite the audience to follow the event on Twitter; you can use the hashtag #IMFFiscal or #IMFMeetings. Both work.

I am very honored and pleased to have such a panel today to discuss fiscal policy. It is definitely very topical–we’re living in fiscal times. I expect the discussion to be very lively. Interventions will be short, brisk, and to the point. I expect the panelists to have views that, on occasion, will not coincide; and we will try to understand why that is the case. And so: what are the most important concentrations for fiscal policy in this “new normal”?

I am really privileged to have this fabulous panel today. On my left side I have Professor Brad DeLong. He is a professor at Berkeley, he is a colleague of our chief economist, he has one of the best websites on macroeconomic policy in general and fiscal policy in particular.

To the left of Brad we have Arvind Subramanian, chief economic advisor of the government of India. He is very well known here because he had a very distinguished career at the IMF as well as the Patterson Institute, and he is coming from one of the most dynamic economies of the world where public finance is transforming itself most rapidly.

And then we have the Minister of Finance of Canada Bill Morneau. And Canada has been pushing outward the envelope of best practices when it comes to fiscal economy, so we have a lot to learn.

And then my friend Ludger Shuknecht—we worked today at the European Central Bank. And as I was saying before, at the ECB Ludger was the fiscal man. The point is that obviously I was not.

Then we have our own Deputy Managing Director Furusawa, who has joined this role only recently, but he has a very distinguished career, both internationally and in Japan, most recently as an advisor to the Japanese Prime Minister.

Now let me address you at this time: we will have time to interact at the end, so please collect your thoughts on fiscal policy and be prepared, when time comes, to trigger your questions and interact with the panel.

Now let me just say a few words about what we mean by the “new normal”. What we have in mind is that the current macroeconomic situation is characterized by slow and shallow economic recovery after the global financial crisis, and we emphasize that without policy action it may well stay that way. That is what the Managing Director calls “the new mediocre”. And policy action is required to prevent “the new mediocre” from materializing.

The second element of this combination is that monetary policy in many advanced economies is very close to the effective lower bound, and inflation is too low, and investment remains subdued.

The third aspect is that fiscal policy is constrained by high levels of public debt in many advanced economies and some diverging market economies. And last, but not least, we have low productivity growth and growing income inequality in many countries; and that is a very hard combination, particularly if you have unfavorable demographics.

So the question for this panel is: do these characteristics of a “new normal” or perhaps the danger of a “new mediocre” require a different approach to fiscal policy? How should fiscal policy respond to this change? How it should behave at business cycle frequency? How can it foster long-term growth? And those questions are questions that of course are going to be answered with clarity by our panel.

But it will take a few minutes. So let’s start off immediately. And I will approach first, Brad, if you allow me. So in your opinion, and tell me from an academic viewpoint, has academic thinking about countercyclical fiscal policy changed recently?

BRAD DELONG: I would not say that thinking has changed. I would say that there is a good chance that thinking is changing. If so, it is as a result of a whole bunch of extraordinary surprises that have hit us all.

Back in 2007 we thought we understood the macroeconomic world, at least in its broad outlines and essentials. It has become very clear to us since 2007 that that is not the case. Right now we have a large number of competing diagnoses about where we were most wrong. We clearly were very wrong about the abilities of major money center banks to manage their derivatives books, or even to understand to understand what their derivatives books were. We clearly did not fully understand how those markets should be properly regulated.

Right now, however:

  • We have people who think the key flaw in the world economy today is an extraordinary shortage of safe assets. Nobody trusts private sector enterprises to do the risk transformation properly. Probably people will not again trust private sector enterprises for at least a generation.

  • We have those who think the problem is an excessive debt load where–I think we should distinguish between debt for which there is nothing safer, the debt of sovereigns that possess exorbitant privilege, and all other debts.

  • We have those who think we are undergoing a necessary deleveraging.

  • We have those who look for causes in the demography.

  • And then there is Larry Summers, as the third coming of British turn-of-the 20th century economist John Hobson. (The second coming was Alvin Hansen in the 1930s.) And the question: just what is Larry talking about?

    • Is Larry talking about the inevitable consequences of the coming of the demographic transition and of the end of Robert Gordon’s long second Industrial Revolution of extremely rapid economic growth?

    • Or is he talking a collapse of the ability of financial markets to do the risk transformation–to actually shrink the equity risk premium from its current absurd level down to something more normal?

If you look at asset prices now, you confront the minus two percent real return on the debt of sovereigns that possess exorbitant privilege with what Justin Lahart of the Wall Street Journal was telling me yesterday is now a 5.5% real earnings yield on the U.S. stock market as a whole. That 7.5% per year equity premium is a major derangement of asset prices. It makes it very difficult for us to use our standard tools to think about what good policy would be.

VITOR GASPAR: That’s excellent as a start-off. Ludger, could you give us the German perspective on the same question? Has fiscal policy evolved recently, and if so, how?


Moderator: Vitor Gaspar is Director of the Fiscal Affairs Department at the International Monetary Fund. Prior to joining the IMF, he held a variety of senior policy positions in Banco de Portugal, including most recently Special Adviser. He served as Minister of State and Finance of Portugal from 2011– 2013. He was head of the European Commission’s Bureau of European Policy Advisers from 2007–2010 and director-general of research at the European Central Bank from 1998 to 2004.

Mitsuhiro Furusawa is Deputy Managing Director of the International Monetary Fund. Mr. Furusawa joined the IMF after a distinguished career in the Japanese government, including several senior positions in the Ministry of Finance in recent years. Immediately before coming to the Fund, he served as Special Advisor to Japanese Prime Minister Shinzo Abe and Special Advisor to the Minister of Finance.
Brad DeLong:

Brad DeLong is a Professor of Economics at the University of California, Berkeley, a research associate of the National Bureau of Economic Research, and a blogger at the Washington Center for Equitable Growth. DeLong served as U.S. Deputy Assistant Secretary of the Treasury for Economic Policy from 1993 to 1995.

Bill Morneau is Canada’s Finance Minister. Previously, he led Morneau Shepell and was Pension Investment Advisor to Ontario’s Finance Minister. He is a former chair of the C. D. Howe Institute. He holds an MSc from the London School of Economics and an MBA from INSEAD.:

Ludger Schuknecht is Chief Economist at the German Ministry of Finance, and head of the Directorate General Fiscal Policy and International Financial and Monetary Policy. In his previous position as Senior Advisor in the Directorate General Economics of the European Central Bank, he contributed to the preparation of monetary policy decision making and the ECB positions in European policy coordination.

Arvind Subramanian is the Chief Economic Advisor to the government of India. He was Assistant Director in the Research Department of the IMF, served at the GATT, and taught at Harvard University’s Kennedy School of Government and at Johns Hopkins School for Advanced International Studies. In 2011, Foreign Policy Magazine named him one of the top 100 global thinkers.


The Clones of Jim Tobin vs. the Gravitational Pull of Chicago: A Paul Krugman Production…

2016 09 20 krugman geneva pdf

The highly-esteemed Mark Thoma sends us to Paul Krugman. In praise of real science: “Some people… always ask, ‘Is this the evidence talking, or my preconceptions?’ And you want to be one of those people…”.

Paul’s most aggressive claim is that our economics profession in 2007 would have done a much better job of economic analysis and policy guidance in real time had it consisted solely of clones of Samuelson, Solow, Tobin–I would add Modigliani, Okun, and Kindleberger–as they were in 1970: that the vector of net changes in macroeconomics in the 1970s were of zero value, and that the vector of net changes in macroeconomics since have been of negative value as far as understanding the world in real time is concerned.

This is, I think, too strong–and Paul does not quite make that claim. Doug Diamond and Phil Dybvig (1983)? Andrei Shleifer and Rob Vishny (1997)? And, of course, that keen-sighted genius Paul de Grauwe (2011).

Paul K. might respond that:

  • Paul de G. is very close to a clone of Jim Tobin who spent fifteen years as a member of the Belgian parliament, to which I can only say “touché”.
  • And you could say that Diamond-Dybvig and Shleifer-Vishny are simply mathing-up Kindleberger (1978), or perhaps Bagehot (1873). But there is great value in the mathing-up.
  • And I am going to have to think about why I have so much softer a spot in my heart for Uncle Milton Friedman than Paul K. does.

But in essentials, yes: Rank macroeconomists in 2007 by how much their intellectual trajectory had been influenced by the gravitational pull o fEd Prescott, Robert Lucas, and even Milton Friedman. Those whose trajectories had been affected least understood the most about the world in which we have been enmeshed since 2007:

Paul Krugman: What Have We Learned From The Crisis?:

We’ve seen a lot of vindication for old, unfashionable ideas–oldies but goodies that got deemphasized, and in some cases effectively blackballed, in the decades following the 1970s, but have turned out to be remarkably useful practical guides….

I was always a bit unsure about my own bona fides. Obviously I’d been a professional success, but why? Was it truly because I’d been making a real contribution to our understanding of how the world works, or was I simply good at playing an academic game?… Then came the crisis… and… several immediate questions in which popular intuitions and simple macroeconomic models were very much at odds. Would budget deficits cause interest rates to soar? Practical men said yes; economists, at least those of us with certain tools in our boxes, said no. Would huge increases in the monetary base cause runaway inflation? Yes, said practical men, politicians, and a few economists; no, said I and others of like mind. Would fiscal austerity depress output and employment? No, said many important people; on the contrary, it would be expansionary, because it would raise confidence. Yes, a lot, said Keynesian-minded economists. And my team won three out of three. Goooaaal!…

Economists from 1970 or so… might well have done a better job responding to the crisis than the economists we actually had on hand…. Tobin was one of the last prominent holdouts against the Friedman-Phelps natural rate hypothesis…. Friedman, Phelps, and their followers argued that any attempt to hold unemployment persistently below the natural rate would lead to ever-accelerating inflation; and their models implied, although this is rarely stressed, that an unemployment rate persistently above the natural rate would lead to ever-declining inflation and eventually accelerating deflation. Tobin was, however, skeptical…. Phillips tradeoffs that persist in the long run, at least at low inflation….

For reasons not completely persuasive to me, the standard response of macroeconomists to the failure of deflation to materialize seems to be to preserve the Friedman-Phelps type accelerationist Phillips curve, but then assert that expected inflation is “anchored”, so that it ends up being an old-fashioned Phillips curve in practice. We can debate why, exactly, we’re going this way. But… Tobin’s 1972 last stand against the natural rate turns out to be a better guide to the post-2008 landscape than just about anything written in the 35 years that followed….

The U.S. Federal funds rate hit zero in late 2008, with the economy still in a nosedive. The Fed responded with the first round of quantitative easing…. Meanwhile, the budget deficit soared…. What effect would these radically unusual policies have? The answer from quite a few public figures was to predict soaring inflation and interest rates. And I’m not just talking about the goldbugs… Allan Meltzer and Martin Feldstein warned about the coming inflation, joined by a Who’s Who of the Republican establishment. Academics like Niall Ferguson and John Cochrane warned about massive crowding out of private investment. But old-fashioned macro, with something like IS-LM at its base, offered startlingly contrary predictions at the zero lower bound…. And sure enough, inflation stayed low, as did interest rates.

IJT-style macro also made a prediction about the output effects of fiscal policy – namely, that it would have a substantial multiplier at the zero lower bound…. Chicago’s Cochrane insisted that the old-fashioned macro behind it had been “proved wrong.” Robert Lucas denounced Christina Romer’s use of multiplier analysis as “shlock economics,” basing his argument on a garbled version of Ricardian equivalence…. Jean-Claude Trichet sunnily declared that warnings about the contractionary impact of austerity were “incorrect”…. A few years on, and the old-fashioned Keynesian analysis looks pretty good… a multiplier around 1.5…. Which just happens to be the multiplier Christy Romer was assuming….

But wait, we’re not quite done. One aspect of the post-2008 story that apparently surprised many people, even smart economists like Martin Feldstein, was that huge increases in the monetary base didn’t seem to produce much rise in broader monetary aggregates, leading to claims that something strange was going on–that maybe it was all because the Fed was paying interest on excess reserves. But the same thing happened in Japan in the early 2000s, without any special interest payments….

The bottom line is that the crisis and its aftermath have actually provided a powerful vindication of macroeconomic models. Unfortunately for many economists, the models it vindicates are more or less vintage 1970. It’s far from clear that anything later added to our ability to make sense of events, and developments in macro over the course of the 80s and after may even have subtracted value….

What looks useful is a sort of looser-jointed approach: ad hoc Hicks-Tobin-type models, with simple models of financial market failure on the side…. For those seeking a definitive, integrated approach this will seem pitifully inadequate; and if I were a young academic seeking tenure I’d run away from all of this and either do empirical work or shun macro altogether. But models don’t have to rigorously dot all i’s and cross all t’s–let alone satisfy the peculiar criteria that modern macro calls “microfoundations”–to be very useful in practice…