What Kind of New Economic Thinking Is Needed Now?: A Twitter Dialogue, with References

A Twitter Dialogue: IS-LM and the Neoclassical Synthesis in the Short-Run and the Medium-Run: Andy Harless asks a question, and I try to explain what I think Paul Krugman is thinking…

And let me put the relevant Paul Krugman pieces down here below the fold… or, rather, below the second fold:

Paul Krugman (October 30, 2015): An Unteachable Moment: “It is, as Antonio Fatas notes, almost seven years since the Fed cut rates to zero…

…The era of lowflation-plus-liquidity-trap now rivals in length the 70s era of stagflation, and has been associated with much worse real economic performance. So where, asks Fatas, is the rethinking of economic theory and policy? I asked the same question a couple of years ago…. Some of us anticipated much though not all of what has gone wrong. [But as] Fatas says…

even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies. Most thought that this was just a unique example of incompetence among Japanese policy makers….

I did write a 1999 book titled The Return of Depression Economics, basically warning that Japan might be a harbinger…. [But even] I never expected policy to be so bad that Japan ends up looking like a role model…. We should have expected… as major a rethink as… in the 70s… [but] we’ve seen almost no rethinking. Economists who wrote that ‘inflation is looming’ in 2009 continued to warn about looming inflation five years later. And that’s the professional economists. As Josh Barro notes, conservatives who imagine themselves intellectuals have increasingly turned to Austrian economics, which explicitly denies that empirical data need to be taken into account….

Back to Fatas: how long will it take before the long stagnation has the kind of intellectual impact that stagflation did… before people stop holding up the 1970s as the ultimate cautionary tale, even… in the midst of a continuing disaster that makes the 70s look mild? I don’t know…. It’s clear that we have to understand this phenomenon in terms of politics and sociology, not logic.

Paul Krugman (October 20, 2015): Rethinking Japan: “The IMF held a small roundtable discussion on Japan yesterday…

…and in preparation for the event I thought it was a good idea to update my discussion of Japan…. I find it useful to approach this subject by asking how I would change what I said in my 1998 paper on the liquidity trap… one of my best papers; and it has held up pretty well…. But… there are two crucial differences between then and now. First, the immediate economic problem is no longer one of boosting a depressed economy, but instead one of weaning the economy off fiscal support. Second, the problem confronting monetary policy is harder than it seemed, because demand weakness looks like an essentially permanent condition.

Back in 1998 Japan was in the midst of its lost decade… good reason to believe that it was operating far below potential output. This is… no longer the case…. Output per working-age adult has grown faster than in the United States since around 2000, and at this point the 25-year growth rates look similar (and Japan has done better than Europe)…. Japan [may be] closer to potential output than we are.

So if Japan isn’t deeply depressed at this point, why is low inflation/deflation a problem?The answer… is largely fiscal. Japan’s relatively healthy output and employment levels depend on continuing fiscal support… large budget deficits, which in a slow-growth economy means an ever-rising debt/GDP ratio. So far this hasn’t caused any problems…. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point. And here’s the thing: under current conditions, with policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion.

The big reason to raise inflation, then, is to make it possible to cut real interest rates… allowing monetary policy to take over from fiscal policy…. The fact that real interest rates are in effect being kept too high by insufficient inflation at the zero lower bound also means that debt dynamics for any given budget deficit are worse than they should be…. Raising inflation would both make it possible to do fiscal adjustment and reduce the size of the adjustment needed.

But what would it take to raise inflation? Back in 1998… I envisaged an economy in which the current level of the Wicksellian natural rate of interest was negative, but that rate would return to a normal, positive level…. It was easy to show that this proposition applied only if the money increase was perceived as permanent, so that the liquidity trap became an expectations problem. The approach also suggested that monetary policy would be effective if… the central bank could ‘credibly promise to be irresponsible’…. But what is this future period of Wicksellian normality of which we speak?…

Japan looks like a country in which a negative Wicksellian rate is a more or less permanent condition. If that’s the reality, even a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t. The only way to be at all sure of raising inflation is to accompany a changed monetary regime with a burst of fiscal stimulus…. While the goal of raising inflation is, in large part, to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion. This… is unconventional enough that one despairs of turning the argument into policy (a despair reinforced by yesterday’s meeting…)

How high should Japan set its inflation target?… High enough so that when it does engage in fiscal consolidation it can cut real interest rates far enough to maintain full utilization…. It’s really, really hard to believe that 2 percent inflation would be high enough…. Japan may face a version of the timidity trap. Suppose it convinces the public that it will really achieve 2 percent inflation… engages in fiscal consolidation, the economy slumps, and inflation falls well below 2 percent… the whole project unravels–and the damage to credibility makes it much harder to try again. What Japan needs (and the rest of us may well be following the same path) is really aggressive policy, using fiscal and monetary policy to boost inflation, and setting the target high enough that it’s sustainable. It needs to hit escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

Paul Krugman (March 21, 2014): Timid Analysis: IAn issue I’ve worried about for a long time…

…which I think I’ve been able to formulate a bit better. Here goes: If you look at the extensive theoretical literature on the zero lower bound since my 1998 paper, you find that just about all of it treats liquidity-trap conditions as the result of a temporary shock… [that] leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment. Eventually, however, the shock will end. So the way out is to convince the public that there has been a regime change, that the central bank will maintain expansionary monetary policy even after the economy recovers, so as to generate high demand and some inflation.

But if we’re talking about Japan, when exactly do we imagine that this period of high demand… is going to happen?… What does it take to credibly promise inflation? Well, it has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation. But a necessary (not sufficient) condition for this to work is that the promised inflation be high enough that it will indeed produce an economic boom if people believe the promise will be kept. If it isn’t, then the actual rate of inflation will fall short of the promise even if people believe in the promise–which means that they will stop believing after a while, and the whole effort will fail….

Suppose that the economy really needs a 4 percent inflation target, but the central bank says, ‘That seems kind of radical, so let’s be more cautious and only do 2 percent.’ This sounds prudent–but may actually guarantee failure.

Paul Krugman (March 20, 2014): The Timidity Trap: “In Europe… they’re crowing about Spain’s recovery…

…growth of 1 percent, versus 0.5 percent, in a deeply depressed economy with 55 percent youth unemployment. The fact that this can be considered good news just goes to show how accustomed we’ve grown to terrible economic conditions…. People seem increasingly to be accepting this miserable situation as the new normal…. How did this happen?… I’d argue that an important source of failure was what I’ve taken to calling the timidity trap–the consistent tendency of policy makers who have the right ideas in principle to go for half-measures in practice, and the way this timidity ends up backfiring, politically and even economically….

There are some important differences between the U.S. and European pain caucuses, but both now have truly impressive track records of being always wrong, never in doubt…. In America… a faction both on Wall Street and in Congress… has spent five years and more issuing lurid warnings about runaway inflation and soaring interest rates. You might think that the failure of any of these dire predictions to come true would inspire some second thoughts, but, after all these years, the same people are still being invited to testify, and are still saying the same things…. In Europe, four years have passed since the Continent turned to harsh austerity programs. The architects of these programs told us not to worry about adverse impacts on jobs and growth–the economic effects would be positive, because austerity would inspire confidence. Needless to say, the confidence fairy never appeared….

So what has been the response of the good guys?… The Obama administration’s heart–or, at any rate, its economic model–is in the right place. The Federal Reserve has pushed back against the springtime-for-Weimar, inflation-is-coming crowd. The International Monetary Fund has put out research debunking claims that austerity is painless. But these good guys never seem willing to go all-in…. The classic example is the Obama stimulus… obviously underpowered given the economy’s dire straits. That’s not 20/20 hindsight….

The Fed has, in its own way, done the same thing. From the start, monetary officials ruled out the kinds of monetary policies most likely to work–in particular, anything that might signal a willingness to tolerate somewhat higher inflation, at least temporarily. As a result, the policies they have followed have fallen short of hopes, and ended up leaving the impression that nothing much can be done.

And the same may be true even in Japan… finally adopting the kind of aggressive monetary stimulus Western economists have been urging for 15 years and more. Yet there’s still a diffidence… a tendency to set things like inflation targets lower than the situation really demands… [that] increases the risk that Japan will fail to achieve ‘liftoff’–that the boost it gets from the new policies won’t be enough to really break free from deflation.

You might ask why the good guys have been so timid, the bad guys so self-confident. I suspect that the answer has a lot to do with class interests. But that will have to be a subject for another column.

On the proper size of the public sector, and the proper level of public debt, in the 21st century

Progress and Confusion cover2 pdf 1 page

Rethinking Macro Policy III

Jack Morton Auditorium, George Washington University :: April 15-16, 2015

It has now been seven years since the onset of the global financial crisis. A central question is how the crisis has changed our view on macroeconomic policy. The IMF originally tackled this issue at a 2011 conference and again at a 2013 conference. Both conferences proved very successful, spawning books titled In the Wake of the Crisis and What Have We Learned? published by the MIT Press.

The time seemed right for another assessment. Research has continued, policies have been tried, and the debate has been intense. How much progress has been made? Are we closer to a new framework? To address these questions the IMF organized a follow up conference on “Rethinking Macro Policy III: Progress or Confusion?”, which took place at the Jack Morton Auditorium in George Washington University, Washington DC, on April 15–16, 2015.

The conference was co-organized by IMF Economic Counselor Olivier Blanchard, RBI Governor Raghu Rajan, and Harvard Professors Ken Rogoff and Larry Summers. It brought together leading academics and policymakers from around the globe, as well as representatives from civil society, the private sector, and the media. Attendance was by invitation only.

Wrap Up Video:

J. Bradford DeLong

On the Proper Size of the Public Sector, and the Proper Level of Public Debt, in the Twenty-First Century


Olivier Blanchard, when he parachuted me into the panel, asked me to “be provocative.”

So let me provoke:

My assigned focus on “fiscal policy in the medium term” has implications. It requires me to assume that things are or will be true that are not now or may not be true in the future, at least not for the rest of this decade and into the next. It makes sense to distinguish the medium from the short term only if the North Atlantic economies will relatively soon enter a regime in which the economy is not at the zero lower bound on safe nominal interest rates. The medium term is at a horizon at which monetary policy can adequately handle all of the demand-stabilization role.

The focus on a medium run thus assumes that answers have been found and policies implemented for three of the most important macroeconomic questions facing us right now, here in the short run, today. Those three are:

  • What role does fiscal policy have to play as a cyclical stabilization policy?
  • What is the proper level of the inflation target so that open-market operation-driven normal monetary policy has sufficient purchase?
  • Should truly extraordinary measures that could be classified as “social credit” policies—mixed monetary and fiscal expansion via direct assignment of seigniorage to households, money-financed government purchases, central bank–undertaken large-scale public lending programs, and other such—be on the table?

Those three are still the most urgent questions facing us today. But I will drop them, and leave them to others. I will presume that satisfactory answers have been found to them, and that they have thus been answered.

As I see it, there are three major medium-run questions that then remain, even further confining my scope to the North Atlantic alone, and to the major sovereigns of the North Atlantic. (Extending the focus to emerging markets, to the links between the North Atlantic and the rest of the world, and to Japan would raise additional important questions, which I would also drop on the floor.) These three remaining medium-run questions are:

  • What is the proper size of the twenty-first-century public sector?
  • What is the proper level of the twenty-first-century public debt for growth and prosperity?
  • What are the systemic risks caused by government debt, and what adjustment to the proper level of twenty-first-century public debt is advisable because of systemic risk considerations?

To me, at least, the answer to the first question—what is the proper size of the twenty-first-century public sector?—appears very clear:

The optimal size of the twenty-first-century public sector will be significantly larger than the optimal size of the twentieth-century public sector. Changes in technology and social organization are moving us away from a “Smithian” economy, one in which the presumption is that the free market or the Pigovian-adjusted market does well, to one that requires more economic activity to be regulated by differently tuned social and economic arrangements (see DeLong and Froomkin 2000). One such is the government. Thus, there should be more public sector and less private sector in the twenty-first century than there was in the twentieth.

Similarly, the answer to the second question appears clear, to me at least:

The proper level of the twenty-first-century public debt should be significantly higher than typical debt levels we have seen in the twentieth century. Looking back at economic history reveals that it has been generations since the intertemporal budget constraint tightly bound peacetime or victorious reserve-currency-issuing sovereigns possessing exorbitant privilege (see DeLong 2014; Kogan et al. 2015).

Thus, at the margin, additional government debt has not required a greater primary surplus but rather has allowed a greater primary deficit—a consideration that strongly militates for higher debt levels unless interest rates in the twenty-first century reverse the pattern we have seen in the twentieth century, and mount to levels greater than economic growth rates.

This consideration is strengthened by observing that the North Atlantic economies have now moved into a regime in which the opposite has taken place. Real interest rates on government debt are not higher but even lower relative to growth rates than they were in the past century. Financial market participants now appear to expect this now ultra-low interest rate regime to continue indefinitely (see Summers 2014).

The answer to the third question—what are the systemic risks caused by government debt?—is much more murky:

To be clear: the point is not that additional government debt imposes an undue burden in the form of distortionary taxation and inequitable income distribution on the future. When current and projected interest rates are low, they do not do so. The point is not that additional government debt crowds out productive investment and slows growth. When interest rates are unresponsive or minimally responsive to deficits, they do not do so. Were either of those to fail to hold, we would have exited the current regime of ultra-low interest rates, and the answer to the second question immediately above would become different.

The question, instead, is this: in a world of low current and projected future interest rates—and thus also one in which interest rates are not responsive to deficits—without much expected crowding out or expected burdens on the future, what happens in the lower tail, and how should that lower tail move policies away from those optimal on certainty equivalence? And that question has four subquestions: How much more likely does higher debt make it that interest rates will spike in the absence of fundamental reasons? How much would they spike? What would government policy be in response to such a spike? And what would be the effect on the economy?

The answer thus hinges on:

  • the risk of a large sudden upward shift in the willingness to hold government debt, even absent substantial fundamental news, and
  • the ability of governments to deal with such a risk that threatens to push economies far enough up the Laffer curve to turn a sustainable into an unsustainable debt.

I believe the risk in such a panicked flight from an otherwise sustainable debt is small. I hold, along with Reinhart and Rogoff (2013), that the government’s legal tools to finance its debt through financial repression are very powerful. Thus I think this consideration has little weight. I believe that little adjustment to one’s view of the proper level of twenty-first-century public debt of reserve-currency-issuing sovereigns with exorbitant privilege is called for because of systemic risk considerations.
But my belief here is fragile. And my comprehension of the issues is inadequate.

Let me expand on these three answers:

The Proper Size of Twenty-First-Century Government

Suppose commodities produced and distributed are properly rival and excludible:

  • Access to them needs to be cheaply and easily controlled.
  • They need to be scarce.
    *They need to be produced under roughly constant-returns-to-scale conditions.

Suppose, further, that information about what is being bought and sold is equally present on both sides of the marketplace—that is, limited adverse selection and moral hazard.

Suppose, last, that the distribution of wealth is such as to accord fairly with utility and desert.

If all these hold, then the competitive Smithian market has its standard powerful advantages. And so the role of the public sector should then be confined to:

  1. antitrust policy, to reduce market power and microeconomic price and contract stickinesses,
  2. demand-stabilization policy, to offset the macroeconomic damage caused by macroeconomic price and contract stickinesses,
  3. financial regulation, to try to neutralize the effect on asset prices of the correlation of current wealth with biases toward optimism or pessimism, along with
  4. largely fruitless public-sector attempts to deal with other behavioral economics-psychological market failures—envy, spite, myopia, salience, etc.

The problem, however, is that as we move into the twenty-first century, the commodities we will be producing are becoming:

  • less rival,
  • less excludible,
  • more subject to adverse selection and moral hazard, and
  • more subject to myopia and other behavioral-psychological market failures.

The twenty-first century sees more knowledge to be learned, and thus a greater role for education. If there is a single sector in which behavioral economics and adverse selection have major roles to play, it is education. Deciding to fund education through very long-term loan financing, and thus to leave the cost-benefit investment calculations to be undertaken by adolescents, shows every sign of having been a disaster when it has been tried (see Goldin and Katz 2009).

The twenty-first century will see longer life expectancy, and thus a greater role for pensions. Yet here in the United States the privatization of pensions via 401(k)s has been, in my assessment, an equally great disaster (Munnell 2015).

The twenty-first century will see health care spending as a share of total income cross 25 percent if not 33 percent, or even higher. The skewed distribution across potential patients of health care expenditures, the vulnerability of health insurance markets to adverse selection and moral hazard, and simple arithmetic mandate either that social insurance will have to cover a greater share of health care costs or that enormous utilitarian benefits from health care will be left on the sidewalk.

Moreover, the twenty-first century will see information goods a much larger part of the total pie than in the twentieth. And if we know one thing, it is that it is not efficient to try to provide information goods by means of a competitive market for they are neither rival nor excludible. It makes no microeconomic sense at all for services like those provided by Google to be funded and incentivized by how much money can be raised not fromthe value of the services but fromthe fumes rising from Google’s ability to sell the eyeballs of the users to advertisers as an intermediate good.

And then there are the standard public goods, like infrastructure and basic research.

Enough said.

The only major category of potential government spending that both should not—and to an important degree cannot—be provided by a competitive price-taking market, and that might be a smaller share of total income in the twenty-first century than it was in the twentieth? Defense.

We thus face a pronounced secular shift away from commodities that have the characteristics—rivalry, excludability, and enough repetition in purchasing and value of reputation to limit myopia—needed for the Smithian market to function well as a societal coordinating mechanism. This raises enormous problems: We know that as bad as market failures can be, government failures can often be little if any less immense.

We will badly need to develop new effective institutional forms for the twenty-first century.

But, meanwhile, it is clear that the increasing salience of these market failures has powerful implications for the relative sizes of the private market and the public administrative spheres in the twenty-first century. The decreasing salience of “Smithian” commodities in the twenty-first century means that rational governance would expect the private-market sphere to shrink relative to the public. This is very elementary micro- and behavioral economics. And we need to think hard about what its implications for public finance are.

The Proper Size of the Twenty-First-Century Public Debt

Back in the Clinton administration—back when the US government’s debt really did look like it was on an unsustainable course—we noted that the correlation between shocks to US interest rates and the value of the dollar appeared to be shifting from positive to zero, and we were scared that the United States was alarmingly close to its debt capacity and needed major, radical policy changes to reduce the deficit (see Blinder and Yellen 2000).

Whether we were starting at shadows then, or whether we were right then and the world has changed since, or whether the current world is in an unstable configuration and we will return to normal within a decade is unclear to me.

But right now, financial markets are telling us very strange things about the debt capacity of reserve-currency-issuing sovereigns.

Since 2005, the interest rate on US ten-year Treasury bonds has fallen from roughly the growth rate of nominal GDP—5 percent/year—to 250 basis points below the growth rate of nominal GDP. Because the duration of the debt is short, the average interest rate on Treasury securities has gone from 100 basis points below the economy’s trend growth rate to nearly 350 basis points below. Maybe you can convince yourself that the market expects the ten-year rate over the next generation to average 50 basis points higher than it is now. Maybe.

Taking a longer run view, Richard Kogan and co-workers (2015) of the Center on Budget and Policy Priorities have been cleaning the data from the Office of Management and Budget. Over the past two hundred years, for the United States, the government’s borrowing rate has averaged 100 basis points lower than the economy’s growth rate. Over the past one hundred years, 170 basis points lower. Over the past fifty years, 30 basis points lower. Over the past twenty years, the Treasury’s borrowing rate has been on average greater than g by 20 basis points. And over the past ten years, it has been 70 basis points lower.

When we examine the public finance history of major North Atlantic industrial powers, we find that the last time that the average over any decade of government debt service as a percentage of outstanding principal was higher than the average growth rate of its economy was during the Great Depression. And before that, in 1890.

Since then, over any extended time period for the major North Atlantic reserve-currency-issuing economies, g > r, for government debt.

Only those who see a very large and I believe exaggerated chance of global thermonuclear war or environmental collapse see the North Atlantic economies as dynamically inefficient from the standpoint of our past investments in private physical, knowledge, and organizational capital: r > g by a very comfortable margin for investments made in private capital. Investments in wealth in the form of private capital are, comfortably, a cash flow source for savers.

But the fact that g > r with respect to the investments we have made in our governments raises deep and troubling questions.

Since 1890, a North Atlantic government that borrows more at the margin benefits its current citizens, increases economic growth, and increases the well-being of its bondholders (for they do buy the paper voluntarily): it is win-win-win. That fact strongly suggests that North Atlantic economies throughout the entire twentieth century suffered from excessive accumulation of societal wealth in the form of net government capital—in other words, government debt has been too low.

The North Atlantic economies of major sovereigns throughout the entire twentieth century have thus suffered from a peculiar and particular form of dynamic inefficiency. Over the past one hundred years, in the United States, at the margin, each extra stock 10 percent of annual GDP’s worth of debt has provided a flow of 0.1 percent of GDP of services to taxpayers, either in increased primary expenditures, reduced taxes, or both.

What is the elementary macroeconomics of dynamic inefficiency? If a class of investment—in this case, investment by taxpayers in the form of wealth held by the government through amortizing the debt—is dynamically inefficient, do less of it. Do less of it until you get to the Golden Rule, and do even less if you are impatient. How do taxpayers move away from dynamic inefficiency toward the Golden Rule? By not amortizing the debt, but rather by borrowing more.

Now we resist this logic. I resist this logic.

Debt secured by government-held social wealth ought to be a close substitute in investors’ portfolios with debt secured by private capital formation. So it is difficult to understand how economies can be dynamically efficient with respect to private capital and yet “dynamically inefficient” with respect to government-held societal wealth. But it appears to be the case that it is so. But there is this outsized risk premium, outsized equity and low-quality debt premium, outsized wedge. And that means that while investments in wealth in the form of private capital are a dynamically efficient cash flow source for savers, investments by taxpayers in the form of paying down debt are a cash flow sink.
I tend to say that we have a huge underlying market failure here that we see in the form of the equity return premium—a failure of financial markets to mobilize society’s risk-bearing capacity—and that pushes down the value of risky investments and pushes up the value of assets perceived as safe, in this case the debt of sovereigns possessing exorbitant privilege. But how do we fix this risk-bearing capacity mobilization market failure? And isn’t the point of the market economy to make things that are valuable? And isn’t the debt of reserve-currency-issuing sovereigns an extraordinarily valuable thing that is very cheap to make? So shouldn’t we be making more of it? Looking out the yield curve, such government debt looks to be incredibly valuable for the next half century, at least.

These considerations militate strongly for higher public debts in the twenty-first century then we saw in the twentieth century. Investors want to hold more government debt: the extraordinary prices at which it has sold since 1890 tell us that. Market economies are supposed to be in the business of producing things that households want whenever that can be done cheaply. Government debt fits the bill, especially now. And looking out the yield curve, government debt looks to fit the bill for the next half century at least.

Systemic Risks and Public Debt Accumulation

One very important question remains very live: Would levels of government debt issue large enough to drive r > g for government bonds create significant systemic risks? Yes, the prices of the government debt of major North Atlantic industrial economies are very high now. But what if there is a sudden downward shock to the willingness of investors to hold this debt? What if the next generation born and coming to the market is much more impatient? Governments might then have to roll over their debt on terms that require high debt-amortization taxes, and if the debt is high enough, those taxes could push economies far enough up a debt Laffer curve. That might render the debt unsustainable in the aftermath of such a preference shift.

Two considerations make me think that this is a relatively small danger:

  1. When I look back in history, I cannot see any such strong fundamental news-free negative preference shock to the willingness to hold the government debt of the North Atlantic’s major industrial powers since the advent of parliamentary government. The fiscal crises we see—of the Weimar Republic, Louis XIV Bourbon, Charles II Stuart, Felipe IV Habsburg, and so forth—were all driven by fundamental news.

  2. As [Reinhart and Rogoff (2013)(http://www.imf.org/external/pubs/ft/wp/2013/wp13266.pdf) have pointed out at substantial length, twentieth- and nineteenth-century North Atlantic governments proved able to tax their financial sectors through financial repression with great ease. The amount of real wealth for debt amortization raised by financial repression scales roughly with the value of outstanding government debt. And such taxes are painful for those taxed. But only when even semi-major industrial countries have allowed large-scale borrowing in potentially harder currencies than their own—and thus have written unhedged puts on their currencies in large volume—is there any substantial likelihood of major additional difficulty or disruption.

Now, Kenneth Rogoff (2015) disagrees with drawing this lesson from Reinhart and Rogoff (2013). And one always disagrees analytically with Kenneth Rogoff at one’s great intellectual peril. He sees the profoundly depressed level of interest rates on the debt of major North Atlantic sovereigns as a temporary and disequilibrium phenomenon that will soon be rectified. He believes that excessive debt issue and overleverage are at the roots of our problems—call it secular stagnation, the global savings glut, the safe asset shortage, the balance sheet recession, whatever.

In Rogoff’s view:

Unlike secular stagnation, a debt supercycle is not forever.… Modern macroeconomics has been slow to get to grips with the analytics of how to incorporate debt supercycles.… There has been far too much focus on orthodox policy responses and not enough on heterodox responses.… In a world where regulation has sharply curtailed access for many smaller and riskier borrowers, low sovereign bond yields do not necessarily capture the broader “credit surface” the global economy faces.… The elevated credit surface is partly due to inherent riskiness and slow growth in the post-Crisis economy, but policy has also played a large role.

The key here is Rogoff’s assertion that the low borrowing rate faced by major North Atlantic sovereigns “do[es] not necessarily capture the broader ‘credit surface’”—that the proper shadow price of government debt issue is far in excess of the sovereign borrowing rate. Why? Apparently because future states of the world in which private bondholders would default are also those in which it would be very costly in social utility terms for the government to raise money through taxes.

I do not see this. A major North Atlantic sovereign’s potential tax base is immensely wide and deep. The instruments at its disposal to raise revenue are varied and powerful. The correlation between the government’s taxing capacity and the operating cash flow of private borrowers is not that high. A shock like that of 2008–2009 temporarily destroyed the American corporate sector’s ability to generate operating cash flows to repay debt at the same time that it greatly raised the cost of rolling over debt. But the US government’s financial opportunities became much more favorable during that episode.

Moreover, Rogoff also says:

When it comes to government spending that productively and efficiently enhances future growth, the differences are not first order. With low real interest rates, and large numbers of unemployed (or underemployed) construction workers, good infrastructure projects should offer a much higher rate of return than usual.

and thus, with sensible financing and recapture of the economic benefits of government spending, have little or no impact on debt-to-income ratios.


Looking forward, I draw the following conclusions:

  1. North Atlantic public sectors for major sovereigns ought, technocratically, to be larger than they have been in the past century.

  2. North Atlantic relative public debt levels for major sovereigns ought, technocratically, to be higher than they have been in the past century.

  3. With prudent regulation—that is, the effective limitation of the banking sector’s ability to write unhedged puts on the currency—the power major sovereigns possess to tax the financial sector through financial repression provides sufficient insurance against an adverse preference shock to the desire for government debt.

The first two of these conclusions appear to me to be close to rock-solid. The third is, I think, considerably less secure.

Nevertheless, in my view, if the argument against a larger public sector and more public debt in the twenty-first century than in the twentieth for major North Atlantic sovereigns is going to be made successfully, it seems to me that it needs to be made on a political-economy government-failure basis.

The argument needs to be not that larger government spending and a higher government debt issued by a functional government would diminish utility but rather that government itself will be highly dysfunctional. Government needs to be viewed not as one of several instrumentalities we possess and can deploy to manage and coordinate our societal division of labor, but rather as the equivalent of a loss-making industry under really existing socialism. Government spending must be viewed as worse than useless. Therefore relaxing any constraints that limit the size of the government needs to be viewed as an evil.

Now the public choice school has gone there. As Lawrence Summers (2011) said, they have taken the insights on government failure and “driven it relentlessly towards nihilism in a way that isn’t actually helpful for those charged with designing regulatory institutions,” or, indeed, making public policy in general. In my opinion, if this argument is to be made, it needs a helpful public choice foundation before it can be properly built.

Figure 20.1: Ten-year Constant Maturity U.S. Treasury Nominal Rate:

10 Yr U S Treasury Nominal Interest Rate Source FRED png

Source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis.

Figure 20.2: Economic Growth and Interest Rates Have Become More Closely Aligned:

Nominal Interest Rate & Smoothed Forward Nominal GDP Growth Rate:

Nom Int Rate Smoothed GDP Growth Rate png

Source: Richard Kogan and colleagues of the Center on Budget and Policy Priorities http://CBPP.org


Blinder, Alan, and Janet Yellen. 2000. The Fabulous Decade: Macroeconomic Lessons from the 1990s. New York: Century Foundation.

DeLong, J. Bradford. 2014. “Notes on Fiscal Policy in a Depressed Interest-Rate Environment.” Faculty blog, Department of Economics, University of California, Berkeley, March 16. http://delong.typepad.com/delonglongform/2014/03/talk-preliminary-notes-on-fiscal-policy-in-a-depressed-interest-rate-environment-the-honest-broker-for-the-week-of-february.html.

DeLong, J. Bradford, and A. Michael Froomkin. 2000. “Speculative Microeconomics for Tomorrow’s Economy.” First Monday 5 (2), February 7. http://firstmonday.org/ojs/index.php/fm/article/view/726.

Goldin, Claudia, and Lawrence Katz. 2009. The Race between Education and Technology. Cambridge, MA: Harvard University Press.

Kogan, Richard, Chad Stone, Bryann Dasilva, and Jan Rezeski. 2015. “Difference between Economic Growth Rates and Treasury Interest Rates Significantly Affects Long-Term Budget Outlook.” Washington, DC: Center on Budget and Policy Priorities, February 27. http://www.cbpp.org/research/federal-budget/difference-between-economic-growth-rates-and-treasury-interest-rates.

Munnell, Alicia. 2015. “Falling Short: The Coming Retirement Crisis and What to Do About It.” Brief 15-7. Center for Retirement and Research, Boston College,April. http://crr.bc.edu/briefs/falling-short-the-coming-retirement-crisis-and-what-to-do-about-it-2.

Reinhart, Carmen M., and Kenneth S. Rogoff. 2013. “Financial and Sovereign Debt Crises: Some Lessons Learned and Those Forgotten.” Working Paper 266. Washington, DC: IMF, December 24. https://www.imf.org/external/pubs/cat/longres.aspx?sk=41173.0.

Rogoff, Kenneth. 2015. “Debt Supercycle, Not Secular Stagnation.” VoxEU. Centre for Economic Policy and Research, April 22. http://www.voxeu.org/article/debt-supercycle-not-secular-stagnation.

Summers, Lawrence. 2011. “A Conversation on New Economic Thinking.” LarrySummers.com, April 8. http://larrysummers.com/commentary/speeches/brenton-woods-speech.

Summers, Lawrence. 2014. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound.” Business Economics 49 (2): 65–73.


Must-Read: Marshall Steinbaum: The Unseen Threat of Capital Mobility

Must-Read: Marshall Steinbaum: The Unseen Threat of Capital Mobility: “The Hidden Wealth of Nations: The Scourge of Tax Havens

…by Gabriel Zucman, University of Chicago Press, $20 (cloth). Out of Sight: The Long and Disturbing Story of Corporations Outsourcing Catastrophe by Erik Loomis, The New Press, $25.95 (cloth). Two new books link rising inequality to unseen forces: tax havens in economist Gabriel Zucman’s case, and overseas labor and environmental exploitation in historian Erik Loomis’s. The adverse consequences of the free movement of capital suffuse both narratives…. Both authors propose tariffs, capital controls, and international regulatory standards that would either re-erect national boundaries or threaten to do so–proposals that will strike many readers as misguided, out of touch with political reality, or both….

When the Rana Plaza factory collapsed in 2013, Loomis engaged in a memorable online dispute with Matthew Yglesias, who published a piece on the disaster headlined ‘Different Places Have Different Safety Rules and That’s Okay’…. Loomis’s and Zucman’s calls for re-erecting national boundaries and re-empowering democratically accountable regulators are implications of a much more successful model for explaining why inequality has risen so much within developed and developing countries than in Yglesias’ just-so story: capital has gained the upper hand over labor by creating and accessing outside options while eliminating those of its opponents. Both books are the product of careful reconsideration and critique of received wisdom in the fields each covers, and more casual commentators would be wise to take heed of their implications instead of peddling discredited objections to any check on international capital mobility.

Must-Read: Antonio Fatas: The Missing Lowflation Revolution

Antonio Fatas: The Missing Lowflation Revolution: “It will soon be eight years since the US Federal Reserve decided to bring its interest rate down to 0%…

…In these eight years central banks have used all their available tools to increase inflation closer to their target and boost growth with limited success. GDP growth has been weak or anemic, and there is very little hope that economies will ever go back to their pre-crisis trends…. Very few would have anticipated… that central banks cannot lift inflation rates closer to their targets over such a long horizon… that a crisis can be so persistent and that cyclical conditions can have such large permanent effects on potential output… the slow (or inexistent) natural tendency of the economy to adjust by itself to a new equilibrium. To be fair… we had been warned about this by those who had studied the Japanese experience: both Krugman and Bernanke, among others…. But my guess is that even those who agreed with this reading of the Japanese economy would have never thought that we would see the same thing happening in other advanced economies….

It might be time to rethink our economic policy framework. Some obvious proposals include raising the inflation target and considering “helicopter money” as a tool for central banks. But neither of these proposals is getting a lot of traction. My own sense is that the view among academics and policy makers is not changing fast enough…. The comparison with the 70s when stagflation produced a large change in the way academic and policy makers thought about their models and about the framework for monetary policy is striking…. How many more years of zero interest rate will it take to witness a similar change in our economic analysis?

Secular Stagnation–That’s My Title, of the Longer Version at Least

J. Bradford DeLong: The Tragedy of Ben Bernanke: Project Syndicate:

Ben Bernanke has published his memoir, The Courage to Act.

I am finding it hard to read. And I am finding it hard to read as anything other than a tragedy. It is the story of a man who may have been the best-prepared person in the world for the job he was given, but who soon found himself outmatched by its challenges, quickly falling behind the curve and never quite managing to catch up.

It is to Bernanke’s great credit that the shock of 2007-2008 did not trigger another Great Depression. But the aftermath was unexpectedly disappointing… READ MOAR AT PROJECT SYNDICATE

Must-Read: Yael T. Abouhalkah: Paging Gov. Sam Brownback’s Sycophants

Must-Read: I must say: this amazes me. The old argument was that large Kansas-Missouri differences in AFDC payments back before 1995 did not lead single mothers to move across State Line Road into Kansas, so why should we expect even sharp state tax differentials to pull people across? The answer to that is: It was very, very clear that African-Americans in Kansas City were suppose to stay east of Troost. And non-African American AFDC recipients were much more geographically dispersed, hence it was not a short move.

Thus I thought business would be different.

I really did think that Brownback’s tax cuts would pull enough income across State Line Road to allow him to declare him non-defeat, and indeed to avoid utter defeat, when the rubber of his ideology met the road of reality and he had to make a Kansas state budget. Yet it is not so:

Yael T. Abouhalkah: Paging Gov. Sam Brownback’s Sycophants: “Kansas tax cuts still aren’t killing Missouri jobs in KC area…

…Jobs continue to grow more quickly on the Missouri side of the state line than on the Kansas side of the Kansas City metropolitan area. The Bureau of Labor Statistics reported that the Missouri portion of the region gained 2 percent in employment from September 2014 to September 2015. Meanwhile, the Kansas portion gained .9 percent…. This new report continues a recent trend in year-over-year superiority for the Missouri side…. This is not supposed to be happening, at least according to Brownback and his followers. He has stated that the income tax cuts he put in place in 2013 would generate more jobs especially in the Kansas City area, because it’s supposedly so easy just to hop the state line to reap tax benefits. Yet, month after month, that’s not happening…

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: Henry Aaron: Can Taxing the Rich Reduce Inequality? You Bet It Can!

Must-Read: Henry Aaron: Can Taxing the Rich Reduce Inequality? You Bet It Can!: “Two recently posted papers by Brookings colleagues purport to show that…

…‘even a large increase in the top marginal rate would barely reduce inequality.’  This conclusion, based on one commonly used measure of inequality, is an incomplete and misleading answer to the question posed: would a stand-alone increase in the top income tax bracket materially reduce inequality?  More importantly, it is the wrong question to pose, as a stand-alone increase in the top bracket rate would be bad tax policy that would exacerbate tax avoidance incentives.  Sensible tax policy would package that change with at least one other tax modification, and such a package would have an even more striking effect on income inequality.  In brief:

  • A stand-alone increase in the top tax bracket would be bad tax policy, but it would meaningfully increase the degree to which the tax system reduces economic inequality.  It would have this effect even though it would fall on just ½ of 1 percent of all taxpayers and barely half of their income.
  • Tax policy significantly reduces inequality.  But transfer payments and other spending reduce it far more.  In combination, taxes and public spending materially offset the inequality generated by market income.
  • The revenue from a well-crafted increase in taxes on upper-income Americans, dedicated to a prudent expansions of public spending, would go far to counter the powerful forces that have made income inequality more extreme in the United States than in any other major developed economy.”

Must-Read: Paul Krugman: Rethinking Japan

Must-Read: Paul Krugman is musing about and rethinking his 1998 analysis of Japan and its macroeconomic problems:


Paul Krugman: Rethinking Japan: “[How] would change what I said in my 1998 paper…

…on the liquidity trap[?]… Japan and the world look different…. First, the immediate economic problem is… weaning the economy off fiscal support. Second… demand weakness looks… permanent…. Back in 1998 Japan… [was] operating far below potential…. This is, however, no longer the case…. Output per working-age adult has grown faster than in the United States since around 2000…. [But] Japan’s relatively healthy output and employment levels depend on continuing fiscal support… ever-rising debt/GDP…. So far this hasn’t caused any problems…. But even those of us who believe that the risks of deficits have been wildly exaggerated would like to see the debt ratio stabilized and brought down at some point…..

With policy rates stuck at zero, Japan has no ability to offset the effects of fiscal retrenchment with monetary expansion. The big reason to raise inflation… is to… allow… monetary policy to take over from fiscal policy…. But what would it take to raise inflation?… Back in 1998… [I assumed] the Wicksellian natural rate of interest… would return to a normal, positive level at some future date… [thus] the liquidity trap became an expectations problem…. But what is this future… normality[?]… [If] a negative Wicksellian rate is… permanent… [even] a credible promise to be irresponsible might do nothing: if nobody believes that inflation will rise, it won’t….

The only way to be at all sure… is… a changed monetary regime with a burst of fiscal stimulus…. While the goal… is… to make space for fiscal consolidation, the first part of that strategy needs to involve fiscal expansion… really aggressive policy, using fiscal and monetary policy to boost inflation… setting the target high enough… escape velocity. And while Abenomics has been a favorable surprise, it’s far from clear that it’s aggressive enough to get there.

In many ways, things are even worse than Paul says. Paul Krugman’s original argument assuming that the economy would eventually head towards a long-run equilibrium in which flexible wages and prices what make Say’s Law hold true, in which there would be a positive natural nominal rate of interest, and thus in which the price level would be proportional to the money stock. That now looks up for grabs. It is the fact that that is up for grabs that currently disturbs Paul. Without a full-employment Say’s Law equilibrium out there in the transversality condition to which the present day is anchored by intertemporal financial-market and intertemporal consumer-utility arbitrage, all the neat little mathematical tricks that Paul and Olivier Blanchard built up at the end of the 1970s to solve for *the* current equilibrium break in their hands. And we enter Roger Farmer-world–a scary and frightening place.

But there is even more. Paul Krugman’s original argument also assumed back-propagation into the present via financial-market intertemporal arbitrage and consumer-satisfaction intertemporal utility arbitrage of the effects of that future well-behaved full-employment equilibrium. The equilibrium has to be there. And the intertemporal arbitrage mechanisms have to work. Both have to do their thing.

But, as Paul wrote in another context:

Paul Krugman**: Multipliers and Reality: “Rigorous intertemporal thinking…

…even if empirically ungrounded, can be useful to focus one’s thoughts. But as a way to think about the reality of spending decisions, no…. Consider… what the public knows about the biggest new government program of recent years[, ObamaCare]…. If people are that uninformed about something that big, imagining that they do anything like the calculations assumed in DSGE models is ludicrous. Surely they rely on rules of thumb that don’t make use of the kind of information that plays such a large role in our models…

Suppose the full employment equilibrium is really out there. People still have to anticipate that it is out there, and then take account of the fact that it is out there and the way that a rational-expectations utility-maximizing agent would.

Now sometimes we get lucky.

Sometimes the fact that one can transact on financial markets on a large scale means that even if only a few are willing to bet on fundamentals, the fact that they can make huge fortunes betting on fundamentals on a large scale drives current asset prices to fundamental values, and those asset prices then drive the current behavior even those who do not know anything about the future equilibrium that is driving the present via this process of expectational back-propagation inductive-unraveling.

But when we are talking about inducing people to spend more now because they fear their money will be worth less then in the future when the debt will have been monetized–well, if that were an important and active channel, we would not now have our current sub-2%/year inflation in Japan and the United States, would we?

Time to drop a link to my New Economic Thinking, Hicks-Hansen-Wicksell Macro, and Blocking the Back Propagation Induction-Unraveling from the Long Run Omega Point: The Honest Broker for the Week of May 31, 2015.

In fact, let me just repeat the whole thing below the fold…

Over at Equitable Growth: In the long run… when the storm is long past, the ocean is flat again.

At that time–or, rather, in that logical state to which the economy will converge if values of future shocks are set to zero–expected inflation will be constant at about the 2% per year that the Federal Reserve has announced as its target. At that time the short-term safe nominal rate of interest will be equal to that 2% per year of expected inflation, plus the real profits on marginal investments, minus a rate-of-return discount because short-term government bonds are safe and liquid. At that time the money multiplier will be a reasonable and a reasonably stable value. At that time the velocity of money will be a reasonable and a reasonably stable value. Why? Because of the powerful incentive to economize on cash holdings provided by the the sacrifice of several percent per year incurred by keeping cash in your wallet rather than in bonds. And at that time the price level will be proportional to the monetary base. READ MOAR

That was and is the logic behind so many economists’ beliefs. Their beliefs before 2008 that economies could not get stuck in liquidity traps (because central banks could always create inflation by boosting the monetary base); beliefs in 2008 and 2009 that economies’ stays in liquidity traps would be very short (because central banks were then boosting the monetary base); and beliefs since then that (because central banks had boosted the monetary base) those who believe will not taste death before, but will live to see exit from the liquidity trap and an outburst of inflation as the Federal Reserve tries and fails at the impossible task of shrinking its balance sheet to normal without inflation–all of these beliefs hinged and hinge on a firm and faithful expectation that this long run is at hand, or is near, or will soon draw near (translations from the original koine texts differ). Because the long run will come, increases now in the monetary base of sufficient magnitude that are believed to be permanent will–maybe not now, but soon, and for the rest of our lives, in this long run–produce equal proportional increases in the price level, and thus substantial jumps in the inflation rate as the price level transits from its current to its long-run level.

Moreover, there is more to the argument: The long run is not here. The long run may not be coming soon. But the long run will come. And so there will will a time when the long run is near. At that time, those who are short long-term bonds will be about to make fortunes as interest rates normalize and long bond prices revert to normal valuation ratios. At that time, those who are leveraged and short nominal debt will be about to make fortunes as the real value of their debt is heavily eroded by the forthcoming jump in the price level .

And there is still another step in the argument: When the long run is near but not yet here–call it the late medium run–investors and speculators will smell the coffee. This late medium run will see investors and speculators frantically dumping their long bonds so as not to be caught out as interest rates spike and bond prices collapse. It will see investors and speculators frantically borrowing in nominal terms to buy real assets and currently-produced goods and services so as not to be caught out when the price level jumps. Thus even before the long run is here–even in the late medium run–their will already be very powerful supply-and-demand forces at work. Those forces will be pushing interest-rates up, pushing real spending levels, and pushing price levels and inflation rates up.

The next step in the argument continues the induction unraveling: When it is not yet the late medium run but only the medium run proper, rational investors and speculators must still factor the future coming of the long run into their decisions. The long run may not be near. But it may be that soon markets will conclude the long run is near. Thus in the medium run none will want their portfolios to be so imbalanced that when the late medium run does come and with it the time to end your exposure to long-term bonds and to nominal assets and leverage up, you are on the wrong foot and so last person trying to get through the door in the stampede. There may be some short run logic that keeps real spending low, prices low, inflation quiescent, and interest rates at zero. But that logic’s effects will be severely attenuated when the medium run comes, for then investors and speculators will be planning not yet for the long run or even the at-handness of the long run, but for the approach of the approach of the long run.

And so we get to the final step of the induction-unraveling: Whatever may be going on in the short run must thus be transitory in duration, moderate in their effects, and limited in the distance it can can push the economy away from its proper long run equilibrium. And it certainly cannot keep it there. Not for long.

This is the real critique of Paul Krugman’s “depression economics”. Paul can draw his Hicksian IS-LM diagrams of an economy stuck in a liquidity trap:

The Inflationista Puzzle NYTimes com

He can draw his Wicksellian I=S diagrams of how the zero lower bound forces the market interest rate above the natural interest rate at which planned investment balances savings that would be expected were the economy at full employment:

Lifestream vpdoc 2015 06 02 Tu Krugman Feldstein

Paul can show, graphically, that conventional monetary policy is then completely ineffective–swapping two assets that are perfect substitutes for each other. Paul can show, graphically, that expansionary fiscal policy is then immensely powerful and has no downside: it does not generate higher interest rates; it does not crowd out productive private investment; and, because interest rates are zero, it entails no financing burden and thus no required increase in future tax wedges. But all this is constrained and limited by the inescapable and powerful logic of the induction-unraveling propagating itself back through the game tree from the Omega Point that is the long run equilibrium. In the IS-LM diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the IS curve up and to the right, and thus leading the economy to quickly exist the liquidity trap. In the Wicksellian I=S diagram, the fact that the long run is out there means that even the contemplation of permanent expansion of the monetary base is rapidly moving the I=S curve up so that the zero lower bound will soon no longer constrain the economy away from its full-employment equilibrium.

The “depression economics” equilibrium Paul plots on his graph is a matter for today–a month or two, or a quarter or two, or at most a year or two.

But it will soon be seven years since the U.S. Treasury Bill rate was more than whispering distance away from zero. And it is now more than two decades since Japan’s short-term bonds sold at less than par.

Paul has a critique of the extremely sharp Marty Feldstein’s latest over at Project Syndicate (parenthetically, I must say it is rather cruel for Project Syndicate to highlight Feldstein’s August 2012 “Is Inflation Returning” in site-searches for “Feldstein”):

Paul Krugman: The Inflationista Puzzle: “Martin Feldstein has a new column on what he calls the ‘inflation puzzle’…

…the failure of inflation to soar despite the Fed’s large asset purchases, which led to a very large rise in the monetary base. As Tony Yates points out, however, there’s nothing puzzling at all about what happened; it’s exactly what you should expect when interest rates are near zero…. This isn’t an ex-post rationale, it’s what many of us were saying from the beginning. Traditional IS-LM analysis said [it]… so did the translation of that analysis into a stripped-down New Keynesian framework that I did back in 1998, starting the modern liquidity-trap literature. We even had solid recent empirical evidence: Japan’s attempt at quantitative easing in the naughties, which looked like this:


I’m still not sure why relatively moderate conservatives like Feldstein didn’t find all this convincing back in 2009. I get, I think, why politics might predispose them to see inflation risks everywhere, but this was as crystal-clear a proposition as I’ve ever seen.

Still, even if you managed to convince yourself that the liquidity-trap analysis was wrong six years ago, by now you should surely have realized that Bernanke, Woodford, Eggertsson, and, yes, me got it right…. Maybe it’s because those tricksy Fed officials started paying all of 25 basis points on reserves[?] ([But] Japan never paid such interest[.]).

Anyway, inflation is just around the corner, the same way it has been all these years.

Unlike Paul, I get why moderate conservatives like Feldstein didn’t find “all this convincing” back in 2009. I get it because I only reluctantly and hesitantly found it convincing. Feldstein got the Hicksian IS-LM and the Wicksellian S=I diagrams: he just did not believe that they were anything but the shortest of short run equilibria. He could feel in his bones and smell in the air the up-and-to-the-right movement of the IS curve and the upward movement of the S=I curve as investors, speculators, and businesses took look at the size of the monetary base and incorporated into their thinking about the near future the backward induction-unraveling from the long run Omega Point. My difference with Marty in 2009 is that he thought then that the liquidity trap was a 3 month-1 year phenomenon–that that was the duration of the short run–while I was much more pessimistic about the equilibrium-restoring forces of the market: I thought it was a 3 year-5 year phenomenon.

And it was not just me. Consider Ben Bernanke. I have no memory any more of who was writing [Free Exchange] back in 2009. But whoever it was was very sharp, and wrote:

????: Person of the next five to ten years: “There are those who blame [Bernanke] for missing all the warning signs…

…those who blame him for managing the crisis in the most Wall Street-friendly way… those who blame him for laying the groundwork for a future asset bubble or inflation crisis…. I think his defining decision… has been to conclude that 10% unemployment is acceptable–that having averted a Depression-style 25% unemployment scenario, his countercyclical work is complete… that the risk of sustained high unemployment is outweighed by the risk of… efforts to boost the economy… by asking for more fiscal stimulus… targeting nominal GDP or… committing… to some [higher] level of inflation….

Bernanke believes most of the increase in unemployment… to be cyclical… does not think that pushing… unemployment… down to… 7% would overextend the economy…. He simply seems to think that leaving his primary job half done is acceptable. That’s a pretty momentous choice, affecting millions of people directly and billions indirectly. It will shape American politics and economics for the next decade, at least…. He deserves… person of the year…. But reappointment? That’s another story entirely.

What this leaves out is that Bernanke was willing to take his foot off the gas in late 2009 with an unemployment rate of 10% because, like Marty, he could smell the back-propagation of the induction-unraveling of the short run equilibrium. He us expected that, with his foot off the gas, unemployment would be 8.5% by the end of 2010, 7% by the end of 2011, 6% by the end of 2013–and thus that further expansionary policies in 2010-2011 would run some risk of overheating the economy in 2013-2014 that was not worth the potential game. He didn’t see the liquidity trap short run as as brief as Marty did. But he also didn’t see the short run as as long as I did–and I have greatly underestimated its duration.

(Someday I want Christina Romer to write up her memoir of late 2009-late 2010, as she wandered the halls of the White House, the Federal Reserve, the IMF, and the OECD, trying to convince a bunch of economists certain that the short run was a year or two that all the historical evidence we had–the Great Depression and Japan’s Lost Decades, plus what we dimly think we know about 1873-9, and so forth–suggested, rather, that it the short run would, this time, be a five to ten-year phenomenon. Yet even with backing by Rinehart and Rogoff on the short run equilibrium duration (albeit not the proper fiscal policy) front, she made little impression and had next to no influence.)

Ahem. I have gotten off track…

My point:

Back in late 2009 I thought that the liquidity-trap short run was likely to be a three-to-five-year phenomenon. It has now been six. And the Federal Reserve’s proposed interest-rate liftoff now scheduled for the end of 2015 appears to me profoundly unwise as a matter of technocratic optimal control, prudent policy, and recognition of the situation. The duration of the short run thus looks to me to be, this time, not three to five years but more like ten. Or more. The backward-propagation of the induction-unraveling of the short run under pressure of the healing rays of the long run Omega Point is not just not as strong as Marty Feldstein thought, is not just not as strong as I thought, it is nearly non-existent.

Thus I find myself getting somewhat annoyed at Paul Krugman when he writes that:

Paul Krugman: Choose Your Heterodoxy: “A lot of what I use is 1930s economic theory…

…via Hicks. And I should be deeply ashamed…. [But] plenty of physicists who still use Newtonian dynamics, which means that they’re seeing the world through the lens of 17th-century theory. Fools!… Farmer is trying to explain an empirical regularity he thinks he sees, but nobody else does–a complete absence of any tendency of the unemployment rate to come down when it’s historically high. I’m with John Cochrane here: you must be kidding…

Or that:

Paul Krugman: Nonlinearity, Multiple Equilibria, and the Problem of Too Much Fun: “Was the crisis something that requires novel multiple-equilibrium models to understand?…

…That’s far from obvious. The run-up to crisis looks to me more like Shiller-type irrational exuberance. The events of 2008 do have a multiple-equilibrium feel to them, but not in a novel way… pull Diamond-Dybvig…. And since the crisis struck, as I’ve argued many times, simple Hicksian macro–little equilibrium models with some real-world adjustments–has been stunningly successful…


Paul Krugman: Learned Helplessness: “We knew all about liquidity traps, and had at least thought about balance-sheet crises…

…a decade ago…. The Return of Depression Economics in 1999. The world we’re now in isn’t that different from the world I suspected, back then, we’d find ourselves in. Oh, and about Roger Farmer and Santa Fe and complexity and all that: I was one of the people who got all excited about the possibility of getting somewhere with very detailed agent-based models–but that was 20 years ago. And after all this time, it’s all still manifestos and promises of great things one of these days…

The problem is that the macroeconomics that Paul Krugman learned at Jim Tobin’s knee wasn’t just 1930s-style Hicks-Hansen Keynesianism. It was the 1970s adaptive-expectations Phillips Curve neoclassical synthesis–nearly the same stuff that I first learned at Marty Feldstein and Olivier Blanchard’s knees in the spring of 1980. That is the framework that Marty is using know, and that generates his puzzlement. That framework had a short run of 1-2 years, a medium-run transition-dynamics phase of 2-5 years, and a long run of 5 years or more baked into it. You cannot–or at least I cannot–just throw away the medium run transition dynamics* and the declaration that the long run Omega Point is five years out, and say that mainstream economics does well. You need to explain why the back-propagation induction-unraveling worked at its proper time scale in the 1970s and the 1980s, but is nowhere to be found now.

And so I am much less confident that I have solid theoretical ground under my feet than Paul Krugman does.

A Reader’s Guide to the Secular Stagnation Debate: The Honest Broker for the Week of October 12, 2015

The very sharp and energetic Peter Passell, who runs the Milken Institute Review these days, commissioned me to write a reader’s guide to the secular stagnation debate. I set it up as a four-corner cage match–Bernanke, Rogoff, Krugman, and Summers–and I am proud of it. (But I have to offer apologies to those–Koo, Blanchard, Feldstein come most immediately to mind, but there are others–who have their own serious positions that are not completely and satisfactorily understood as linear combinations of the four I chose to be my basis vectors.) It is out:

J. Bradford DeLong (2015): The Scary Debate Over Secular Stagnation, Milken Institute Review 2015:IV (October) pp. 34-51:

Bernanke… says we have entered an age of a “global savings glut.”… Rogoff… points to the emergence of global “debt supercycles.”… Krugman warns of the return of “Depression economics.” And… Summers calls for broad structural shifts in government policy to deal with “secular stagnation.” All… are expecting a future that will be very different than the second half of the 20th century, or even the so-far, not-so-good third millennium. But they… [differ on] optimism or pessimism… [and on whether] cautious repairs or an abrupt break with policy as usual [are needed. This] is, I believe, the most important policy-relevant debate in economics since John Maynard Keynes’s debate with himself… which transformed him from a monetarist to the apostle of active fiscal policy.

I think Summers is largely right, but then, I would, since I have been losing arguments with him since I was 20. What’s needed here, though, is not a referee’s decision, but a guide to the fight…


  • Bernanke sees anomalies in portfolio decisions by emerging-market central banks and plutocrats that have generated a global savings glut in the relatively short-run.
  • Rogoff sees overleverage as having created a medium-run period of stagnation that requires active debt-liquidation policies to shorten it.
  • Krugman sees the end of the era of moderate inflation as bringing about a return to “Keynesian” economic structures that require activist fiscal policy.
  • Summers sees deeper problems that call for more in the way of government’s acting as investment-spender, risk-bearer, safe asset-supplier, and bubble-preventer of last resort, and thus extend its proper role beyond that of Keynesian demand-management policies toward what Keynes called a “comprehensive socialization of investment”.

All are serious and live possibilities…