Krugman’s blog, 6/3/15

There were two posts yesterday.  The first was “Backward Induction and Brad DeLong (Wonkish):”

Brad DeLong is, unusually, unhappy with my analysis in a discussion of the inflationista puzzle — the mystery of why so many economists failed to grasp the implications of a liquidity trap, and still fail to grasp those implications despite 6 years of being wrong. Brad sorta-kinda defends the inflationistas on the basis of backward induction; I find myself somewhat baffled by that defense.

Actually, I find myself baffled both theoretically and empirically.

It’s true that the Hicksian framework I usually use to explain the liquidity trap is both short-run and quasi-static, and you might worry that its conclusions won’t hold up when you take expectations about the future into account. In fact, I did worry about that way back when. My work on the liquidity trap began as an attempt to show that IS-LM was wrong, that once you thought in terms of forward-looking behavior in a model that dotted all the intertemporal eyes and crossed all the teas it would turn out that expanding the monetary base was always effective.

But what I found was that the liquidity trap was still very real in a stripped-down New Keynesian model. And the reason was that the proposition that an expansion in the monetary base always raises the equilibrium price level in proportion only actually applies to apermanent rise; if the monetary expansion is perceived as temporary, it will have no effect at the zero lower bound. Hence my call for the Bank of Japan to “credibly promise to be irresponsible” — to make the expansion of the base permanent, by committing to a relatively high inflation target. That was the main point of my 1998 paper!

It’s true that some economists reading this didn’t believe it — basically because they believed that markets would regard any large increase in the monetary base as likely to become permanent. In his discussion of the 1998 paper, Ken Rogoff declared that

No one should seriously believe that the BOJ would face any significant technical problems in inflating if it puts it mind to the matter, liquidity trap or no. For ex- ample, one can feel quite confident that if the BOJ were to issue a 25 percent increase in the current supply and use it to buy back 4 percent of government nominal debt, inflationary expectations would rise.

But even in 1998 we had good reason not to believe this claim; here’s US monetary base and prices during the 1930s:

And a few years after I published that paper, the BoJ put it to the test with an 80 percent rise in the monetary base that utterly failed to move inflation expectations. In general, Japanese experience gave us plenty of reason to realize that macroeconomics changes at the zero bound. So it’s still a puzzle that so many macroeconomists tried to apply non-liquidity-trap logic in 2009 — and just embarrassing that they’re still doing it.

One more thing: Brad says that we came into the crisis expecting business cycles and possible liquidity-trap phases to be short. What do you mean we, white man? Again, we had the example of Japan — and even aside from Rheinhart-Rogoff, it was obvious that Postmodern business cycles were different, with prolonged jobless recoveries.

In the end, while the post-2008 slump has gone on much longer than even I expected (thanks in part to terrible fiscal policy), and the downward stickiness of wages and prices has been more marked than I imagined, overall the model those of us who paid attention to Japan deployed has done pretty well — and it’s kind of shocking how few of those who got everything wrong are willing to learn from their failure and our success.

Yesterday’s second post was “Multipliers and Reality:”

The fiscal multiplier — the increase in real GDP per dollar of government stimulus spending, or the fall per dollar of austerity cuts — has assumed a lot of significance in recent years. When Bernstein and Romer assumed that it was 1.5, Robert Lucas accused them of “shlock economics“, and smeared Romer’s professional ethics. Since then there has been quite a lot of empirical work, which generally indicates a multiplier of about … 1.5.

Now, however, there is an exchange between Simon Wren-Lewisand Robert Waldmann that raises some interesting issues.

Wren-Lewis argues for a multiplier of around one, based not on empirical evidence but on a priori reasoning. Suppose the government builds a school; then

my starting point is to note that because the increase in government spending is temporary, any impact on pre-tax income or taxes will be relatively small relative to a consumer’s lifetime income. As a result, aggregate consumption is likely to change either way by an amount that is a lot less than the cost of the school.

Waldmann counters that there is essentially no reason to believe that consumers engage in the kind of calculation that’s involved here, that real consumption decisions reflect rules of thumb that can easily lead to a multiplier much more than one.

I’m actually mainly with Waldmann on this one, although Wren-Lewis’s analysis is nonetheless very useful. For the point he makes about the implications even of perfectly well-informed and rational consumers was and as far as I know still is totally misunderstood by freshwater economists, who throughout this debate have given every sign of not understanding their own models. Lucas’s attack on Romer rested in part on the claim that government spending on a new bridge would lead consumers, anticipating future taxes, to offset it one for one with cuts in their own spending; this is completely wrong if the spending is temporary.

But aside from exposing the intellectual decline and fall of the Chicago School, is this the way we should go about modeling such things? Well, yes, sometimes, because 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. Ordinary households — and that’s who makes consumption decisions — have no idea what the government is spending, whether it is temporary or permanent, whatever. Consider (from Vox) what the public knows about the biggest new government program of recent years:

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.

That said, I still do believe that the multiplier is not much bigger than 1 — indeed, around 1.5; partly because of the econometrics, but also because taxes and transfers act as automatic stabilizers.



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