Dr. Krugman and Mr. Keynes

In earlier research Dr. Krugman pointed out that monetary policy could be effective in a liquidity trap, as long as it was expected to be permanent. One way of doing that is with inflation targeting (level targeting.) The Fed should commit to a rising price level path, which could lead to lower real interest rates and higher AD. Dr. Krugman recently argued that the Fed is too conservative to adopt such a policy today, and things would have to get worse for them to do so. Of course Ben Bernanke is a student of the Great Depression, and obviously wouldn’t let things get too much worse. Indeed the so-called “QE policy” instituted in March of this year was a tacit admission by the Fed that things had gotten worse, and that more aggressive steps were necessary. Since then the outlook has become a tiny bit better, although it’s hard to say exactly why. (In my view it’s 80% China, 15% QE, and 5% fiscal stimulus.)

What does all this mean? It means that there is a sort of “Bernanke put” on NGDP. I don’t know exactly where it is, but I’m pretty sure we were very close to that point last winter. This also means that any fiscal policy counterfactuals must address the likely monetary policy response.

Every so often Dr. Krugman drinks a secret potion and emerges as the sinister “Mr. Keynes.” One example occurred recently when he argued that without the massive fiscal stimulus, we would have slid into another Great Depression. He used a crude Keynesian model, the sort of model that isn’t capable of explaining the level of nominal GDP. In other words, a model where monetary policy plays no role. Keynesians think this is justified in a liquidity trap, but even the good Dr. Krugman implied that if things got really bad, the Fed might have taken the sort of drastic steps necessary to get us out of the liquidity trap.

What did the massive fiscal stimulus accomplish? Who knows? In my view the Fed would never have allowed a steep deflation. I think Keynesians overestimate the “multiplier,” but let’s say they’re right, and let’s say that prices would have fallen much more sharply without the fiscal stimulus. That would have almost certainly caused the Fed to finally wake up and do something effective. And if they had we might be far ahead of where now, with a budget deficit nearly a trillion dollars smaller.

Just a day later Mr. Keynes showed up again. This time criticizing Bryan Caplan’s argument that the burden imposed on employers by the health care bill might lead to less employment. This seems like a reasonable argument, a simple application of supply and demand. But Mr. Keynes would have none of it. The General Theory mentions the theoretical possibility that higher wages might not reduce employment; indeed Mr. Keynes once suggested it might even increase employment. Few economists take this seriously, but Mr. Keynes’ tone of voice implied that Caplan must be pretty dense if he doesn’t accept everything in the GT as gospel.

BTW, Franklin Roosevelt (one of Mr. Keynes’s favorite presidents) tried a high wage policy 5 times. Each time the policy was adopted during periods of near zero interest rates and very rapid economic growth. And as I showed in this post, each time the policy brought promising recoveries from the Great Depression to a screeching halt. I don’t know about you, but I’m not willing to abandon good old supply and demand for a bizarre theory featuring upward slopping AD curves that was tried 5 times, and failed spectacularly each time.

PS. In the Dr. Krugman post I linked to he hints that the inflation target would need to be higher than 2% to produce robust growth. That is not accurate. Because the SRAS is relatively flat when AD has fallen sharply, right now an expected inflation rate of even 2% would imply very robust expected NGDP growth.

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