What is the free-market solution to a liquidity trap? Higher inflation!

Three seventeen-year old quotes from Paul Krugman (Paul R. Krugman (1998): It’s Baaack: Japan’s Slump and the Return of the Liquidity Trap, Brookings Papers on Economic Activity 1998:2 (Fall), pp. 137-205):

Suppose that the required real rate of interest is negative; then the economy ‘needs’ inflation, and an attempt by the central bank to achieve price stability will lead to a zero nominal interest rate and excess cash holdings…


In a flexible-price economy, the necessity of a negative real interest rate [for equilibrium] does not cause unemployment…. The economy deflates now in order to provide inflation later…. This fall in the price level occurs regardless of the current money supply, because any excess money will simply be hoarded, rather than added to spending…. The central bank- which finds itself presiding over inflation no matter what it does, [but] this [flexible-price version of the liquidity] trap has no adverse real consequences…


A liquidity trap economy is “naturally” an economy with inflation; if prices were completely flexible, it would get that inflation regardless of monetary policy, so a deliberately inflationary policy is remedying a distortion rather than creating one…

Thinking about these three quotes has led me to change my rules for reading Paul Krugman.

My rules were, as you remember:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).

They are now:

  1. Paul Krugman is right.
  2. If you think Paul Krugman is wrong, refer to (1).
  3. And even if you thought Paul Krugman was right already, go reread and study him more diligently–for he is right at a deeper and subtler level than you would think possible.

Let us imagine a fully-flexible distortion-free free-market economy–the utopia of the Randites. Let us consider how it would respond should people suddenly become more pessimistic about the future.

People feel poorer. Feeling poorer, people want to spend less now. However, today’s productive capacity has not fallen. Thus the market economy, in order to incentivize people to keep spending now at a rate high enough to maintain full employment, drops the real interest rate. It thus makes the future more expensive relative to the present, and makes it sufficiently more expensive to incentivize keeping real spending now high enough to maintain full employment.

The real interest rate has two parts. It is equal to:

  1. the nominal interest rate,
  2. minus the inflation rate.

If money demand in the economy is interest elastic, the fall in the real interest rate will take the form of adjustments in both pieces. First, the free-market flexible-price distortion-free economy’s equilibrium will shift to drop the nominal interest rate. Second, the equilibrium will also shift to drop price level will drop immediately and instantaneously. Then the subsequent rebound of the price level back to normal produces the inflation that is the other part of The adjustment of the real interest rate.

If money demand takes the peculiar form of a cash-in-advance constraint, then:

  1. the interest elasticity of money demand is zero as long as the interest-rate is positive, and then
  2. the interest elasticity of money demand is infinite when the interest-rate hits zero.

In this case, the process of adjustment of the real interest rate in response to bad news about the future has two stages. In the first stage, 100% of the fall in the real interest rate is carried by a fall in the nominal interest rate, as the price level stays put because the velocity of money remains constant at the maximum technologically-determined rate allowed by the cash-in-advance constraint. In the second stage, once the nominal interest rate hits zero, and there is no longer any market incentive to spend cash keeping velocity up, 100% of the remaining burden of adjustment rests on the expected rebound inflation produced by an immediate and instantaneous fall in the price level. These two stages together carry the real interest rate down to where it needs to be, in order to incentivize the right amount of spending to preserve full employment.

The free-market solution to the problem created by an outbreak of pessimism about the future is thus to drop the nominal interest rate and then, if that does not solve the problem, to generate enough inflation in order to solve the problem.

Now we do not have the free-market distortion-free flexible-price economy that is the utopia of the Randites. We have an economy with frictions and distortions, in which the job of the central bank is to get price signals governing behavior to values as close as possible to those that the free-market distortion-free flexible-price economy that is the utopia of the Randites would produce.

In particular, our economy has sticky prices in the short run. There can be no instantaneous drop in the price level to generate expectations of an actual rebound inflation. If the central bank confines its policies to simply reducing the nominal interest rate while attempting to hold its inflation target constant, it may fail to maintain full employment. Even with the nominal interest rate at zero, the fact that the price level is sticky in the short-run may mean that the real interest rate is still too high: there may still be insufficient incentive to get spending to the level needed to preserve full employment.

A confident central bank, however, would understand that its task is to compensate for the macroeconomic distortions and mimic the free-market flexible-price full-employment equilibrium outcome. It would understand that proper policy is to set out a path for the money stock and for the future price level that produces the decline in the real interest rates that the flexible-price market economy would have generated automatically.

Thus a confident central bank would view generating higher inflation in a liquidity trap not as imposing an extra distortion on the economy, but repairing one. The free-market flexible-price distortion-free economy of Randite utopia would generate inflation in a liquidity trap in order to maintain full employment–via this instantaneous and immediate initial drop in the price level. A central bank in a sticky price economy cannot generate this initial price-level drop. But it can do second-best by generating the inflation.

All of my points above are implicit–well, actually, more than implicit: they are explicit, albeit compressed–in Paul Krugman’s original 1998 liquidity trap paper.

And yet I did not come to full consciousness that they were explicit until I had, somewhat painfully, rethought them myself, and then picked up on them when I reread Krugman (1998).

On the one hand, I should not feel too bad: very few other economists have realized these points.

On the other hand, I should feel even worse: as best as I can determine, no North Atlantic central bankers have recognized these points laid out in Paul Krugman’s original 1998 liquidity trap paper.

Central bankers, instead, have regarded and do regard exceeding the previously-expected level of inflation as a policy defeat. No central bankers recognize it as a key piece of mimicking the free-market full-employment equilibrium response to a liquidity trap. None see it as an essential part of their performing the adjustment of intertemporal prices to equilibrium values that their flexible-price benchmark economy would automatically perform, and that they are supposed to undertake in making Say’s Law true in practice.

But why has this lesson not been absorbed by policymakers? It’s not as though Krugman (1998) is unknown, or rarely read, is it?

It amazes me how much of today’s macroeconomic debate is laid out explicitly–in compressed form, but explicitly–in Krugman’s (1998) paper and in the comments by Dominguez and Rogoff, especially Rogoff…

Must-Read: Steve Pearstein: The Value and Limits of Economic Models

Must-Read: Let me agree with Steve Perlstein here: the economics that the very sharp Dani Rodrik praises is not the strongest current, outside of our liberal-arts non-business school ivory towers, and not always even in them.

Steven Pearlstein: The Value and Limits of Economic Models: “The alleged failings of economics are now widely understood…

…except perhaps by economists themselves. You hear that economics is ideology masquerading as hard science. That it has become overly theoretical and mathematical, based on false or oversimplified assumptions about the ways real people behave. That it systematically misunderstands the past and fails to anticipate the future. That it celebrates selfishness and greed and values only efficiency, ignoring fairness, social cohesion and our sense of what it is to be human. In his latest book, ‘Economics Rules,’ Dani Rodrik tries to bridge the gap between his discipline and its skeptics….

What economists forget, Rodrik says–or even worse, what they never are taught–is that the answer to most important questions is “It depends.” What’s right for one country at one time may not be right for another country or another time. Context matters. And because context matters, he argues that too much of the focus in economics has been on developing all-encompassing models and grand theories that can be applied to every context, and too little on expanding the inventory of more narrowly focused models and developing the art of knowing which ones to use….

Rodrik no doubt set out to offer an evenhanded view of modern economics, [but] in the end he winds up delivering a fairly devastating critique. “The discipline hobbles from one set of preferred models to another, driven less by evidence than by fads and ideology,” he writes. He despairs that his profession has become one that values “smarts over judgment,” has disdain for other disciplines and is content to produce mathematically elegant research papers that few outside the guild will ever use or understand. The standard economics course offered to undergraduates, he rightly complains, winds up presenting nothing more than “a paean to markets” rather than a “richer paradigm of human behavior.” Rodrik’s plea is for economics to be practiced with a bit more humility both by those who extol free markets and those who would tame them. Economics, he argues, is less a hard science capable of producing provable truths than a set of intuitions disciplined by logic and data and grounded in experience and common sense…

Painful lessons from the Great Recession: Hoisted from the archives from 5 years ago

What Have We Unlearned from Our Great Recession?

Jan 07, 2011 10:15 am, Sheraton, Governor’s Square 15 American Economic Association: What’s Wrong (and Right) with Economics? Implications of the Financial Crisis (A1) (Panel Discussion): Panel Moderator: JOHN QUIGGIN (University of Queensland, Australia)

  • BRAD DELONG (University of California-Berkeley) Lessons for Keynesians
  • TYLER COWEN (George Mason University) Lessons for Libertarians
  • SCOTT SUMNER (Bentley University) A defense of the Efficient Markets Hypothesis
  • JAMES K. GALBRAITH (University of Texas-Austin) Mainstream economics after the crisis:

My role here is the role of the person who starts the Alcoholics Anonymous meetings.

My name is Brad DeLong.

I am a Rubinite, a Greenspanist, a neoliberal, a neoclassical economist.

I stand here repentant.

I take my task to be a serious person and to set out all the things I believed in three or four years ago that now appear to be wrong. I find this distressing, for I had thought that I had known what my personal analytical nadir was and I thought that it was long ago behind me

I had thought my personal analytical nadir had come in the Treasury, when I wrote a few memos about how Rudi Dornbusch was wrong in thinking that the Mexican peso was overvalued. The coming of NAFTA would give Mexico guaranteed tariff free access to the largest consumer market in the world. That would produce a capital inflow boom in Mexico. And so, I argued, the peso was likely to appreciate rather than the depreciate in the aftermath of NAFTA.

What I missed back in 1994 was, of course, that while there were many US corporations that wanted to use Mexico’s access to the US market and so locate the unskilled labor parts of their value chains south, there were rather more rich people in Mexico who wanted to move their assets north. NAFTA not only gave Mexico guaranteed tariff free access to the largest consumer market in the world, it also gave US financial institutions guaranteed access to the savings of Mexicans. And it was this tidal wave of anticipatory capital flight–by people who feared the ballots might be honestly counted the next time Cuohtemac Cardenas ran for President–that overwhelmed the move south of capital seeking to build factories and pushed down the peso in the crisis of 1994-95.

I had thought that was my worst analytical moment.

I think the past three years have been even worse.

So here are five things that I thought I knew three or four years ago that turned out not to be true:

  1. I thought that the highly leveraged banks had control over their risks. With people like Stanley Fischer and Robert Rubin in the office of the president of Citigroup, with all of the industry’s experience at quantitative analysis, with all the knowledge of economic history that the large investment and commercial banks of the United States had, that their bosses understood the importance of walking the trading floor, of understanding what their underlings were doing, of managing risk institution by institution. I thought that they were pretty good at doing that.

  2. I thought that the Federal Reserve had the power and the will to stabilize the growth path of nominal GDP.

  3. I thought, as a result, automatic stabilizers aside, fiscal policy no longer had a legitimate countercyclical role to play. The Federal Reserve and other Central Banks were mighty and powerful. They could act within Congress’s decision loop. There was no no reason to confuse things by talking about discretionary fiscal policy–it just make Congress members confused about how to balance the short run off against the long run.

  4. I thought that no advanced country government with as frayed a safety net as America would tolerate 10% unemployment. In Germany and France with their lavish safety nets it was possible to run an economy for 10 years with 10% unemployment without political crisis. But I did not think that was possible in the United States.

  5. And I thought that economists had an effective consensus on macroeconomic policy. I thought everybody agreed that the important role of the government was to intervene strategically in asset markets to stabilize the growth path of nominal GDP. I thought that all of the disputes within economics were over what was the best way to accomplish this goal. I did not think that there were any economists who would look at a 10% shortfall of nominal GDP relative to its trend growth path and say that the government is being too stimulative.

With respect to the first of these–that the large highly leveraged banks had control over their risks: Indeed, American commercial banks had hit the wall in the early 1980s when the Volcker disinflation interacted with the petrodollar recycling that they had all been urged by the Treasury to undertake. American savings and loans had hit the wall when the Keating Five senators gave them the opportunity to gamble for resurrection while they were underwater. But in both of these the fact that the government was providing a backstop was key to their hitting the wall.

Otherwise, it seemed the large American high commercial and investment banks had taken every shock the economy could throw at them and had come through successfully. Oh, every once in a while an investment bank would flame out and vanish. Drexel would flame out and vanish. Goldman almost flamed out and vanished in 1970 with the Penn Central. We lost Long Term Capital Management. Generally we lost one investment bank every decade or generation. But that’s not a systemic threat. That’s an exciting five days reading the Financial Times. That’s some overpaid financiers getting their comeuppance, which causes schadenfreude for the rest of us. That’s not something of decisive macro significance.

The large banks came through the crash of 1987. They came through Saddam Hussein’s invasion of Kuwait. Everyone else came through the LTCM crisis. Everyone came through the Russian state bankruptcy when the IMF announced that nuclear-armed ex-superpowers are not too big to fail. They came through assorted emerging market crisis. They came through the collapse of the Dot Com Bubble.

It seemed that they understood risk management thing and that they had risk management thing right. In the mid 2000s when the Federal Reserve ran stress tests on the banks the stress was a sharp decline in the dollar if something like China’s dumping its dollar assets started to happen. Were the banks robust to a sharp sudden decline in the dollar, or had they been selling unhedged puts on the dollar? The answer appeared to be that they were robust. Back in 2005 policymakers could look forward with some confidence at the ability of the banks to deal with large shocks like a large sudden fall on the dollar.

Subprime mortgages? Well, those couldn’t possibly be big enough to matter. Everyone understood that the right business for a leveraged bank in subprime was the originate-and-distribute business. By God were they originating. But they were also distributing.

I thought about theses issues in combination with the large and persistent equity premium that has existed in the US stock market over the past century. You cannot blame this premium on some Mad Max scenario in which the US economy collapses because the equity premium is a premium return of stocks over US Treasury bonds, and if the US economy collapses then Treasury bonds’ real values collapse as well–the only things that hold their value are are bottled water, sewing machines and ammunition, and even gold is only something that can get you shot. You have to blame this equity risk premium on a market failure: excessive risk aversion by financial investors and a failure to mobilize the risk-bearing capacity of the economy. This there was a very strong argument that we needed more, not less leverage on a financial system as a whole. Thus every action of financial engineering–that finds people willing to bear residual equity risk and that turns other assets that have previously not been traded into tradable assets largely regarded as safe–helps to mobilize some of the collective risk bearing capacity of the economy, and is a good thing.

Or so I thought.

Now this turned out to be wrong.

The highly leveraged banks did not have control over their risks. Indeed if you read the documents from the SECs case against Citigroup with respect to its 2007 earnings call, it is clear that Citigroup did not even know what their subprime exposure was in spite of substantial effort by management trying to find out. Managers appeared to have genuinely thought that their underlings were following the originate-and-distribute models to figure out that their underlings were trying to engage in regulatory arbitrage by holding assets rated Triple A as part of their capital even though they knew fracking well that the assets were not really Triple A.

Back when Lehman Brothers was a partnership, every 30-something in Lehman Brothers was a risk manager. They all knew that their chance of becoming really rich depended on Lehman Brothers not blowing as they rose their way through the ranks of the partnership.

By the time everything is a corporation and the high-fliers’ bonuses are based on the mark-to-model performance of their positions over the past 12 months, you’ve lost that every-trader-a-risk manager culture. i thought the big banks knew this and had compensated for it.

I was wrong,

With respect to the second of these–that the Federal Reserve had the power and the will to stabilize nominal GDP: Three years ago I thought it could and would. I thought that he was not called “Helicopter Be”n for no reason. I thought he would stabilize nominal GDP. I thought that the cost to Federal Reserve political standing and self-perception would make the Federal Reserve stabilize nominal GDP. I thought that if nominal GDP began to undershoot its trend by any substantial amount, that then the Federal Reserve would do everything thinkable and some things that had not previously been thought of to get nominal GDP back on to its trend growth track.

This has also turned out not to be true.

That nominal GDP is 10% below its pre-2008 trend is not of extraordinarily great concern to those who speak in the FOMC meetings. And staffing-up the Federal Reserve has not been an extraordinarily great concern on the part of the White House: lots of empty seats on the Board of Governors for a long time.

With respect to the third of these–that discretionary fiscal policy had no legitimate role: Three years ago I thought that the Federal Reserve could do the job, and that discretionary countercyclical fiscal policy simply confused congress members, Remember Orwell’s Animal Farm? Every animal on the Animal Farm understands the basic principle of animalism: “four legs good, two legs bad” (with a footnote that, as Squealer the pig says, a wing is an organ of locomotion rather than manipulation and is properly thought of as leg rather than an arm–certainly not a hand).

“Four legs good, two legs bad,” was simple enough for all the animals to understand. “Short-term countercyclical budget deficit in recession good, long-run budget deficit that crowds out investment bad,” was too complicated for Congressmen and Congresswomen to understand. Given that, discretionary fiscal policy should be shunted off to the side as confusing. The Federal Reserve should do the countercycical stabiization job.

This also turned out not to be true, or not to be as true as we would like. When the Federal funds rate hits the zero lower bound making monetary policy effective becomes complicated. You can do it, or we think you can do it if you are bold enough, but it is no longer straightforward buying Treasury Bonds for cash. That is just a swap of one zero yield nominal Treasury liability for another. You have got to be doing something else to the economy at the same time to make monetary policy expansion effective at the zero nominal bound,

One thing you can do is boost government purchases. Government purchases are a form of spending that does not have to be backed up by money balances and so raise velocity. And additional government debt issue does have a role to play in keeping open market operations from offsetting themselves whenever money and debt are such close substitutes that people holding Treasury bonds as saving vehicles are just as happy to hold cash as savings vehicles. When standard open market operations have no effect on anything, standard open market operations plus Treasury bond issue will still move the economy.

With respect to the fourth of these–that no American government would tolerate 10% unemployment: I thought that American governments understood that high unemployment was social waste: that it was not in fact an efficient way of reallocating labor across sectors and response to structural change. When unemployment is high and demand is low, the problem of reallocation is complicated by the fact that no one is certain what demand is going to be when you return to full employment. Thus it is very hard to figure which industries you want to be moving resources into: you cannot look at profits but rather you have to look at what profits will be when the economy is back at full employment–and that is hard to do.

For example, it may well be the case that right now America is actually short of housing. There is a good chance that the only reason there is excess supply of housing right now is because people’s incomes and access to credit are so low that lots of families are doubling up in their five-bedroom suburban houses. Construction has been depressed below the trend of family formation for so long that it is hard to see how there could be any fundamental investment overhang any more.

It is always much better to have the reallocation process proceed by having rising industries pulling workers into employment because demand is high. It is bad to have the reallocation process proceed by having mass unemployment in the belief that the unemployed will sooner or later figure out something productive to do. I thought that American governments understood that.

I thought that American governments understood that high unemployment was very hazardous to incumbents. I thought that even the most cynical and self-interested Congressmen and Congresswomen and Presidents would strain every nerve to make sure that the period of high unemployment would be very short.

It turned out that that wasn’t true.

I really don’t know why. I have five theories:

  1. Perhaps the collapse of the union movement means that politicians nowadays tend not to see anybody who speaks for the people in the bottom half of the American income distribution.
  2. Perhaps Washington is simply too disconnected: my brother-in-law observes that the only place in America where it is hard to get a table at dinner time in a good restaurant right now is within two miles of Capitol Hill.
  3. Perhaps we are hobbled by general public scorn at the rescue of the bankers–our failure to communicate that, as Don Kohn said, it’s better to let a couple thousand feckless financiers off scot-free than to destroy the jobs of millions, our failure to make that convincing.
  4. I think about lack of trust in a split economics profession–where there are, I think, an extraordinarily large number of people engaging in open-mouth operations who have simply not done their homework. And at this point I think it important to call out Robert Lucas, Richard Posner, and Eugene Fama, and ask them in the future to please do at least some of their homework before they talk onsense.
  5. I think about ressentment of a sort epitomized by Barack Obama’s statements that the private sector has to tighten its belt and so it is only fair that the public sector should too. I had expected a president advised by Larry Summers and Christina Romer to say that when private sector spending sits down then public sector spending needs to stand up–that is is when the private sector stands up and begins spending again that the government sector should cut back its own spending and should sit down.

I have no idea which is true.

I do know that when I wander around Capitol Hill and the Central Security Zone in Washington, the general view I hear is: “we did a good job: we kept unemployment from reaching 15%–which Mark Zandi and Alan Blinder say it might well have reached if we had done nothing.” That declaration of semi-victory puzzles me.

Three years ago, I thought that whatever theories economists worked on they all agreed the most important thing to stabilize was nominal GDP. Stabilizing the money stock was a good thing to do only because money was a good advance indicator of nominal GDP. Worrying about the savings-investment balance was a good thing to worry about because if you got it right you stabilized nominal GDP. Job 1 was keeping nominal GDP on a stable growth path, so that price rigidity and other macroeconomic failures did not cause high unemployment. That, I thought, was something all economists agreed on. Yet I find today, instead, the economics profession is badly split on whether the 10% percent shortfall of nominal GDP from its pre-2008 trend is even a major problem.

So what are the takeaway lessons? I don’t know.

Last night I was sitting at my hotel room desk trying to come up with the “lessons” slide.

The best I could come up with is to suggest that perhaps our problem is that we have been teaching people macroeconomics.

Perhaps macroeconomics should be banned.

Perhaps it should only be taught through economic history and the history of economic thought courses–courses that start in 1800 back when all issues of what the business cycle was or what it might become were open, and that then trace the developing debates: Say versus Mathis, Say versus Mill, Bagehot versus Fisher, Fisher versus Wicksell, Hayek versus Keynes versus Friedman, and so forth on up to James Tobin. I really don’t know who we should teach after James Tobin: I haven’t been impressed with any analyses of our current situation that have not been firmly rooted in Tobin, Minsky, and those even further in the past.

Then economists would at least be aware of the range of options, and of what smart people have said and thought it the past. It would keep us from having Nobel Prize-caliber economists blathering that the NIPA identity guarantees that expansionary fiscal policy must immediately and obviously and always crowd-out private spending dollar-for-dollar because the government has to obtain the cash it spends from somebody else. Think about that a moment: there is nothing special about the government. If the argument is true for the government, it is true for all groups–no decision to increase spending by anyone can ever have any effect on nominal GDP because whoever spends has to get the cash from somewhere, and that applies to Apple Computer just as much as to the government.

And that has to be wrong.

So let me stop there and turn it over to Scott Sumner…

Must-Read: Mark Thoma: Where Fed’s Critics Got It Wrong in GOP Debate

Must-Read: After being wrong for eight straight years, critics of expansionary macro policies in a high-slack low-inflation economy–those who say that fiscal stimulus is sugar, and monetary expansion is opium–have not only not rethought their positions, but have taken over economic policy, in rhetoric at least, everywhere in the Republican Party. Can somebody please tell me what is going on?

Mark Thoma: Where Fed’s Critics Got It Wrong in GOP Debate: “The Federal Reserve was instrumental in easing the impact of the Great Recession…

…So it has been disappointing to hear Republican presidential candidates bash the Fed in their debates and on the campaign trail… blamed… income inequality…. [But] ould inequality be lower, on average, if the unemployment rate were 8 percent instead of 5 percent and if millions more were unemployed?… The Fed is also accused of playing politics by keeping interest rates low…. Republicans criticize the Fed because its low interest rate policy supposedly hurts the economy, yet somehow the central bank is keeping interest rates [artificially] low to help the economy [and thus the Democrats in office]? I am not impressed…. The Fed is keeping interest rates low because that’s what economic conditions demand…. And don’t get me started on the proposals to return to a gold standard….

It’s a bit irksome to hear Republicans, many of whom are in Congress, spouting on about the Fed’s poor policy when they are the ones who endorsed a policy mistake in pursuit of political and ideological objectives. The Fed did what it needed to do. Republican lawmakers didn’t…. The next time you hear Republicans call for more control and oversight of the Fed by Congress, think about how poorly Congress did with fiscal policy, and how creative and aggressive the Fed became in trying to compensate for that failure. Then ask yourself whether that is a good idea.

Must-Read: Paul Krugman: Austerity’s Grim Legacy

Paul Krugman: Austerity’s Grim Legacy: “The consequences of the wrong turn we took look worse now…

…than the harshest critics of conventional wisdom ever imagined. For those who don’t remember (it’s hard to believe how long this has gone on): In 2010, more or less suddenly, the policy elite on both sides of the Atlantic decided to stop worrying about unemployment and start worrying about budget deficits instead. This shift wasn’t driven by evidence or careful analysis… was very much at odds with basic economics. Yet ominous talk about the dangers of deficits became something everyone said because everyone else was saying it… those parroting the orthodoxy of the moment [were the] Very Serious People. Some of us tried in vain to point out that deficit fetishism was both wrongheaded and destructive…. And we were vindicated by events. More than four and a half years have passed since Alan Simpson and Erskine Bowles warned of a fiscal crisis within two years; U.S. borrowing costs remain at historic lows. Meanwhile, the austerity policies that were put into place in 2010 and after had exactly the depressing effects textbook economics predicted; the confidence fairy never did put in an appearance…. [And] there’s growing evidence that we critics actually underestimated just how destructive the turn to austerity would be. Specifically, it now looks as if austerity policies didn’t just impose short-term losses of jobs and output, but they also crippled long-run growth….

At this point… evidence practically screams “hysteresis”. Even countries that seem to have largely recovered from the crisis, like the United States, are far poorer than precrisis projections suggested they would be at this point. And a new paper by Mr. Summers and Antonio Fatás… shows that the downgrading of nations’ long-run prospects is strongly correlated with the amount of austerity they imposed…. The turn to austerity had truly catastrophic effects…. The long-run damage suggested by the Fatás-Summers estimates is easily big enough to make austerity a self-defeating policy even in purely fiscal terms: Governments that slashed spending in the face of depression hurt their economies, and hence their future tax receipts, so much that even their debt will end up higher than it would have been without the cuts. And the bitter irony of the story is that this catastrophic policy was undertaken in the name of long-run responsibility….

There are a few obvious lessons… groupthink is no substitute for clear analysis… calling for sacrifice (by other people, of course) doesn’t mean you’re tough-minded. But will these lessons sink in? Past economic troubles, like the stagflation of the 1970s, led to widespread reconsideration of economic orthodoxy. But one striking aspect of the past few years has been how few people are willing to admit having been wrong about anything…

Must-Read: Lawrence Summers: Global Economy: The Case for Expansion

Must-Read: Uncertainty about what the correct model of the economy is and a strongly asymmetric loss function do not simply apply to the question of whether the Federal Reserve should start a tightening cycle now or delay for a year and reevaluate then. It also applies to the question of whether fiscal policy–with its substance-free love of austerity–is fundamentally, tragically, and potentially catastrophically misguided:

Lawrence Summers: Global Economy: The Case for Expansion: “The inability of the industrial world to grow at satisfactory rates even with very loose monetary policies…

…problems in most big emerging markets, starting with China… the spectre of a vicious global cycle…. The risk of deflation is higher than that of inflation… we cannot rely on the self-restoring features of market economies… hysteresis–where recessions are not just costly but stunt the growth of future output–appear far stronger…. Bond markets… are [saying:] risks tilt heavily towards inflation… below… targets… [despite expected] monetary policy… looser than the Federal Reserve expects… [plus] extraordinarily low real interest rates….

If I am wrong about [the need for] expansionary fiscal policy, the risks are that inflation will accelerate too rapidly, economies will overheat and too much capital will flow to developing countries. These outcomes seem remote. But even if they materialise, standard approaches can be used to combat them. If I am right and policy proceeds along the current path, the risk is that the global economy will fall into a trap not unlike the one Japan has been in for 25 years…. What is conventionally regarded as imprudent offers the only prudent way forward.

If the world undertook a large, coordinated fiscal expansion, five years from now we might regret it: we might be trying to reduce an uncomfortably-high inflation rate via tight monetary policy and relatively-high interest rates, and worrying about the long-term sustainability of government debt given that, finally, r>g. But those are problems we can handle, and those are problems of a world near full employment with ample incentives to invest in physical capital, organizational business models, and new technology.

If the world does not undertake a large, coordinated fiscal expansion, five years from now we might regret it: having failed to do anything to claw the global economy off the lee shore of the zero lower bound in 2015-6, the next adverse shock would leave the world mired in a depression as deep as 2008-9 with no available monetary policy tools to fight it.

In a world of uncertainty about the right model, the correct policy choice is obvious.

Yet the center of the Fed–both FOMC participants and staff alike–say things like: “You cannot make policy without a forecast.” And they go on to say that they will take the next policy step as if the forecast is accurate, and reevaluate only as outcomes differ from expectations. This seems to me to be an elementary mistake: in finance, after all, those who neglect optionality get taken to the cleaners by those who see it and use it.

And it is not as if the Federal Reserve’s current forecast–for rising PCE inflation crossing 2%/year in less than two years–even looks to me like the right forecast: is this a pattern that you think will generate wage growth high enough to sustain 2%/year-plus PCE inflation in two years?

A kink in the Phillips curve Equitable Growth

Must-Read: Matt Phillips: Bernanke: I’m not really a Republican anymore

Must-Read: As I have said before and will stay again, the Republican Party could be taking a serious policy victory lap right now, not just with respect to health policy–as Mitt Romney tried to do yesterday before losing his nerve and pulling back–and with respect to monetary policy. they could be pointing out right now that the most successful recovery in the North Atlantic from 2008-9 was engineered by Republican Ben Bernanke following Friedmanite countercyclical monetary policies.

But no!

They would rather be Hayekians, predicting imminent hyperinflation…

Why? I think it’s the Fox News-ification of political discourse: terrify people in the hope that you will then gain their attention and they will give you money…

Matt Phillips: Bernanke: I’m not really a Republican anymore: “Ben Bernanke has publicly broken ranks with the Republican party…

…In one of the more revealing passages of… The Courage to Act… [he] lays out his experience with Republican lawmakers during the twin financial and economic crises….Continual run-ins with hard-right Republicans… pushed him away from the party that first put him in charge of the Fed….

[T]he increasing hostility of the Republicans to the Fed and to me personally troubled me, particularly since I had been appointed by a Republican president who had supported our actions during the crisis. I tried to listen carefully and accept thoughtful criticisms. But it seemed to me that the crisis had helped to radicalize large parts of the Republican Party….

The former Princeton economics professor said he had:

lost patience with Republicans’ susceptibility to the know-nothing-ism of the far right. I didn’t leave the Republican Party. I felt that the party left me.

He later concludes: ‘I view myself now as a moderate independent, and I think that’s where I’ll stay’…

The Extremely-Sharp Tim Duy Sees the Fed Moving Away from Contractionary Policy

FRED Graph FRED St Louis Fed

The extremely-sharp Tim Duy sees a much bigger potential impact than I do from Fed Governor Lael Brainard’s recent speech telegraphing future dissents on her part if the Federal Reserve raises interest rates in the current situation. Briefly, this: The failure to raise interest rates over the next nine months will call forth dissents from those whose analytical perspectives have been wrong pretty much all the time since 2007. Raising interest rates will call forth dissents from those whose analytical perspectives have been pretty much right all the time since 2007. Moreover, it is straightforward to undo the damage from being behind the curve in raising interest rates. It is impossible to undo the damage from being ahead of the curve in raising interest rates.

It would be one thing to raise interest rates if it were the unanimous consensus of the committee that it was time to do so. It is quite another, in a world of uncertainty and the need for prudent risk management. It’s quite another to risk making unrecoverable errors by endorsing those whose positions have been wrong in the past over the objections of those whose positions have been right.

Tim Duy: Brainard Drops A Policy Bomb: “Lael Brainard dropped a policy bomb…

…a direct challenge to Chair Janet Yellen and Vice Chair Stanley Fischer. Is was, as they say, a BFD. That, at least, is my opinion…. [She] stands in sharp contrast with Yellen and Fischer. Their efforts have been spent on explaining why rates need to rise soon. Hers… on why they do not…. Brainard asserts….

I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation. A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak….

Recall that Yellen, in her most recent speech, made the Phillips Curve the primary basis for her case that rates will soon need to rise…. While Yellen sees the risks weighted toward rebounding inflation, Brainard sees the opposite. Moreover, policymakers have been twiddling their thumbs as the world economy turns against them:

Over the past 15 months, U.S. monetary policy deliberations have been taking place against a backdrop of progressively gloomier projections of global demand. The International Monetary Fund (IMF) has marked down 2015 emerging market and world growth repeatedly since April 2014.

While all of you have been arguing about when to raise rates, the case for raising rates has been falling apart!… [Brainard] calls for different risk management:

These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize….

The Fed can’t cut rates quickly, but they can raise rates quickly…. Suppose that the Fed needs raise rates at twice the pace they currently anticipate.  What does that mean? 25bp at every meeting instead of every other meeting? Is that really an ‘abrupt tightening?’ Not sure that Yellen has a very strong argument here. Or one that would withstand repeated attacks from her peers…. I think Yellen wants to raise interest rates. I think Fischer wants to raise rates.  I think both believe the downward pressure on inflation due to labor market slack is minimal, and the Phillips Curve will soon assert itself. I think both do not find the risks as asymmetric as does Brainard…. I think that Brainard knows this. I think that this speech is a very deliberate action by Brainard to let Yellen and Fischer know that she will not got quietly into the night…. And now that Brainard has laid down the gauntlet, it will look very, very bad for Yellen and Fischer if their plans go sideways….

Brad DeLong suggested the Fed commit to one of two policy messages:

I must say that they are not doing too well at the clear-communication part. I want to see one of following things in Fed statements:

  1. We will begin raising interest rates in December at a pace of basis points per quarter, unless economic growth and inflation fall substantially short of our current forecast expectations.

  2. We will delay raising interest rates until we are confident that it will not be appropriate to return them to the zero lower bound after liftoff.

If we had one of these, we would know where we stand.

But Stan Fischer’s speech provides us with neither.

I think that Fischer wants the first option, but knows Brainard’s views, and hence knows that December is not a sure thing if Brainard can build momentum for her position. Hence the muddled message. Brainard could be the force that drives the Fed toward option number two… closer to that of Evans and… Kocherlakota…. This is the most exciting speech I have read in forever…

As a matter of economic reality, Brainard is correct: The lesson of Staiger, Stock, and Watson (1997) is that the Phillips Curve is much too imprecisely-estimated to weigh as more than a feather in the scales to reduce uncertainty about the state of the economy two years from now. The risks are asymmetric: The option to change course and quickly neutralize the effects of your past year’s policies is a very valuable one. Raising interest rates and starting a tightening cycle throws away that option. You can always raise interest rates quickly and further and undo the effects of being behind the curve in withdrawing monetary stimulus. You cannot lower interest rates below zero and undo the effects of premature tightening away from the zero lower bound.

As I have repeatedly said, the mystery is why the lessons of SSW and the asymmetry of the risks have not been the decisive arguments among the serious members of the FOMC all along.

Must-Read: Matt Phillips: Bernanke: I’m not really a Republican anymore

Must-Read: As I have said before and will stay again, the Republican Party could be taking a victory lap right now with respect to monetary policy–pointing out that the most successful recovery in the North Atlantic from 2008-9 was engineered by a Republican following Friedmanite countercyclical monetary policies. But no! They would rather be Hayekians, predicting imminent hyperinflation…

Why? I think it’s the Fox News-ification of the Republican Party: terrify people in the hope that you will then gain their attention and they will give you money…

Matt Phillips: Bernanke: I’m not really a Republican anymore: “Ben Bernanke has publicly broken ranks with the Republican party…

…In one of the more revealing passages of… The Courage to Act… [he] lays out his experience with Republican lawmakers during the twin financial and economic crises….Continual run-ins with hard-right Republicans… pushed him away from the party that first put him in charge of the Fed….

[T]he increasing hostility of the Republicans to the Fed and to me personally troubled me, particularly since I had been appointed by a Republican president who had supported our actions during the crisis. I tried to listen carefully and accept thoughtful criticisms. But it seemed to me that the crisis had helped to radicalize large parts of the Republican Party….

The former Princeton economics professor said he had:

lost patience with Republicans’ susceptibility to the know-nothing-ism of the far right. I didn’t leave the Republican Party. I felt that the party left me.

He later concludes: ‘I view myself now as a moderate independent, and I think that’s where I’ll stay’…

Must-Read: Paul Krugman: Did The Fed Save The World?

Must-Read: Looking back at my archives, I find that my own ratio of “Paul Krugman is right” to “Paul Krugman is wrong” posts is not in the rational range between 10-1 and 5-1, but is 15-1. So I am looking for an opportunity to rebalance. And I find one this morning: Here I think Paul Krugman is wrong. Why? Because of this:

2015 10 06 for 2015 10 07 DeLong ULI key

Housing crashes. And does not bounce back quickly by the end of 2010–or, indeed, at all. And Paul Krugman is correct to write that “Even a total collapse of home lending couldn’t have subtracted more than a point or two more off aggregate demand”:

2015 10 06 for 2015 10 07 DeLong ULI key

But exports collapse as the financial crisis hits, and then bounce back very rapidly as the financial crisis passes:

2015 10 06 for 2015 10 07 DeLong ULI key

And roughly one-third of the financial-crisis associated collapse in business investment is quickly reversed after the financial crisis passes:

2015 10 06 for 2015 10 07 DeLong ULI key

Together these two factors plausibly associated with the reuniting of the web of financial intermediation look to me to be five times as large as the fiscal stimulus measured by government purchases. Now fiscal stimulus worked through channels other than government purchases. And without the Recovery Act we would have seen states and localities not holding their purchases constant over 2008-2011 but cutting them by 1% of GDP or so. And not all of the export and business investment bounce-back in the two years after the 2009 trough can be attributed to lender-of-last-resort and easy-money policies.

But it looks to me like the balance is that–even with housing left to rot on the stalk–monetary and banking policy did more than fiscal policy to stem the downturn and promote recovery up to 2011. And it looks to me that, since 2011, it is the reknitting of the financial system and easy money that has kept the extraordinary austerity that the states and the Republicans imposed and that Obama has bought into from sending the U.S., at least, into a renewed and deeper downturn.

Paul Krugman: Did The Fed Save The World?: “Bernanke’s basic theme is that the shocks of 2008 were bad enough that we could have had a full replay of the Great Depression…

…the reason we didn’t was that in the 30s central banks just sat immobilized while the financial system crashed, but this time they went all out to keep markets working. Should we believe this?… I very much agree with BB that pulling out all the stops was the right thing to do…. But I’m not persuaded that the real difference between 2008 and 1930-31 (which is when the Depression turned Great) lies in central bank action, or related bailouts. It’s true that the 30s were marked by a big financial disruption…. Shadow banking rapidly shriveled up, with repo and other alternatives to bank financing shrinking very fast; liquidity for everything but the safest of assets disappeared even though the big financial firms remained in being. And if we’re looking for effects of the tightening in credit conditions, remember that credit policy usually exerts its biggest effects through housing — and housing investment fell more than 60 percent as a share of GDP….

So really, was putting a limit on the financial crisis the reason we didn’t do a full 1930s? Or was it something else? And there is one other big difference between the world in 2008 and the world in 1930: big government…. Again, Bernanke and company were right to step in forcefully. But I’d argue that the fiscal environment was probably more important than monetary actions in limiting the damage. Oh, and since 2010 officials everywhere, but especially in Europe, have been doing all they can to undo the favorable effects…. And the result is that in Europe economic performance is at this point considerably worse than it was at this point in the 1930s.